China is an investment destination of choice for real estate investors, but its a rocky trip.
Return-hungry institutional investors are sold on the regions potential, compared with predictions of slowing real estate returns at home. Real estate returns in the United States are expected to dip below 10%, possibly down to 7.7% this year from 16.6% in 2006, according to an April report for California Public Employees Retirement System, Sacramento, by consultant Pension Consulting Alliance, Portland, Ore.
Real estate investors have been attracted to Chinas booming economy. The countrys gross domestic product grew 10% in 2006 and is expected to be around 9.5% this year, making it among the fastest growth rates of all major global economies in the region, according to recent research from Deutsche Bank AG, Frankfurt.
China is going through an industrial revolution. More than 40% of the population lived in cities in 2005, compared with 15% in 1950s, and Chinas urban population is expected to grow about 60% to 875 million by 2030, according to forecasts by Deutsche Banks RREEF Real Estate and the United Nations Population Division forecasts, both in New York.
To be a player in the 21st century, you have to be a player in China, said David Rubenstein, managing director at the Carlyle Group, Washington-based alternative investment management firm speaking about Chinas investment climate at the Milken Institutes recent global conference held in Beverly Hills, Calif.
U.S. institutions were among the first investors in China real estate, mainly through regional opportunity funds. Some of these investment managers have entered into joint ventures with local developers.
An investor really needs a strong local partner in order to navigate the numerous rules and bureaucracy, said Howard Altshuler, director at Ernst & Young Hua Assurance and Advisory Business Services, Shanghai.
Real estate money managers now investing in China include:
cING Clarion Partners, which invests in China through its $350 million ING Real Estate China Opportunity Fund. Within the last two months, the fund entered into joint ventures with local Chinese developers Longher Real Estate Development and Gemdale Corp., both based in Hong Kong. (ING Clarion Partners is the U.S. investment management arm of ING Real Estate Investment Management, which has offices in Beijing, Hong Kong and Shanghai);
cHines CalPERS China Interests LP, a joint venture of CalPERS, with $241.7 billion in assets, and Hines Interests LP, Houston, an international real estate firm; and
cMorgan Stanley Investment Management, whose Morgan Stanley Real Estate Fund V invests in China and owns a 5% stake in Chinese developer Shimao Property Holdings Ltd. The fund closed in 2006 with $2.25 billion in commitments. Morgan Stanley Real Estate Special Situations Fund III and Morgan Stanley Real Estate Fund V also have $2.7 billion jointly invested in China, including Hong Kong, according to Alyson DAmbrisi, Morgan Stanley spokeswoman. (Morgan Stanleys real estate investment division has offices in Hong Kong, Shanghai and Beijing.)
JPMorgan Asset Management, Grosvenor Fund Management, the Carlyle Group, Macquarie Capital and INVESCO Real Estate also are developing real estate funds to invest in China.
Over the past several months, investment in China among institutional investors worldwide has begun to grow, Mr. Altshuler said.
Investing in China is, of course, on everyones radar screen, and I think that managers have started to accept the higher risks associated with investing here, Mr. Altshuler said. The investors that got here first have made the very strong returns, so the current investors who are just starting out should consider tempering their return expectations, and also recognize that there is a learning curve to investing in China real estate.
Strong all around
Real estate markets are strong in all sectors and most locations in China, he said. However, returns in the first-tier cities of Shanghai, Beijing and Hong Kong, where most investors seek to invest, have started to drop as more money came into the market and competed for the same properties, he explained.
Because Chinas real estate markets are small, they do not need much to lead to oversupply, said Peter Hobbs, managing director and head of global real estate and infrastructure research of RREEF Real Estate, New York. When supply is high, rents and ultimately, returns drop. For example, new construction in the last decade accounts for more than 20% of the office buildings in China, twice the regional average. So, office rents and vacancy rates have been volatile, leading to uncertain returns.
But there are downsides to the hot market.
Central government control provides a high degree of country risk, according to a RREEF report on China released in March. This is due to uneven regulation of credit, labor and business markets and an uncertain legal structure that makes property rights hazy.
China, as a developing country with a different culture, has many things that just dont work like they do in other places, Ernst & Youngs Mr. Altshuler said.
For example, the federal government can make changes to laws and regulations without advance notice, and the local governments are responsible for implementation, which is not always consistent, he explained.
Political risk is a huge challenge in China, agreed Mark Karlan, executive managing director at CB Richard Ellis Investors, Los Angeles-based real estate investment firm.
China is different from the West or even Japan, Mr. Karlan said. China is nominally communist, but it is the most aggressively capitalist country on the planet.
Another downside to investing in China is that tight controls on foreign investment makes it difficult to get money in and take money out of the country, because they dont want investors speculating on the currency, Mr. Karlan said.
The system is not set up to make Western investors rich, said Carlyles Mr. Rubenstein.
Looking for potential
Experienced real estate managers differ as to which Chinese real estate market they see as having the most growth potential. RREEF Real Estate executives are concentrating on the lower-to-middle residential and commercial markets, Mr. Hobbs said. Grosvenor Fund Management, London, is concentrating on luxury residential and Grade A office real estate markets. ING Clarion Partners, New York, is investing in the upper and middle residential development markets.
Upper-middle market residential development is the only segment with significant liquidity, said Richard T.G. Price, managing director, ING Clarion, Partners, New York. The market for commercial real estate is there, but it does not trade often.
It is important to be able to sell properties and recycle the capital to earn returns, Mr. Price said. Moreover, the residential rental market is mostly composed of foreigners, because Chinese people do not rent, he explained.
People would rather live with their families until they can afford to buy, he said.