Ebb and Flow: The Changing Dynamics of China's Real Estate Investment Market--Jones Lang Lasalle

8/6/2019 Ebb and Flow: The Changing Dynamics of China's Real Estate Investment Market--Jones Lang Lasalle

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Ebb and Flow:

The Changing Dynamics

of Chinas Real Estate

Investment Market


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China investment market outlook 3

Foreign investors buyers return

In 2010, en bloc real estate investment

transactions reached a record USD 15.02 billion,

an increase of 34.6% compared to the year before

(Figure 1). Foreign players shook off the effects

of the global nancial crisis. Those from other

parts of Asia Pacic purchased en bloc real estate

assets worth a record USD 5.1 billion, eclipsing

the USD 3.5 billion purchased in 2007. Indeed,

investors from Hong Kong and Singapore showed

themselves to be nimble, well connected and

aggressive in China in 2010, and we have seen

more clearly than ever the importance of China to

the regions investors.

In 2010, for the third straight year, purchases

by foreign investors from outside Asia were

less than USD 1 billion after peaking at almost

USD 3 billion in 2007. One interesting difference

between the two foreign investor groups has

been how investment purchases by US- and

European-based investors have been extremely

concentrated in Shanghai (Figure 2) while

Asia-based real estate investors have shown a

willingness and ability to purchase assets all over

China. With a relatively limited trading stock of

buildings in Shanghai weve seen ofce assets

like Platinum and Cross Tower trade on an almost

annual basis these foreign investors will be

severely limited if they keep to such a narrow view

of direct investments going forward.

Figure 1. En bloc real estate investment transactions in China by source of capital

China Real Estate Investment Transactions

Purchases(USD

Billion)

02005 2006 2007 2008 2009 2010

4

8

12

16

Domestic Foreign (Intra-Regional, Asia Pac) Foreign (Inter-Regional)

Source: Jones Lang LaSalle

Figure 2. Investors from outside Asia have focused heavily on Shanghai

Real Estate Investment Transactions in Shanghai as a percentage of those in all of China

0%

10%

20%

30%

40%

50%

60%

70%

80%

2005 2006 2007 2008 2009 2010

Purchasesin

Shanghai

Foreign (Intra-Regional, Asia Pac) Foreign (Inter-Regional)

Source: Jones Lang LaSalle

There is genuine concern in the government about hot money

inows now that the Chinese yuan is once again appreciating

against the US dollar. In November and December 2010, the State

Administration of Foreign Exchange (SAFE , )

and the Ministry of Finance and Commerce (MOFCOM,

) issued regulations indicating that foreign

investments in real estate considered to be speculative in nature

may not receive the required government approvals. In our view,

currency appreciation has not been and will not be the major driver of

real estate investment decisions in China. As we will see in this paper, investors both foreign and domestic have strong market fundamentals on their side.

Consequently we do not anticipate the SAFE or MOFCOM regulations will pose

major obstacles in the year ahead.


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healthcare facilities. Given their alignment with

government objectives, we may expect some

innovations in funding and development nancing

for these emerging asset classes like REITs,

funds and trusts, and securitisations to emerge in

the future, with uniquely Chinese characteristics

that adapt them to the local market situation.

Let us rst review the insurance sector as one

of the most high-prole changes of recent years

and a key topic of our earlier paper, The Rise of

Mainland Chinas Institutional Investors.

Insurance companies get the green lightIn August and September 2010, the China

Insurance Regulatory Commission (CIRC,

) issued modied rules on

investment by Chinas insurance giants including

the long-awaited details regarding investment in

real estate (Table 1). The promulgation of these

regulations came nearly one year after the law

was adopted permitting their participation in

the market.

One of the key details in the new regulations

was insurance companies being able to invest

up to 10% of their total assets in property and

property related nancial products, a limit at

the upper end of the expected range. Total

insurance company assets in China were just

over RMB 5 trillion (USD 770 billion) at the end

of 2010, and growing 25% per year (Figure 3).

With a restriction on investment in residential

development projects, Chinas insurers could

theoretically purchase the entire tradable stock of

commercial real estate assets several times over.

In fact, with RMB 985 billion (USD 149 billion) in

new capital accumulated in 2010, a 10% allocation

to real estate (Figure 4) would have enabled

Chinas insurance companies alone to buy the

equivalent of all the en bloc real estate investment

transactions done in 2010. Clearly, however, this

did not happen.

But what will this mean for the market and why

havent we seen much activity from the insurance

companies so far? First, commercial real estate

generally and real estate investment specically,

Figure 3. The total capital of Chinas insurance companies has grown large quickly

China Insurance Company Capital

1Q06

2Q06

3Q06

4Q06

1Q07

2Q07

3Q07

4Q07

1Q08

2Q08

3Q08

4Q08

1Q09

2Q09

3Q09

4Q09

1Q10

2Q10

3Q10

4Q10

0%

10%

20%

30%

40%

50%

60%

1

0

2

3

4

5

6

Gro

wth(y-o-ychange)

Total

Capital(RMBtrillion)

Source: China Insurance Regulatory Commission, Jones Lang LaSalle analysis

Figure 4.At 10% of capital, insurance companies have the potential to makesignicant real estate investments

New Insurance Company Capital for Potential Real Estate Investment

RMB(billion)

5

0

10

15

20

25

30

2Q06

1Q06

3Q06

4Q06

1Q07

2Q07

3Q07

4Q07

1Q08

2Q08

3Q08

4Q08

1Q09

2Q09

3Q09

4Q09

1Q10

2Q10

3Q10

4Q10

Source: China Insurance Regulatory Commission, Jones Lang LaSalle analysis

Table 1: Key regulations regarding insurance company investment in property

Can invest up to 10% of total assets into property and property relatednancial products

Can invest in commercial property (ofce, retail, healthcare), for self-use, and forelderly care use

Minimum 5 year holding period on property investments

No residential development investments or investments in non-listed developers

Must report property investments to CIRC on a quarterly and annual basis

Real estate investment management team must be of a certain minimum size andqualication, though out-sourcing is permitted as a supplement

Investment in overseas real estate assets is permitted


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are relatively new industries in China. Insurance

companies are in a highly competitive market

for both the talent to build their real estate

investment management teams and for the assets

themselves. Several groups, such as Ping An,

PICC, Taikang and China Life, are making good

progress in terms of building their real estate

investment management capabilities. However

it takes more than just people for an insurance

company to invest in real estate. Internal risk

management, compliance, investment portfolio

management and asset-liability matching

infrastructure are needed. Real estate asset

management and property management

capabilities are also required. It will probably be

at least another year before we see insurance

companies showing up in the market in a big way.

Nonetheless, the sheer volume of capital they

have to potentially invest in real estate assets has

impacted the market. Investment yields across

commercial real estate in China are at their lowest

levels ever, even as interest rates have begunto rise. For existing owners of real estate this

has been a boon and the insurance companies

demand for assets promises a secure exit strategy

for years to come. On the other hand, there is

a real risk that commercial real estate markets

in Tier II cities, which already have a tendency

towards oversupply, will see a new speculative

building cycle. This will be the case if insurance

companies do not employ rigorous evaluation,

due diligence and approval standards in their

investment decision making.

Quality making the investment grade?

As Chinas insurance companies build their

capabilities to invest in real estate in a big way,

so too should developers be looking at the quality

of the commercial products they construct. A

lack of investment grade stock will surely be

another limiting factor for insurance companies

going forward. Insurance companies are core

investors for which real estate as an asset class

is ideal as a long-term investment to offset their

long-term liabilities. But for real estate to actually

be a suitable long-term investment asset, one that

maintains and grows in value over time, it should

be designed and built as a quality product and then

be professionally maintained. High quality property

and asset management capabilities, or service

providers, will be essential in preserving the value

of these investments. In fact, one could argue that

until the pendulum in China swings meaningfully

toward valuing income generation and asset quality

over its capital appreciation potential, Chinas

insurance companies should exert as much effort

looking for investment grade assets overseas as

they do looking within China. Today, the relative

risk and return proles for real estate in more

mature Asian and Western markets remain quite

attractive following the global nancial crisis. This

kind of international investment naturally raises a

different set of contingent risks such as currency

and political risks. However, it is noteworthy that

under current regulations, such activity is already

approved (see Table 1).

REITs and RMB FundsWe mentioned at the start of this report that REITs

seemed as though they had been six months

away for several years and enthusiasm about

their imminent approval waxes and wanes like

the seasons. Today there is no reason to believe

that hurdles to the approval of REITs are any

closer to being resolved. It is still not clear if they

will fall under the China Securities Regulatory

Commission (CSRC,

) or the China Banking Regulatory Commission(CBRC, ) and be listed versus

non-listed vehicles. We believe the government is

still concerned about the introduction of additional

large pools of investment capital fuelling asset

price ination. For this reason alone, they may

choose to keep REITs on the sidelines indenitely.

That could spell trouble for domestic groups who

have been accumulating assets to put into a REIT,

expecting their approval months or years ago.

One possibility that could materialise in the near

term is the creation of a REIT-like structure

to nance low-rent housing development.


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While REITs are not traditionally a vehicle for

development projects, this type of scheme in

China would be virtually indistinguishable from a

government bond. The government determines the

yield or margin by setting both the land price and

the rents. It even provides an implicit guarantee on

the REITs cashow through its income subsidies

to the tenants. The major risk lies in the developers

ability to manage the cost of construction. There

have been media reports of a potential REIT similar

to this being considered in Tianjin.

RMB funds, and their ability to invest in real estateassets, also stand on ambiguous legal ground

with regulations being developed on a pilot basis

in Shanghai, Beijing and Tianjin as these cities try

to attract and develop a domestic private equity

industry. A number of prominent foreign fund

managers have established the relevant on-shore

fund management enterprise entities (FEIMCs)

to set up RMB funds, with Prax Capital notably

raising an RMB 600 million real estate fund in

2. Troutman Sanders, RMB Funds in China by Edward Epstein and Kim Tung, November 20103. Caixin online, China Tightens Controls on SOE Property Lending, 6 Dec 2010

4. Xinhua, 20 more SOEs to fully exit real estate business, 22 Feb 2011

What of the 78 SOEs who were required to exit the real estate industry by Chinas State-owned Assets Supervision and Administration

Commission (SASAC, ) last March? In December 2010, China Security Journal reported that banks were notied they should only

make development loans to SOEs if they are among the 16 approved to remain in the real estate industry3. In February 2011, SASAC

provided an update, saying that 20 more of those SOEs will have fully exited the real estate industry by the end of the year, in addition to

the 14 from 20104. We have believed, since SASAC rst announced its intention to bar from the real estate industry those SOEs whose

main business was not real estate development, that the key issue was the rapidly rising price of land. By removing these cash-rich

buyers from the market for land and development, they hoped to be able to curtail both the money chasing the land auctions and

the hubris driving bidders eager to be dubbed Land Kings. We believe this shows the government has taken a multi-pronged approach to taming rising housing prices and we do admit a sense of relief that the SOEs exit from the market

has thus far been an orderly one.

Shanghais Pudong New Area in 2009. Under

regulations effective March 2010, Carlyle Group

and domestic company Fosun formed the rst

foreign invested partnership (FIP), which many

others have since emulated2.

The excitement, though, is in the way the

regulators seem to be responding to the needs of

this fast developing industry in real time, at least

in government terms. Weve seen announcements

on inbound currency convertibility and the impact

of the percentage of foreign capital on the funds

treatment as a domestic investor. However,uncertainty remains, in part, because unlike many

aspects of hi-tech and clean-tech investing, real

estate is not categorised as an encouraged

industry for foreign investment. Still, there is

tremendous excitement among foreign fund

managers because of the huge pools of domestic

capital that can be tapped, such as the insurance

companies, pension funds and high net worth

individuals, and the chance to operate on an


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equal footing with domestic investors. For most

real estate fund managers, their future in China is

in raising capital onshore and then investing that

capital in China and eventually offshore.

Fundamental Opportunities

So with all of these challenges, where are the

opportunities in Chinas real estate investment

market? How will changes in the market

participants, as well as the markets fundamentals,

create opportunities for investors going forward?

Figure 6. Grade A Ofce rents are on the rise

Grade A Office Rent

1Q05

3Q05

1Q06

3Q06

1Q07

1Q08

3Q07

1Q09

3Q08

1Q10

3Q09

1Q11

3Q110

1Q12

3Q11

3Q12

0

1,000

2,000

3,000

4,000

5,000

6,000

G

radeAOfficeRent(RMB/sqm/

year)

Shanghai Beijing Guangzhou Shenzhen

Source: Jones Lang LaSalle (Real Estate Intelligence Service), 4Q10

Figure 5. Strong demand has lowered vacancy rates in Chinas Tier I cities

Grade A Office Market

0%

5%

10%

15%

20%

25%

30%

0

200,000

400,000

600,000

800,000

1000,000

1200,000

1,400,000

Vacancy

GradeAOfficeSupplyandDemand(sqm)

Supply

2006

2008

2007

2009

2007

2009

2007

2009

2007

2009

2010

2012

2011

2006

2008

2010

2011

2011

2011

2012

2006

2008

2010

2012

2006

2008

2010

2012

Net Take Up Vacancy (RHS)

Beijing Shanghai Guangzhou Shenzhen

Source: Jones Lang LaSalle (Real Estate Intelligence Service), 4Q10 Healthy ofce markets

In the ofce sector, just as the market was

beginning to rebound in 2009, we saw the SOEs

be very active in purchasing buildings out ofthe future supply for self-use. Today the ofce

markets in Chinas Tier I cities are healthy, having

enjoyed record amounts of net take-up in 2010

(Figure 5). Vacancy rates improved, dramatically

in Beijings case, and rents rose across the board.

While its much easier for an owner-occupier to

purchase a brand new building, since they wont

have to wait for any lease expirations, investors

prefer stabilised assets with proven tenant appeal.

As more investors become convinced of theimproving fundamentals and outlook for the ofce

market (Figure 6), interest has grown steadily

in this sector. However, there are simply not

that many tradable ofce assets for institutional

investors to purchase. As a result, we have now

seen some assets, like Platinum and Cross Tower

in Shanghai, trade three or more times as capital

values have risen and cap rates compressed.

Bolder investors are now looking for value in

emerging areas within the Tier I cities such as

newly accessible areas peripheral to the CBD.

As the metro systems are built out, they are

seeing development of Grade A quality buildings.


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Others are looking at ways to add value to existing

buildings either through capital improvements to

upgrade well located Grade A and B buildings or

by greening existing Grade A buildings.

In Tier II cities, where whole new CBDs are under

development, we have seen developers turning

to the strata title market in the face of relatively

thin leasing demand. In some cities, investors

with a long investment horizon, such as insurance

companies, may be able to take advantage of

relatively low capital values to buy into

promising markets.

Retail Chinas consumption story

Similarly, on the retail side, terric market

fundamentals have attracted investor interest.

One important distinction, however, is that unlike

the ofce sector, where investors are primarily

interested in the Tier I markets, in the retail sector,

investors have shown interest in well located

assets anywhere in China. This can be attributed

to a number of factors, an important one being

the Central Governments policies to increase

consumption across the entire economy, as

well as steadily rising urban incomes across the

country (Figure 7). In short, Chinas consumption

story is a highly compelling one

and real estate fund managers

and their investors are eager to

be involved.

The retail sector also has a lot of supply

in the pipeline, similar to the ofce sector,

but success in the retail sector is much more

dependent upon successful asset management.

Shopping centres are living assets, needing

to adapt and evolve as market conditions

and consumer tastes change. We believe the

opportunity remains for experienced managersof retail assets to capture outsized market share

even in the face of the coming supply. This is

especially the case for those who have strong

relationships with domestic and international

mass-market brands.

Residential tighter lending environmentwill create opportunities

Much attention has been focused on the Central

Governments demand suppression policies and

their efforts to restrict price appreciation in the

residential market. From an investor perspective

the interesting part actually lies elsewhere. In July

2010, Fitch Ratings released a blockbuster report

on off balance sheet lending by Chinas banks5.

5. Fitch Ratings, Chinese Banks Informal Securitization Increasingly Distorting Credit Data, by Charlene Chu, 14 July 2010

Chinas urban income and consumption growth

0%

5%

10%

15%

20%

25%

30%

35%

0

3,000

6,000

9,000

12,000

15,000

18,000

21,000

PerCapita(RMB)

Growth(y-o-ychamge)

Urban Disposable Income Urban Consumption Expenditure

Consumption Growth

Income Growth

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

Source: CEIC, China National Statistics Bureau, Jones Lang LaSalle analysis

Figure 7. Rapid income growth fuels consumption


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It indicated that in spite of the reduction in headline

lending quota set by the CBRC for 2010, the rapid

increase in these informal securitisations more than

offset the reduction in reported lending. With banks

now required to bring all off balance sheet lending

back onto their balance sheets by the end of 2011,

the reduction in onshore liquidity that was meant to

begin in 2010 will now surely happen in 2011.

This comes at a time when residential developers

are in the midst of a very capital intensive part of

the development cycle, having purchased ever-

increasing amounts of land in 2009 and 2010 atever-increasing prices. Combined with government

policies to encourage them to start construction

more quickly, build faster and complete projects

sooner, the effects of the reduction in liquidity could

be dramatic. For over a year, developers have been

required to put down larger deposits after prevailing

in land auctions. In some cities development loans

and proceeds from presales must be deposited into

escrow accounts that can only be used to complete

construction of that specic project. The prots are

released to them only when the project is nished.

By the end of 2011, we expect residential

developers will be launching new projects

positioned for buyers at lower income levels as

policy headwinds remain strong in the upper

end of the market. There is strong potential for

transaction volumes to increase signicantly for

developers that follow this strategy because the

depth of demand among owner occupiers further

down the income scale is enormous. However,

because of the increase in land prices over the

last two years, margins will certainly be squeezed

and ultimately distress will become more readily

apparent among over-geared developers. We see

opportunities for investors in this scenario. Firstly,

there is an opening for equity joint ventures in some

of these distressed situations and opportunities

for developers who are able to take over entire

projects from weaker players. Secondly, we expect

an increased willingness on the part of residential

developers to consider more reasonable pricing

on the sale of some of their commercial, income-

producing assets from their existing portfolios and

future pipelines.

Ultimately, less domestic liquidity means a returnof cash as a competitive advantage in China and

an even more active investment market across all

asset classes in 2011 and beyond.


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Looking ahead

There are clearly opportunities for investors given the strong market fundamentals. Foreign investors will aggressively chase the momentum

in Chinas retail and ofce property markets, even as the global economic environment remains challenging. As the torrent of onshore

liquidity returns to pre-crisis levels and signs of distress emerge, their capital will once again be relevant. Nonetheless, China remains a very

challenging business and regulatory environment to operate in.

We expect domestic and foreign real estate investment managers to be creative in their approach to Chinas unique status and brand of

state-enabled development going forward. Ofcial encouragement for developing social housing and for foreign investment in hospitals,

along with growing market-based demand for elderly care facilities, will add to these opportunities for institutional investors. Rapid

government driven progress in RMB funds and REITs, along with insurance company investments will bring these new sectors to the fore.

As insurance companies ramp up their operations, their presence will be increasingly felt in the market. Dont be surprised if the government

forces them back to the sidelines of the commercial markets if asset prices rise too quickly. Lower investment yields, along with limitedinvestment grade stock, will lead to new opportunities for raising capital from domestic investors destined for overseas real estate markets.

Chinas real estate investment market promises to be as dynamic as ever in the years ahead.

Please look out for our next report on Guangzhous real estate investment market later this year. In future reports we will update you on the

latest developments in the market whos buying what and where and key issues like the impact of pilot property taxes.

David Hand MRICS

Head of Investment - China

[email protected]

+86 10 5922 1101

An International Director, David is one of the most experienced international commercial property

professionals in China. Based in Beijing since 2001, as the former managing director of the Beijingbusiness, he led a team of 200 professionals and was directly involved in the investment, property

& shopping centre management, leasing, research and consultancy businesses. A frequent media

commentator, David is also an Executive Education Instructor on Chinese real estate investment at

Harvard University (GSD).

Michael KlibanerHead of Research - China

[email protected]

+86 21 6133 5707

A National Director, Michael works with a team of 35 researchers in Jones Lang LaSalles nine ofces

in China covering 20 Tier I, II, and III markets across the ofce, retail, residential and industrial sectors.

With 17 years of business experience, Michael has an extensive background in nance and consulting.

Michael is the Chairman of AmCham Shanghais Real Estate Committee and a frequent commentator on

Chinas property markets.


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COPYRIGHT JONES LANG LASALLE 2011 All rights reserved. No part of this publication may be published without prior written permission from Jones Lang LaSalle. The information in this

publication should be regarded solely as a general guide. Whilst care has been taken in its preparation no representation is made or responsibility accepted for the accuracy of the whole or any part.

We stress that forecasting is a problematical exercise which a t best should be regarded as an indicative assessment of possibilities rather than absolute certainties. The process of making forward

projections involves assumptions regarding numerous variables which are acutely sensitive to changing conditions, variations in any one of which may signicantly affect the outcome, and we draw your

attention to this factor.

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Ebb and Flow: The Changing Dynamics of China's Real Estate Investment Market--Jones Lang Lasalle