Domestic managers make inroads in China

International managers used to dominate the Chinese real estate market. But most of the successful fundraising initiatives in 2013 have been led by domestic specialists, writes Maha Khan Phillips

Real estate fund managers are struggling to reach pre-crisis levels of fundraising in China. The news is hardly surprising. China’s economy has slowed down, and there are, arguably, better opportunities elsewhere. In 2008, 12 new funds closed, raising an aggregate $3.6bn in assets, according to Preqin, the data provider. Five years on, and things look very different. So far, in 2013, only four funds have reached a final close, on an aggregate $1bn. Preqin points out that this is also less than half of both the number of funds that closed in 2012 and the amount raised.

Part of the reason is that China has more competition for yield. Industry participants point out that, in the past, investors have been used to allocate to riskier, more opportunistic funds in the market in the search for higher-yielding products. Opportunistic funds are, by far, the most commonly utilised strategy by fund managers, with 67% of all funds closed since 2011 using this strategy, according to Preqin. But now, investors are getting the same sort of yields in Europe with less risky strategies.

“Funds were increasing rapidly up to the global financial crisis,” says Henry Ching, principal in Mercer’s real estate boutique business. “We had seen quite a few China funds because people were chasing higher returns. China was a big investment theme and there was lots of money pouring in. After the crisis, the market has slowed down a little bit, and you saw a shift in capital back to Europe and the US because there were opportunities there. You can get similar returns from distressed debt in real estate [in developed markets].”

Market dynamics have changed as well. International managers no longer dominate the market. The proportion of funds focusing on Greater China raised by international fund managers decreased following the financial crisis, according to Preqin. In 2007, 75% of funds closed were managed by international managers. In 2009, 100% of the funds that closed were managed by domestic managers. And in 2013 year-to-date, only 25% of funds closed have been managed by international players.

“More money is being raised by China or Hong Kong-based investors to invest in China,” says Andrew Moylan, head of real asset products at Preqin. “Investors at this stage are very much interested in managers with people on the ground. But the fundraising is also a reflection of the general development of the real estate market in China. As it grows, more and more funds are coming to the market.”

His assessment is supported by figures from Indirex, the information exchange for indirect real estate. It offers slightly different data, but reaches the same conclusion. Indirex data reveals that there have been 14 new fund announcements targeting a total capital raise of $12bn with a focus on China (see table). The majority, eight of the 14, will be raised by managers headquartered in the domestic market.

Christina Gaw, managing principal and head of capital markets at Gaw Capital Partners, the domestic specialist that has had one of the few successful fund raises this year, suggests that one of the reasons for the growth in domestic fundraising is due to the uncertainty around bank-owned real estate management businesses.

“During the 2006 and 2007 era, there was bigger money being raised by global managers, and investment bank-backed funds that targeted real estate also raised billions of dollars globally,” she says. “During the crisis, though, many did not do too well. Some of the global players are now exiting the market. As big banks pulled out of the real estate business, more local funds came into it. A lot of investors wanted to start with the bigger names, but as they got to know the market themselves, they looked at local managers to invest in. Now, local managers have more of a track record as well.”

Gaw Capital Partners is closing its Gateway Real Estate Fund IV this month. Its aim was to raise $1bn from investors globally. Industry participants explain that there are only three of four firms in the market that have been able to raise this kind of cash and achieve closings. The rest are finding it more difficult.

Gaw points out that the firm is considered one of the older domestic managers in the market. “We are only an eight-year-old fund manager but, as a Greater China manager, we are considered one of the longer-term players in the market in terms of experience,” she explains.

Gaw believes many newly created domestic funds will struggle, however, because they do not have the operational focus required for investors who have been burnt by the financial crisis and are paying more attention to operational risk. “Things have changed a lot since 2005, with investors placing more emphasis on the operational aspects of a fund, with strict compliance and control these days,” she says. “LPs are focused on the operational support, which might not always be as broad for smaller managers as with some of the global managers.”

But Bhagesh Malde, senior managing director at State Street’s Alternative Investment Solutions Group, says it is a problem international managers grapple with also. “Local knowledge is key,” he says. “There are local regulators with local requirements in these markets. If you are a very large hundred-billion-dollar global manager and you have fantastic infrastructure in the US, when you stretch that out to China or India that infrastructure doesn’t really help you, because you don’t have the local expertise.”

Still, domestic managers have a lot going in their favour. Paul Jayasingha, senior investment consultant at Towers Watson, says the firm prefers local players when it selects managers. “We are strongly in favour of locally-based managers as opposed to Western firms which have teams operating more remotely. This is real estate and it helps to have people that are culturally and locally knowledgeable.”

He also says that there has been a change in the governance approach taken by a lot of funds. “We have seen a big change in the last five years or so in terms of transparency and governance. There are some very good local firms that we think are highly skilled and have good transparency and governance,” he explains.

However, Jayasingha is not convinced that all the funds in the market will provide long-term value. “The broader issue with China real estate is that there are so many funds raising and the size of the funds are getting larger, and I wonder how strong the vintage is going to be versus opportunities in Europe,” he says.

Specialist focus
Another reason domestic managers are faring well is because of their specialist focus. Stuart Jackson, head of real estate in Asia and Europe for Infrared Capital Partners, the HSBC spin-out, says that many pan-Asian funds are having difficulty raising money in the market, compared with China-only funds.

“You have to have a proven track record and a differentiated strategy,” he says. “Platforms which have chequered track records are finding it hard. It is also difficult for pan-Asian managers to be successful in China. If you look at the funds that have successfully raised money, they are China specialists, whereas some of the pan-Asian managers have struggled to get off the ground.”

It is understood that Infrared is currently fundraising now for a new fund, and has received investor interest, primarily from investors in Asia, with some from Europe and the US as well. The firm says it cannot comment on any current fundraising activity, for legal compliance reasons. Its first fund closed in August 2007, with $707m in equity. It has deployed $1.2bn into the Chinese real estate market since its business was established in 2011.

Managers in China are also now moving away from opportunistic strategies they have traditionally employed. “Now that the China market is becoming more mature and developed, we see more investments into other real estate sectors such as logistics and business parks, and mixed-use real estate development, including commercial and retail components for the development,” says Ching.

Almost half of the funds that have closed since 2006 have followed a diversified approach, and 33% and 15% of funds, respectively, have focused on retail and residential investments.

In its September 2013 Investment Edge report, Aviva Investors warns that a Chinese economic slowdown will have implications for real estate and recommends focusing on longer-term growth drivers that are less vulnerable to a slowdown in credit-driven growth. Logistics is a prime example.

“Few areas of China’s property market have better credentials in this respect than its logistics sector, which offers good quality tenants and long-term leases alongside the opportunity to capture China’s consumption power and the meteoric rise of online retailing in China,” according to the report.

The report also advises against investing in tier-three cities in light of the slowdown. But others see opportunities in both tier-three and tier-four locations. In its September 2013 report, Deutsche Bank argues that tier-three and tier-four cities could be better than tier-one cities for developers, although it depends on the execution ability of management.
Tier-three cities have different characteristics – those of lower total amount but high demand for management resources– and some developers have not been successful in their attempts to penetrate the market thus far “because they do not have a good grasp of the necessary business model and operating strategies in tier three/four cities”, according to the report.

Milan Khatri, global property market strategist at Aberdeen Asset Managers, believes that, even with a China slowdown, investors will continue to want access to different levels of the market, and funds will continue to be launched. “When you think about the size of the property market in China today, but also where it might be in 10 to 15 years’ time, it could conceivably be very large. And, in that sense, if you are a long-term investor, like a pension fund, then China has to come on your radar. It might be very expensive to buy core assets, but if you can develop the assets and lease them out, then you have exposure to a vast expanding market,” he argues.

Khatri also believes that the concept of an economic slowdown is relative. “When you have significant size, it equates to opportunity,” he says. “China still has strong economic growth, even if it has slowed down from two or three years ago. Many investors still equate strong economic growth with a strong property market.”

But local funds also have to compete increasingly with institutional demand, from within China, for growth opportunities elsewhere. In September, Gaw Capital Partners announced the creation of a new US entity, Gaw Capital US, which will manage the new real estate funds and provide advisory services for investors looking to tap the US market.

“Asian investors have started to venture overseas into the core asset space, because of the crisis. There are opportunities for core assets at a very good yield. If you look at Asian real estate, the yields are lower because GDP is higher, so there is more upside in actual capital appreciation. Overseas, assets are more mature, fully stabilised, and tend to provide a higher yield,” explains Gaw.

It means that fundraising in China may have slowed down, but over the long term the market still offers up plenty of potential.