Supply-side risks and competition from local investors will be important considerations for investors into China and India where development is likely to remain the principal strategy as Milan Khatri and Glyn Nelson report
India and China have both been gradually reforming their economies, with the ultimate intention of raising living standards. These efforts have been broadly successful, with average real economic growth over the past decade of 7.5% and 10% per annum respectively for India and China. We see further income gains ahead but some supply-side risks.
China and India's growth paths are following the well-trodden route laid by other large Asian economies. The progress of Japan and Korea in the last 50 years indicates considerable scope for both China and India to have income gains in the decades ahead, although the scale of the task is enormous given the vastly higher population levels of the two emerging giants.
On an absolute income basis India has lagged, and continues to lag, behind China. Nevertheless, since the reforms instigated in the aftermath of the 1991 balance of payments crisis, its growth profile has matched that of China from the mid 1980s. Interestingly, India's growth has been balanced between rising investment and relatively high consumer spending. But growth over the past decade has been characterised by a notable slowing in the consumption share of GDP because of fixed investment benefiting from rapid urbanisation. There is significant room for a further scaling up of domestic investment; indeed, it is necessary if India is to progress to a high-income economy.
China's growth model has come under scrutiny for its dependence on investment, and a lack of consumption. Urbanisation and income catch-up has much further to run, and implies a continued emphasis on investment-driven growth to move the economy up the value chain, to increase productivity and provide employment opportunities for labour migrating from the rural economy. However, China's huge economy means that political constraints from its major trading partners, the US and Europe, might necessitate a moderation in growth to forestall protectionist pressures.
A subdued global climate lends itself to more moderate Chinese growth, but is likely to be met with high government-led domestic investment. Consumer spending can help, but we doubt it can be the main driver for a country with low per capita income. India is not close to matching the physical investment engine of China, impeded by domestic over-regulation and under-developed governance. Looking beyond the inevitable volatility of short-term growth, over the next decade China is expected to sustain a large positive income gap over India.
Real estate is still emerging
Economic reform and market liberalisation has kick-started a swift rise in new real estate development, while demographics and wealth creation have been considerable demand-side drivers. Nonetheless, both property markets are still emerging, lagging the wider economic development.
A measure of their evolution is the relative size of their current real estate stock. China has an investment stock that is less than a quarter that of the US. Moreover, China's commercial investment property market is some 30 times larger than India's, according to DTZ. This is disproportionate to the relative size of their economies. But as they become richer, high sustained development will be needed to provide commercial, entertainment and housing stock.
Beyond their actual size, we expect pricing in each country to evolve. Both are large, continent-style markets. When we look at similar sized but more mature markets we find two different styles of evolution. The US is a market with fewer supply constraints than Europe, in part because of a different approach to urban planning. This has made the US a more income-driven market with higher real estate yields than in Europe.
Which model will China and India follow? This depends to a large extent on their respective urban development. In the coming decades construction levels should be robust, which implies that returns on standing investments are likely to be more income driven than delivered through capital growth (mirroring the US), and rental depreciation is likely to be high, reinforcing the trend as new modern stock is rolled into the market. Prime real estate pricing until 2008 broadly mirrored this view. India could achieve a better balance of income and capital returns as yields are starting at a considerably higher level than in China, and have more potential to decline if India delivers steady management of the economy.
The best investment opportunities in India and China are likely to be in development, with the potential to deliver strong capital gains. The risks from rapidly expanding real estate stock might mean that foreign capital is focused higher along the risk curve, even with the evolution of stabilised assets. For the stabilised market, a pricing tension is likely to exist between foreign and domestic capital, with prices higher than foreign investors view as fair value. This is evident in China, where property yields on stabilised assets seem low, although they may reflect, partly, the domestic cost of capital.
Compared with mature Asia-Pacific markets, China and India should continue to offer high returns, however, commensurate with the risk of investing. As emerging real estate markets have higher volatility, are not so open to international capital and are more prone to governmental intervention, we estimate that the risk premium to enter these markets is almost double that of such markets as Australia and Japan.
Development strategies attractive
A key theme for India and China is the supply-side risks from ongoing and substantial urbanisation during the income catch-up phase in the decades ahead. Rational pricing would imply stabilised real estate yields are likely to be high relative to mature markets. However, domestic investors in markets where international capital mobility is still restricted are likely to price stabilised yields lower than foreign capital finds acceptable.
The investment style for foreign capital is likely to target development strategies for some time, rather than the core-style investing seen in the US/Europe. Risk-adjusted returns should remain attractive over the medium term, despite some expected short-term uncertainty.
Milan Khatri (left) is global property strategist, Glyn Nelson is head of property research, Asia Pacific, Aberdeen