Do not be blinded by China's stellar growth. Pay careful attention to transparency and ownership issues, says Kristen Paech
Pension funds investing in the Chinese property market should brace themselves for more downbeat returns in 2008. Tighter government regulations intended to ‘cool' the housing market have inadvertently hit developers on the supply side of the investment chain.
The stricter measures, aimed at adjusting the imbalance between demand and supply and curbing soaring property prices in China, prompted Fitch Ratings to warn of an ease in rising prices, with property developers likely to face more pressure in financing and liquidity.
Describing the sector outlook as "somewhat negative in 2008", Fitch says undersupply has been blamed for overheating within the property market but real demand, "overdrawn" in advance, and investment-driven demand also play important roles due to the expected rapid price increases, creating a self-fulfilling cycle.
"The market will consequently face stricter regulations, and credit tightening will become the normal practice in the sector," says Matthew Kong, associate director in Fitch's Asia corporates team, in a special report on the outlook for China's property market this year. However, the authorities will put more emphasis on addressing supply issues while continuing to curb demand to narrow the demand-supply gap and steady property prices."
In July 2006, China clamped down on foreign investment in real estate in a bid to keep speculative investment at bay. The government raised the ratio of registered capital in property developers' overall investment and increased restrictions on residential property purchases by foreign institutions and retail investors.
Foreign institutions are no longer allowed to use offshore vehicles to invest in Chinese real estate. They must have a fully registered onshore entity to acquire real estate assets which is subject to corporate taxes within China and withholding taxes on profits outside of China, making it more challenging to deploy capital for new market entrants.
Chris Brooke, president and CEO, greater China, at CBRE in Beijing, says the regulations have increased the complexity around asset acquisition. "Asset acquisition is still possible but you need to take into account the different structuring and legal and tax implications around the new regulations," he says.
"You have to have an onshore entity, so it's more time-consuming because it requires quite a lot of government approvals and the government is more focused on approving things that are consistent with its broader objectives. You're more likely to get approval if you're investing in a second tier-city or a sector the government is supporting, like logistics or hotels, rather than luxury apartments."
It is thought that the cumulative effects of the regulations and policies will narrow the demand-supply gap and thereby rein in the escalation in prices. However, in some cities where property prices grew dramatically last year, Fitch predicts considerable property price volatility.
Tightening credit and rising land acquisition costs have also raised entry barriers to the industry and affected property developers' financial flexibility and liquidity. In this environment, small developers or companies that aggressively buy large areas of land at high cost may encounter liquidity issues if the conditions see them become vulnerable to a weakened cash flow.
Despite this, the fundamental reasons for investing in Chinese real estate are sound. In its China Quarterly Update in February, the World Bank noted that growth prospects remain robust in the face of macro policy challenges, including from inflation.
While past performance is no indication of future success, strong economic growth is expected to continue to underpin strong demand for property. GDP in China grew 11.4% in 2007, making it the fifth year in a row with double-digit growth, according to the World Bank.
The Bank projects 9.6% GDP growth this year, down from the previous projection of 10.8% in early September, amid financial market turmoil and increased uncertainty.
The country's rapid urbanisation and high demand for housing is also expected to drive growth in the sector. There are said to be five million people a year moving from rural areas to the cities, with that level of urbanisation forecast to continue for the next 10 years.
In Shanghai, Jones Lang LaSalle says new retail and office sub-centres are emerging, creating more options for occupiers and investors. The four high-priority areas - Xujiahui, Wujiaochang, Zhenru and Huamu - are pinpointed in the official urban-planning scheme of the Shanghai government as official sub-centres.
Steven McCord, manager, research, at Jones Lang LaSalle in Shanghai, says, while Xujiahui is already mature, the newly emerging sub-centres are seeing a wave of new retail and office supply to cater to the day-to-day needs of a growing suburban population.
"With the tide of suburbanisation, retail and office properties along metro lines have great opportunities," McCord says. "However, location alone cannot guarantee success. The retail sector will continue to face the problem of changing people flow to real customers. For the office sector, a clear market positioning is crucial, and we can see that places led by ‘A-grade' clusters such as Hongkou and Changning will likely have a brighter future."
Stephen Hayes, portfolio manager at Perennial Real Estate in Sydney, sees a lot of investment potential in the Shanghai property market. "The office markets are very tight and I think there will be a huge amount of opportunity there over the next five years," he says. "The retail environment is also strong, there is strong real retail sales growth occurring, a huge middle class that's emerging and a lack of quality investment grade shopping centres."
The restrictions around direct asset acquisition and a desire to access local expertise have pushed pension funds down the route of indirect investment via joint ventures and funds of funds.
Brooke says foreign investors are starting to explore strategic partnerships with local developers as a means of accessing the market. "The institutional investor is offering capital markets expertise and expertise in structuring the vehicle, and the local partner is putting in the assets, and they are setting up a joint vehicle," he says.
"That's in the early stages but we're beginning to see that being explored by a number of people. It's an alternative to doing it on an individual asset acquisition basis, which has become more complicated and time consuming with the approval process."
John Su, director of investment strategy in Asia at Goodman Property Investors, says the indirect route may be the easiest approach for pension funds. "Given the nature of pension funds is focused on generating stable incomes to meet liabilities, the emerging nature of China is most likely a diversification play," he says.
"However, high-quality single-ownership buildings with a good tenant profile located in first-tier cities do exist (ie lower risk), but are rarely for sale. It may therefore be easier for pension funds to take the indirect approach, for example funds of funds."
Investing through funds of funds arguably diversifies the risks inherent in an emerging market and lessens the burden of due diligence for the pension fund. In a fund of funds, the onus of researching the best talent, examining how new regulations affect the different market players and consequently taking advantage of that falls squarely on the manager.
Nick Wong, head of indirect/multi-manager business at ING Real Estate Select in Asia, says managers have the research capabilities to identify the best opportunities within the local market's parameters.
"For example, the new rules that have been implemented mean it's not a good time to buy shopping malls, to reposition, but at the same time it opens up a lot of opportunity to invest in second-tier and third-tier cities by co-developing with local developers," he says.
Foreign investors are increasingly looking beyond the first-tier cities of Shanghai, Shenzhen, Guangzhou and Beijing to the second-tier cities, such as Hangzhou, Tianjin, Chengdu, Nanjing, Dalian and Wuhan. Tianjin has reportedly been used as the test ground to launch domestic private equity funds to invest in companies and real estate.
Although the first-tier cities have already seen some sharp appreciation in values across all property segments, Su believes they still have good prospects. "In contrast, the potential for second-tier cities are enormous, but will be driven largely by development projects going forward over the next five to 10 years," he says.
However given the immaturity of the market generally, pension fund investment in second-tier cities may be a bridge too far. "Acquiring offshore holding entities with clear and established ownership structures can help mitigate risks, as can targeting first-tier cities where markets are more transparent and prime assets with good tenant profiles," Su says.
Jones Lang LaSalle's Transparency Index, which ranks countries' property markets, awarded Australia, the US and the UK the esteemed level 1 transparency in 2006, while China was given a low level 4 ranking. The firm also notes that transparency levels "differ markedly" between first-tier cities and elsewhere in the country, with reported transparency scores relating only to first-tier cities.
John Wythe, director and head of life funds and international property at UK investment manager Pruprim, says transparency in China remains a major barrier to investment. Pruprim's Asia Property Fund is the first open-ended core fund investing directly in bricks and mortar. It invests in Australia, New Zealand, Hong Kong, Singapore, Korea and Japan.
Wythe says market transparency would need to improve significantly for Pruprim to invest in China. China has 1.3 billion people; five cities where the population is greater than 10 million, a property market worth US$650bn. Last year participants transacted about $7bn, double that of 2006.
Contrast that with the UK, where the population is 60 million, there is one city of eight million (London), the property market is nearer $1trn and turnover last year was about $100bn - more than 10 times the whole of China - and it is obvious that the opportunities to buy and sell assets are not there to the same extent as in developed markets.
"If you compare it to the IPD Index in the UK where you get clear and transparent performance data, indices don't exist in China, so there is a lack of market information," he says. "That is improving. Recent legislation ensures that now land-use rights are tendered by the government and foreign investors are allowed to participate in that tendering process so all the time there is increased transparency but it's still relatively opaque."
Despite this, land titles remain a headache for pension funds and managers investing in the region. Whereas in most countries an investor is given title to the land in perpetuity, in China the government owns all the land and companies and individuals can only own real estate if they obtain land-use rights in respect of the underlying piece of land.
These rights may be ‘allocated' or ‘granted' and may be reclaimed by the government at any time.
"Effectively you don't own the land in China. All the land is owned by the government and leased out on land leases," says Hayes. "That's materially different to investing in the UK or Europe, where you own the land and there is a lot of inherent value in that land, so that needs to be priced into any equation if you are thinking about investing in China."
Other country risks include changing foreign investment policies, repatriation of profit and tightening monetary policies.
Uncertainty over the repatriation of profit is a concern for foreign institutional investors, with current regulations essentially requiring investors to apply for government approval to liquidate or repatriate invested capital.
Brooke says, while there are clearly regulatory risks to contend with, from a pure fundamental point of view, most of the risks are offset by the strong demand. "In terms of market risk, in isolated geographical areas we may see some oversupply in certain sectors… [But] the risks in terms of real estate fundamentals are relatively low," he says.
"The risk is always that the government might change the rules, but we've had a gradual introduction of these measures, which has been successful in keeping the market growing but at a more