The question for pension funds is not whether but how to invest in Chinese real estate, as Shayla Walmsley reports

There are two reasons to invest in Chinese real estate: macroeconomics and fundamentals. There are a few reasons not to as well, but they tend to be further down the agenda.

First, there is the widespread prognosis of continued economic growth. Despite the concerns of some prominent economists such as Diana Choyleva at Lombard Street Research, macroeconomic growth for the foreseeable future is expected to hover at just below 10%.

"At the moment, the Chinese economy is overheating," says Choyleva. "The authorities have always walked a tightrope because they fear social unrest and any challenge to their power. They're in tightening mode now. The problem is that it isn't a domestic credit boom causing excess liquidity; it's an undervalued currency." Even so, she forecasts continued buoyancy in the short term.

Second, the fundamentals of urban Chinese real estate are broadly positive. From fewer than 15% in the 1950s, the UN Population Division estimates that China's urban population will reach 60% (875m people) by 2030. In the process, it has created 113 tier-2 cities with more a 1m people and three with more than 10m. "Secondary is a misnomer because these cities have huge populations," says Chris Reilly, the Singapore-based head of Asian property at Henderson Global Investors. "They aren't secondary cities in any other way."

The result, according to Deutsche Bank real estate subsidiary RREEF, will be Chinese real estate market growth of around 160% in 2007, compared with eastern European growth of 100%.

If pension funds have good reason to look to Chinese real estate, few are yet doing so - outside the near-mandatory minor allocation to an Asian fund. The exception is CalPERS, which has bricks-and-mortar projects underway through various partnerships.

We see attractive opportunities with experienced managers that understand the markets well," says Jane Delfendahl of the pension fund's global real estate unit.
One reason for CalPERS to invest has been its self-imposed restrictions on investing in listed property companies. Since 2002, it has effectively ruled out Chinese equities via a set of guidelines followed by external managers because of concerns over abuse of labour rights. The real estate unit could in March 2008 ease these restrictions when it establishes its own emerging market guidelines for public and private investments as part of its strategic planning process.

China is not where pension funds are likely to invest the bulk of their international real estate allocations. But Reilly claims that as a region Asia offers enough core real estate to make up 60% of an overseas allocation, with China and India making up the rest.
"Asia is a patchwork of different markets," says Reilly, pointing to mature markets such as Japan, Singapore and Australia against emerging markets such as Vietnam and China. "It's too binary to see it as one market and we don't need to."

If Asian real estate makes up, rather than a market, multiple markets with little in common, you could say the same about China. Investment in Chinese real estate effectively means investment in major conurbations with a shortage of prime commercial. The tier-1 cities - Beijing, Shanghai, Guangzhou and Shenzhen - are the obvious targets. They are, says Chin, "fairly mature, with relatively large investment-grade stock" and more in the pipeline. They also have a large and stable tenant base, and the availability of local and international property consultants. But those to keep an eye on are the tier-2 cities "playing catch-up", he says.

"China is not a one-city country," says Chin, who compares it rather to the US for its "city-level sub-markets". If the real estate market is spreading, the focus on sectors remains specific. If it is investible, it is likely prime office, luxury retail (and its associated logistics) or hotels across the spectrum from budget to high-end. As markets go, that is plenty to play for.

There is office, but not enough of it and much of what there is - even the recently constructed variety - is poor quality, and what RREEF describes as "functionally obsolete" for "more sophisticated and more demanding" tenants. The result has been a flight to quality.

Prime retail is even scarcer than prime office - and as much in demand. The opening up of the sector to foreign investors, combined with the existence of a significant spending class, will underpin strong rental growth. Retail rents in Shanghai rose by around 30% in 2006 as a result of demand driven by international retailers.

Many investors see not these but hospitality as the investible segment du jour, driven by inland and international tourism, and increased business travel. By 2020, the World Tourism Organisation forecasts that China will become the world's top tourist destination with 130m arrivals: it certainly has Asia's fullest hotel development pipeline. "The dominance of international hotel operators in the high-end sector and business class hotels will continue, given their established brands," says Chin. "Extensive client and marketing networks, and experienced hotel management teams, put domestic operators at a disadvantage."

Delineated sector trends tell you what is investible but they do not necessarily explain what makes a pension fund invest.

It would be hard to overstate the impact of the familiarity factor on pension funds' willingness to invest in Chinese real estate. Anthony Tam, deputy tax managing partner for southern China at Deloitte, expects the market to become "more and more transparent and be akin to the US and European market in the next four to five years". It is a somewhat optimistic prognosis, though the government is undoubtedly showing willing.

In one of its recent circulars, it required that local authorities responsible for approving foreign invested real estate development projects keep the ministry of commerce (that is, central government) in the loop - probably a first in China.

Yet despite government moves to regularise the legal structure, there remains a shortage of market and performance data. A report published by Deloitte in August highlighted the risks - most of them common to emerging markets - including lack of transparency, the legal system, the transaction process and the liquidity issue. The firm claims such details can ‘make or break' Chinese real estate investment.

The irony of China is that it requires pension funds to invest indirectly in a market with little or no culture of indirect investment.

"Investments from Europe tend to be as passive investors, mostly through real estate funds or real estate investment trusts, which are active in investing in office buildings and development projects in China," says Tam.

Those funds are run by managers reliant almost entirely on local fixers. Tam suggests that European investors demonstrate savvy when it comes to the essence of investing in Chinese real estate effectively by keeping well out of it. "When it comes to investing in China European investors generally rely on outside professionals to do the legal and financial due diligence," he says.

That creates another problem - one that has not yet appeared high on the agenda but is likely to at some point: the shortage of Chinese real estate talent. HSBC Investments, which had planned to hire a Chinese specialist for its fund selection team, earlier this year ‘temporarily' gave up the search after failing to find a likely candidate.

Will the obstacles deter determined investors? As long as the government makes investor-friendly noises and urban populations do not head back for the hills, it is unlikely. Robert Gibb, head of communications at property firm DTZ, which recently acquired its Chinese partner, says that as a market for acquisition "China isn't really more complex. The reality is that every country has its own culture and its own regulations."