In spite of a recent wobble in China's stellar statistics, transaction volumes are increasing and the end of the year may present good opportunities. First, foreign investors must negotiate the obstacle course that is the government approval process, as Paul Benjamin reports

Growth of 8% seemed unrealistic a few months ago, but China has seen something of a turnaround in the past six months, and the consensus now is that it's likely the target will be met, both this year and next. Year-on-year GDP growth rose from 6.1% in the first quarter of 2009 to 7.9% in Q2, and July showed improvements in output, trade and retail sales.

Western countries undergoing true, technical recessions would murder for a growth rate that was in the black by even a few decimals, but for China, which posted a 13% GDP increase in 2007, 8% still amounts to a significant slowdown.

The recent upswing in growth has largely been fuelled by massive bank lending and quantitative easing. Since last October the government has pushed 4 trillion yuan (€412bn) of fiscal stimulus into the economy, while total lending by Chinese banks passed US$1 trillion (€700bn) in the first half of the year. Some analysts think that 15% of that sum has gone into stocks and property. And The World Bank estimated that up to half of China's GDP growth was now reliant on government-related spending. Deflation is deepening and there are concerns about weak export demand from an anaemic world economy.

There are concerns that an asset-price bubble is being created, and questions are being raised over the sustainability of persistent massive bank lending. In mid-August the Shanghai stock index, which has been one of the world's best performers in 2009, slid over doubts about government direction, prompting Premier Wen Jiabao to say that the state would maintain its loose fiscal and monetary position.

Real estate prices have picked up this summer and July's figures showed China's urban property prices in 70 cities rose 1% from a year earlier, extending June's 0.2% increase. Prices actually dropped in certain cities, but the trend in Beijing and Shanghai was fractionally up on last year.

Paul Hart, executive director with Knight Frank in Hong Kong, says: "A staggering amount of liquidity has gone into the Chinese economy. There's been a strong correlation in M1 monetary supply and residential prices. It's like a can of Coke that froths up fast and goes everywhere. Money has had to find a home and interest rates are very low on savings at the moment. There are many positives about getting growth back into the property market, but I am nervous that the bank lending cannot be sustained and will have to contract."

And Chris Brooke, president and CEO of Greater China at CB Richard Ellis in Beijing, says: "Transaction volumes have increased significantly from February onwards. This is partly liquidity driven but also by a consumer view that there will be inflation. The alternatives that people have for investment products are very limited. Many developers are clearing inventory so there are limited price increases. Shanghai has been particularly strong. Shenzhen and Guangzhou have bottomed out and there's been a bit of a bounce-back."

In mid-August China Vanke, the country's biggest listed property developer, announced that it expected a greater supply of new homes later in the year in a robust market, and said it would revise up its 2009 target for housing starts. "Market supply is expected to grow substantially at the end of 2009. By that time, the issue of insufficient new housing supply will be alleviated," says company president Yu Liang.

So in many ways the Chinese real estate market looks positive and encouraging, although how long recent gains will last and how far they will go remains uncertain. The good news is that the government is mindful of creating another bubble like the one of late 2007, and is keen to avoid the kind of painful policy clampdowns it introduced then to cool speculation, increase regulation and dampen the market. With the recent real estate comeback still looking tentative, no crackdown is expected on the sector in the near future, especially given its importance to the overall economy - some say it accounts for a quarter of all investment.

At the same time, clear and dissuasive checks are in place. The China Banking Regulatory Commission ordered domestic banks to charge higher interest rates on mortgages for buyers of second homes and requires down payments of 40% of the purchase price. It also told banks to limit credit to real estate developers. Checks on bank loan quality will also be made to try to reduce non-performing loans, which are another concern.

Wilfred Wong, Greater China executive chairman, Pacific Star Group, adds: "People realise that if prices rise too fast the government may step in. At the moment developers are willing to unload stock. The threat is that if this situation continues developers will have to replenish their land banks. Everyone is expecting that in the next two years land prices will go up."

Investors looking to get into China face a wide range of geographical options in the world's most populous nation of 1.3bn. For starters there are the two dynamic former colonies on its south coast - the gambling haven of Macau, which is now out-earning Las Vegas for some casino operators, and the vibrant centre of Hong Kong, traditionally the Asia HQ for many multinationals and a strong global financial centre. And for some the term China still covers Taiwan. Although in reality it is a separate political and economic entity, it remains culturally Chinese and its leaders have recently been forging free trade agreements with the mainland, strengthening close economic ties.

In mainland China, foreign investor interest started near Hong Kong in the Shenzhen Special Economic Zone and its more historic neighbouring city of Guangdong (formerly known as Canton), back when Deng Xiaoping first opened this ancient country to freer market economics in the mid 1980s. The capital, Beijing, with a population of 17m and still pumped up from infrastructural boosts that came with the Olympics last year, is an obvious and important centre. The flagship metropolis of Shanghai, with a population of 19m, sits near the mouth of the Yangtze River, an important manufacturing region. Beyond these primary options lies a huge array of secondary and tertiary cities. A review by property advisers Knight Frank identified 57 cities with a population over one million and per-capita GDP above US$3,000. Many of these are provincial capitals such as Chengdu and Changsha, others are major cities located much nearer Beijing and Shanghai, such as Tianjin and Hangzhou.

For a long time it was China's coastal region that led the mad dash for growth but a mixture of catch-up, government policies to redistribute growth, and the growing importance of raw materials in China's interior helped the central and northern areas overtake the coastal regions in terms of GDP growth in late 2007.

This has created real estate opportunities across the country, and although there has been a slight flight to capital back to Beijing and Shanghai since the downturn, the potential of other cities remains strong.

Pacific Star's Wong says: "In second and third tier cities residential prices haven't gone up as much as in first tier. People are still coming in from the countryside and there's a middle class looking at trading up. There's a lot of mobility in these cities."

Knight Frank's Hart adds: "There's still interest in the development side for quality residential in second and third tier locations, and we're reasonably upbeat that it's sustainable. Opportunities for retail in these markets are good and the supporting logistics are getting easier to find. However, there's often no shortage of land, so it's easy for product to be duplicated, which can make it difficult to control supply."

Summing up the China outlook, James Buckley, head of Asia Property multi manager with Schroder Investment Management, says: "Late 2009 should provide an excellent time to invest for medium-term to long-term investors. China's economy is recovering, not evenly, but the recovery does seem to be spreading to more sectors. The office market is overheated and the best opportunities will be in the retail and residential sectors.

"There has been a stronger than expected recovery in residential sales in the first quarter, driven by pent-up homebuyer demand and sharply lower mortgage rates. Absolute inventory level is trending downwards and prices are beginning to stabilise. There will be prices firming in some cities but not throughout China. Chongqing, Nanjing and Shanghai's inventory levels are below the national average and are the cities that stand out.

"Excluding Beijing, where there is an oversupply, the retail sector continues to be the most resilient on a relative basis. We're particularly interested in non-discretionary retail rather than luxury. The sector has been underpinned by a general lack of good-quality retail malls, particularly in many of the tier two cities, as well as retail sales that have been holding firm. We remain cautious on the office sector because of the supply outlook and strong contraction in demand. New Grade A supply as a percentage of 2008 stock in Shanghai and Beijing between 2009 and 2011 is 64% and 39% respectively, which puts the supply picture into perspective."

With considerable variations between sectors and cities, a good understanding of local markets is essential, and CBRE's Brooke says: "The main challenge is finding good product. It's getting more competitive with more domestic interest. To find some of the returns that some of the funds were originally set up to achieve is becoming difficult."
REITs do not yet exist in China but could arrive by the end of this year or early next. One analyst fears Chinese investors would treat them with too short-term a focus, dumping them if they did not perform, and that the fund would suffer as a result.

Cultural differences remain great and expatriates can find it difficult to work with the economic and political nationalism that drives many attitudes and policies. The opaque legal system can be bewildering, and many foreign businesses operating in China were unnerved this summer by the arrest of steelmaker Rio Tinto executives on suspicion of stealing trade secrets and taking bribes.

Disparities between central and local government policies can also be great, and this can work to a developer's advantage where the local officials are more relaxed and encouraging of development, especially during this challenging period.

Liu Ming, senior associate in Shanghai with global legal firm Clifford Chance, which has a strong foundation in real estate in China, says: "The largest obstacle for foreign investors is still the government approval process. In China, foreign investment is subject to the approval of NDRC (National Development and Reform Commission) and MOFCOM (Ministry of Commerce). In addition to the normal approval requirements, applications for foreign investment in China's real estate sector usually attract stricter scrutiny from both NDRC and MOFCOM. For example, until recently, all foreign-invested real estate projects have required review by MOFCOM even if they have been approved by local governments. This in effect means that MOFCOM has the final say, and as a result the whole approval process can be time-consuming and complicated.

"This also gives rise to a transparency issue, as the foreign investor has no control over the approval process. Officials dealing with the application may follow certain internal policies or quotas which are not necessarily published."

Ming adds: "It may be necessary for the foreign investor to engage a Chinese partner, especially one with a strong track record, such as a large state-owned enterprise, in order to increase the chance of the investment project being approved. However, the dilemma is that, usually, the ‘stronger' the Chinese partner is, the less keen it will be to allow the foreign investor to have control over the joint venture."

Chinese developers also have issues in dealing with officialdom, but there are indications that their stance towards foreign investment has eased recently. Ming sees no reason why they should not soften further.

Whatever the difficulties on the ground, the fundamental allure of China cannot be ignored, particularly when subdued optimism is growing around a strengthening economy. As Knight Frank's Paul Hart puts it: "Those looking for stability at the moment may end up with stagnation, but China is still a growth story."