Real estate fund managers see a big opportunity in China, but are seeking to capitalise in different ways, writes Maha Khan Phillips

Investing in Chinese real estate is never a straightforward business. It is a policy-driven market, where government intervention is high. There continues to be concern about a housing bubble and about the overall macro-economic environment. But real estate managers are optimistic about the future.

"There is no question that the economy is going through a period of hardship which could be tough in the short term," says Richard Barkham, group research director at Grosvenor Fund Management. "But if you have 8% GDP growth in China and Chinese inflation is 4-5%, then that gives you a 10-13% nominal GDP growth, which is going to drive up value in the long term.

"China is a brilliantly developing market with a lot of positive fundamentals, but there is going to be volatility along the way. If you are prepared to buy assets and hold on for 10 years, you are going to do very well."

In 2010, the Grosvenor Vega-China Retail Fund made its first acquisition, a 126,000sqm retail development in Shanghai. "There's a large amount of construction taking place in China, but particularly within the retail sector. Consequently, there are opportunities there, but you have to be aware of the development environment and the potential competition nearby," Barkham says.

It is easy to see why real estate managers are keen to make inroads into China. In a low-return global environment, fund managers say they have seen IRRs of up to 20%. For yield-hungry investors, China is important. And so fund managers are gearing up.

In May, Aviva Investors bolstered its Asia presence with the appointment of former BlackRock director Elysia Tse as senior vice-president of strategy and research in its Asia Pacific Real Estate business. Ian Hally, chief investment officer at Aviva, says: "The Asia Pacific region has become increasingly important to the global real estate asset management market, based on client demand for exposure
to Asian markets."

Glyn Nelson, head of Asia Pacific Property Research at Aberdeen Asset Management, which runs a property fund of funds business in Asia Pacific, says many international funds are interested in raising money. "Some of them have a track record, and some don't. Some are partnering and doing joint ventures. It's an area where there is a lot of interest and activity."

But investors also see China as an emerging market, with real estate investments higher on the risk spectrum. Fund managers say this is not the whole picture. China is a large country that offers opportunities ranging from core and core-plus to value-added and opportunistic, and so investors have a lot of options.

"Depending on the risk appetite for an individual investor, some of the investors focus on first-tier and some more adventurous go for second-tier cities," says Thomas Au, head of Asian real estate research at Invesco Real Estate Asia. Invesco currently manages $8bn in Japan, China, and Hong Kong.

Au adds: "People look at China as a pure emerging, high-return, high-risk market. Now there are investors who are looking for more income growth, who are buying into income generating properties, not just global investors, but also insurance companies."

Invesco has a range of targets in the country. "Development has always been a major strategy, particularly in the residential sector, despite the headwinds in the market due to government controlled measures. Underlying demand is still very strong. We think there will be pent-up demand," Au says.

For several years, analysts warned that China was in danger of a housing bubble collapse because of government interventionist policies. Most analysts now feel these fears have been exaggerated, although Henry Ching, principal in Mercer's real estate boutique business, warns that there are still short-term concerns.

"Short term we would not recommend residential to our clients," he says. "But if you believe in the long-term economic strategy, with China's GDP growth higher than anywhere else in the world and with a trained and committed work force, then it's different, especially from a homeowner's perspective.

"The long-term fundamentals for commercial properties are still here, even if there is a lot of overbuilding. It's hard to see any meaningful drop in occupancy for prime assets in Beijing, Shanghai, and even major second-tier cities. Entry pricing is always a challenge. For residential, we incline to take a wait-and-see approach."

But fund managers say there is tremendous opportunity. AXA Real Estate is looking to make its first investment in the market this year. It wants to diversify its €42bn portfolio, which consists of mostly European assets. It has partnered with Ping An Trust & Investment.

"Our strategy in China is to focus on mid-tier residential," says Frank Khoo, global head of Asia at AXA Real Estate. "The government is trying to engineer a soft landing and for us this is a great opportunity to work with the government to acquire land. Demand is strong, there continues to be urbanisation and growth in the middle income.

AXA Real Estate prefers residential because of urbanisation trends. Khoo says: "For the first time in history, there are more people living in the cities than outside," he says. "This is projected to grow to about 65-70% over the next 10-20 years. If you look at a population of 1.2bn people, a 10% move is 120m people moving. As middle-income salaries increase, people want better products and are upgrading to better houses. For us, this is definitely not an income play because we are building and we are developing, and trying to sell. We are looking at returns of 18% and above, so for us it's a capital play."

BCA research, the independent research company, suggests that fears of the housing bubble are inflated. Mortgage interest rates have been lifted and lending standards significantly tightened. Developer's access to credit has been sharply reduced, and investment demand for properties has been essentially banned in most cities.

What about offices? "The office sector is appealing without doubt," says Nick Cao, national director at Knight Frank in China. "There is the expansion of multi-national companies, and the growing demand from domestic companies."

The sector did have a difficult few years, however. "After the Beijing Olympics there was a considerable amount of oversupply, followed by the global financial crisis. Vacancy rates spiked to 25% to 30%," says Graham Zink, managing director at Knight Frank.

According to Knight Frank, in the last quarter of 2011 foreign direct investment in Shanghai reached an all-time high of $2.55bn. This brought the total foreign direct investment in 2011 to £12.6bn, an increase of 13% from 2010. As a result, grade-A office space remains strong.

But Shanghai is not the only place where there are opportunities. Jones Lang LaSalle highlights 50 cities, ranging from tier-one to tier-three, where there will be commercial real estate opportunities over the next decade. "We wanted to make the international audience aware of the potential of the markets other than Shanghai and Beijing," says Jeremy Kelly, director in the global research team. "We do expect that investor focus will shift to the second and third-tier cities, and we expect the China 50 market to have transactions of around $20bn a year. That's the equivalent to the annual turnover of central London, in terms of its real estate transaction activity."

But investors need to know the market and its challenges. Pam Alsterlind, a partner and co-head of the private real estate business department at Partners Group, which has invested $400m in direct and secondary investments over the past five years, points to several challenges. For one, China is a policy-driven market where approvals take time. It is also a challenge to find a good local partner. Partners Group has invested in residential in tier-two and tier-three cities, as well as in office developments in tier-one cities.

Nelson says fund managers are aware of China's macro-economic situation, and the risk premium that goes with it. "You should expect volatility and policy intervention, policy loosening as well as policy tightening. That's just part of China, and there's a risk premium people need to add on when investing."

Au remains untroubled. "Regulatory challenges continue, particularly in the residential market," he says. "There's always the macro risk of a hard landing too, but we don't ascribe to that. We think that there will be a slowdown, but that the Chinese economy has a lot of options to safeguard."

It is worth mentioning, however, that even with a slowdown, economic growth in 2011 was 9.2%, according to RREEF.

Given the global market outlook, it is easy to see why the China story is so compelling.