- Guest Writer Zhou Ji Ming

While attending a recent industry event, the conversation again turned to the probability of China introducing REITS this year as an alternative fund raising vehicle for real estate companies. The general consensus was that, at the moment at least, a number of competing factors are making introducing a REIT class in China a difficult decision to take.

While there are currently no REITs listed in China, several REITs do own assets here which have been injected into HK-listed REITs, which has given rise to hope among developers and investors that new investment options will emerge, there are currently no clear indications of when the first REIT will appear in the market.

Regionally, REITs have been badly hurt in the 2nd quarter, as values of Hong Kong-listed REITS alone show that almost everyone down as much as 29% and many down 20% or more by mid-June. The one shining star – GZI – fell only 9%.

In China, the government’s economic stimulus measures and increased lending over the past 3-6 months have helped drive sentiment – and buying of property – so that developers are feeling less financial pain than they were one year ago, while consolidation of smaller developers that was also expected at that time has failed to occur. Taken as a whole, one might conclude that industry players remain strong and have no dire need for additional sources of financing, and that enough has been done by the government to support this key pillar of the national economy.

That being said, it is worth looking beyond the industry to get an indication of why REITs are the next show to drop. Consider what REITs could mean for the equity markets.

In late 2008, the discussion of allowing insurance companies to invest in real estate was raised during a revision of China’s insurance law followed by January 2009’s announcement by the State Council Information office revealed government plans to launch REITs.

The announcement did not, however, indicate a specific timetable for listing the first public real estate trust in China. What matters though is that a new class of REITs would provide additional avenues through which large insurance companies could invest huge amounts of premium capital to invest, the same capital which is pushing the Shanghai index up and up in recent months.

But what does this mean for the small investors?

Culturally, Chinese individual investors tend to purchase their own real estate rather than a fund expecting to use the property and possibly to provide strong longer-term equity returns. But they do not necessarily seek strong short-term yields, so attributing buying behavior to the yield argument would be a mistake. Therefore, I do not believe that the individual Chinese investor will necessarily be drawn more heavily to a REIT product than to a well-known and established Chinese property company such as Vanke (00002). Why buy the REIT, they ask?

In terms of what REITs would mean for the broader equity market, it is reasonable to assume that a portion of the liquidity propping up the Shanghai index at the moment will shift to a REIT but predicting how much new liquidity will be attracted

The most meaningful metric to watch, I think, will be the impact that an entire category of REITs could have on bank lending in China. Presumably, a high quality portfolio would be able to attract cheaper capital and provide higher credit quality debt to their bankers in return. Over time, if investors are able to migrate toward a higher credit quality class of REITs issuing equity calls then banks will be left to compete only for less well established borrowers, reducing the credit quality of their portfolios.

In reality, however, the amount of REIT equity available to investors is unlikely to significantly impact bank lending. Operationally, the possibility of listing a portfolio on the equity market will provide the motivation for property owners to set and achieve higher operating standards across their property management, if not already doing so.

The great thing about REITs is that it does not take a genius or number cruncher to evaluate the portfolio of one. With a little ingenuity, anyone can quickly build a stacking plan, a tenant profile and forecast reasonably – sometimes very accurately – the security of the rental income or cash flow of the portfolio.

It is only likely that a bubble would form around a REIT product is if the Trust can demonstrate the potential of strong rent increases and very stable occupancy over 12-24 months. Assuming the portfolio of the REIT includes Shanghai or Beijing comer properties, the current environment of declining commercial rents is not likely to support a strong yield once a REIT is introduced on the market. I cannot see investors large or small of getting overly excited beyond the initial interest a REIT listing would draw.

The short-term upside a listed REIT provides the market will be limited and will probably have little impact on small operators of virtually all property classes. I anticipate that a new REIT listed portfolio will be comprised mainly of quality office or industrial properties as they tend to provide the most predictable, stable and credit-worthy cash flows. Until multiple REIT products in each property class (industrial, commercial office and residential) emerge, smaller players will be at a disadvantage.

Later that week, while walking from Xintiandi to Huai Hai plaza (roughly 1km) to an event, I took out my iPhone camera to capture one of those moments where I realized that all the good economic recovery news was not translating to the street.

In short, over the course of my 1km journey, I captured roughly 15-20 open retail spaces (recently vacated and going through fit out) that highlighted a simple point… that things are not what they seem.  That, even as some still look to China to be the consumers of last resort and as a source of potential economic catalyst, the fact that there are 15-20 open retail spaces available along one of Shanghai’s busiest retail zones is not only discouraging, but shows that consumers are not going along with the plan unless there is a deal.

There was a time when the only coffee outfit was Starbucks, and its knock off SPR.

Along Nanjing Road, the highest concentration existed with 5 stores between the Portman hotel and People’s park, and in total there were roughly 80 by the end of last year (as you can see from the map above).

Over the last 18 months though Starbucks’s hold on the market changed. Dramatically.

Leaving aside the recession for a moment, and the fact that a tall latte goes for 28RMB, the growth of Starbucks has been eclipsed by the by new entrants: Costa Coffee, 85c, Dunkin Donuts, and others. It is a market that in many ways was made by Starbucks, that others have learned from, and in the case of the Taiwanese 85c brand, looked to take away.

At first, 85c was a single store on the less than traveled corner of Maoming Road and Weihai Road (.5 km south of Nanjing road). A store that perhaps drew few glances at first from the folks at Starbucks, but within a week, it was probably clear to executives on Yishan road that they were witnessing the birth of a strong competitor.

The cakes themselves were measurably better than the local alternatives one would find at some of the other cake shops, and the bread variety was quite good (the Parmesan bread is fantastic!), but it was the 7RMB bubble teas and coffees that were growing in popularity. Everyone was talking about it, and myself and a few others quickly looked at the website and talked about taking up some of the licenses that were being offered up for the new stores.

It was the birth of what will shortly be the largest cafe in Shanghai, and the recent CHAINA article Watch out Starbucks, 85c is the new kid in town in China has a very interesting interview with one of its executives detailing its recent growth,

Q: When did you start the business in China?
PZ: We opened our first store in Shanghai 2 years ago. We now have 42 stores, 31 are in Shanghai and the rest are in Hangzhou and Suzhou. We are planning to open another 91 stores in Shanghai by the end of the year. We built our factory in Song Jiang in June last year.

What it is going to take to support that growth.

Q: Why did you choose Song Jiang as the location of the factory?
PZ: We needed a place big enough to accommodate us. We have around 6,500 square meters, which has the capability to supply 60 stores. Since we are growing so fast, a key issue that we face is how to supply the growing number of stores. We have already found a venue in Hangzhou which is 10,000 square meters in size and we’ll soon build an-other factory there.

.. and the logistics that goes into supporting the stores

Q: How do you manage logistics to each store?
PZ: Currently our 42 stores make their orders every day before 10 a.m. based on their previous day’s sales. Then our factory works 24 hours a day to make the delivery be-fore the following morning since our products have a short shelf-life. We need to pre-set product specifics on each item into our ERP system. So if I need to produce 1,500 pieces of cake today, then the system will tell me how much butter and dough we need and so on. Before 4:00 pm the same day, the products will be ready and around 7:00pm, we’ll make the delivery of the frozen cakes from factory to each store. At 2:00 am, we’ll make the second delivery of the day of normal-temperature cakes.

An interview that is interesting from many angles (Successful China business case, Retail Logistics, Branding, and real estate), I found the dialogue very interesting, telling, and was amazed to see just how profitable one of these stores could be:

What’s the average sales revenue of a store?
PZ: The best shop can have revenue of RMB1.9 million per month in Shanghai, while our store in the US, can do in excess of USD 400,000 per month.

Read the rest of the article here

- by Zhou Ji Ming

Life among Beijing’s commercial office landlords these days is tough at the moment. With vacancy rates expected to climb above 25% during Q3 and average rents falling to below RMB 200 per square meter per month, landlords are facing potentially the toughest situation any landlords have faced since office rents in Shanghai took the dive in the late 1990’s. Lets have a look at some of the factors which are exacerbating the situation:

First, demand is not high at the moment. Over the past several years in Beijing, what industry experts call ‘take-up’ (how much space is actually leased by tenants) is around 600,000 square meters. This year it is expected to fall but only slightly. But the hidden danger exists with those tenants who leased large space (2,000 sqm plus) within the past 2 years. The smart ones are going back to their landlords now and renegotiating lower rents, which landlords must take seriously. There is no reliable measure of how many tenants are in this upper-hand position currently.

Second, supply continues to expand at a rapid pace. From 2001 until now absorption (how much space is leased to tenants) falls somewhere in the 500,000 square meter range, too. But according to the chart below, this year Beijing will see more than 900,000 square meters of new office stock. Several of these projects are already completed while Parkview Green, CWTC III are largely completed but with quite low occupancy rates, if judged from simply looking in from the ground level on the site.

PROPERTY ( Sqm.)
World Financial Centre, Beijing (156,000)
China World Trade Centre III (120,000)
China Overseas International Plaza (100,000)
International Financial Centre East Towers (93,220)
Parkview Green(88,000)
Phoenix City Office Tower 1 (30,000)
Central Point (90,000)
Chaoyang Plaza (124,020)
Raffles City (83,000)
Pangu Plaza (89,000)
Total GFA 973,240

Another specific example of what has occurred in certain buildings is the anemic leasing effort at Guanghua International, located within the Central Business District. Seven months ago the three-building complex was lacking even 1 commercial tenant. Today they have 4 tenants; actually 2 office fit-outs and 2 lonely retail tenants (Costa Coffee and Societe General retail branch).

In terms of performance, a clear distinction can be drawn between those properties built and occupied prior to 2008 and those that have arrived on the market in the past 12 months. What remains significant is not on only the number of new commercial office and retail complexes arriving onto the market in 2009, but rough an equivalent amount being released in 2010, which is said to be an additional 900,000 square meters of space.

The critical issue for owners is the declining valuations in their overall portfolios, which restricts their ability to borrow thereby placing additional financial pressure on existing development projects.

But times are not dire for everyone.

Seasoned properties such as China World, Kerry Center and Oriental Plaza are said to be maintaining high occupancy rates through a combination of efforts aimed at keeping existing tenants inside the property. According to industry sources, sometimes landlords in a falling market are willing to renegotiate leases, but for the landlords in the properties mentioned above, they may be able to dodge that bullet.

Unfortunately for those landlords with no tenants, this strategy holds no value. And with an additional 1.5 million sqm or more of office space scheduled to reach the market in 2010, thanks to the opening of the new CCTV Big Pants Building, there does not really seem to be any hope of this situation changing any time soon.

Conclusions:
This condition will definitely have an effect on the introduction of REITS into China’s public debt markets. REITS rely strictly on cash flows provided by the underlying properties and the reliability of those flows must be certain. Introducing innovations into China’s capital markets has over the past decade come in a deliberate and serious way. Both as matters of business and reputation, the authorities deliberating the introduction of REITS must have cause for concern when the reliability and stability of the cash flows face uncertain times. Ultimately, I expect that in-depth due diligence by the listing authorities will reveal any underlying risk in properties that may be considered for inclusion into the portfolio that eventually lists.
Next week I will look at publicly owned real estate in China.

Over the past week I had the opportunity to survey what is known collectively as Shanghai’s ‘North Bund’ project site and adjacent project sites.  I had not visited that area of Shanghai in quite a while so I read up a bit before the trek.

Anyone involved in Shanghai real estate these days, especially on the commercial side is aware of the objective to complete all major projects prior to the opening of the 2010 World Expo, and it seems like practically the entire bund on the Puxi side around the city center is one big construction site.  So my visit to the north bund area was intended, in part, to evaluate the progress of different sites to try to determine if they will hit the completion target which is less than 12 months away.

Cruise Terminal:

The cruise terminal was initially intended to be able to host ocean going passenger vessles operated by companies such as Star Cruises, Costa Crociere and Royal Caribbean Cruises ferrying passengers between Japan, Hong Kong/Macau and Shanghai.  And while the Huangpu River is certainly deep enough for these ships, the problem is that the Nanpu Bridge to the north sits too low, which prevents the larges ships in these lines from reaching the terminal.  See the related link for more:

http://www.npr.org/templates/story/story.php?storyId=96510518

The main gate of the 165,000 square meter site that is the Shanghai Passenger Cruise Terminal is located on the north side of Suzhou Creek along Da Ming Lu.  The entire kilometer-long site is situated between Da Ming Lu and the Huangpu River which, essentially creating an extension of the walking promenade on the south side of Suzhou Creek, although there is not direct link.

As of today, the entire site has been landscaped with grass and mature trees supported by the omnipresent four-extra-legs sounding all newly planted trees in Shanghai.  Within the site there is a 10-meter high footbridge whose sole purpose is to allow one to climb to the top and view the surrounding area, which is quite a good idea. From this perspective on can view the 20-story office tower of the shanghai International Ports Group and the adjacent duck-egg shaped building that sits atop what appear to be legs.

The north portion of the site is where the action is located.  The landscaping is on-going but that is not the difficult party.  There are still 3 more 3-story buildings to be completed which do not yet have curtain walls in place.  My guess is that by this time next year, the curtain walls will be completed, the site will be fully landscaped and tourists will be frolicking on the site.

Bund 33 Park (old British Consulate General):

Located on the south bank of Suzhou Creek, the site is well-known as the former British Consulate General in old Shanghai.

During my visit to the project yesterday, I was encouraged to note that the newer buildings that border the site are largely completed and appear to be very close to being able to actually hand over to tenants.  The old consulate building itself remains shrouded in the omnipresent green protective hoarding that covers many older buildings undergoing renovation, making it impossible to identify the stage of progress.

That said, within the grounds themselves where piles of building materials which indicate to me that the building is being restored to its original grand state to serve the centerpiece of the project, creating a feeling not unlike that of the Ruijin Hotel complex on Ruijin Lu, where many foreign residents of Shanghai have sipped drinks on a late summer evening at the now defunct Face Bar.

Overall, the project appears to be on course to be operational within one year, assuming there are no issues that prevent whatever operator plans to run the place runs into in terms of operating licenses, etc.

Aside from these two major projects, scaffolding and hording appear all along Zhongshan Lu these days and I will plan to update this post within the next 6 months to track the progress (or lack thereof).

Zhou

The Chinese web site Sohu reported one of the more bizarre episodes in recent memory, as one building of a multi-phase residential construction project literally fell over in an early morning rain storm killing one person on the construction site.

The 13-floor building is – was – located on Shanghai’s Jian Hua Nan Lu in Minhang district and was nearing completion when the accident occurred. It is reported that more than 200 units in the complex had been sold and as news of the collapse spread, angry home-owners began to appear to demand a resolution.

This incident brings into clear focus the problem of construction quality in the real estate industry. In western countries the standards is for commercial housing stock and commercial office stock is expected to have a life of between 60 – 80 years. Downtown Chicago, for example, contains office buildings that are more than 70 years old that have been renovated to extend their lives for another 20.

By contrast anyone surveying Shanghai can see housing and office stock constructed within the past 20-30 years that has become dilapidated more quickly than expected due not only to the use of low-grade construction materials, poor construction quality and poor management. In the case of this property in Minhang, the inevitable results just occurred more quickly.

- Guest Writer: Zhou Zhi Min

For those looking for good news on China’s property market, I am not sure if the recent JLL Property Market Monitor will be the document you were hoping for, but Steven McCrord’s Page 1 was sobering for me:

Total prime retail stock in 21 major Chinese cities will grow at a CAGR of 20.2% through the next three years, while retail sales are only projected to grow at 9.2%. The divergence between stock growth and retail sales growth will drive up the national vacancy rate from 7.2% at end 2008 to a projected 13.9% at the end of 2011.

A projection that has plenty of support in the 3 page document that highlights problems in the residential, commercial, and retail sectors (the one bright spot was reserved for infrastructure).

Download the full report here

While visiting Chengdu this week on some non-profit work, I took notice of the fact that the city of Chengdu has become a work zone.

Reminding me of Beijing 8 years ago, the sky is absolutely filled with cranes and half built buildings are EVERYWHERE.

Speaking to friends, many of these buildings are selling well, but are 2nd and 3rd homes… and therefore no one is living in the buildings (sounds familiar).

To give you some idea of the scale of the building, I took out my camera while headed out of town.  Essentially, the 20 or so pictures below all represent different sites that start a bit south of the High tech zone and make our way out of town.  This ws just a tip of the iceberg, and on my next trip in a few weeks, I will do my best to capture more of what is going on down town.

Another youtube piece on the recent real estate buying trips, but unlike the previous clips/ news bits that have been released on the Soufun trip, this clip provides some live shots and interviews.

A quick follow up to a post earlier this month All Aboard! China’s Real Estate Tour Groups are Now In Full Steam, where I highlighted the recent announcement that Soufun would be offering the first (of what is sure to be many) house hunting trips to the United States (and I am sure the EU – Spain – is in the planning).

In this recent announcement, we learn a lot more about the group of 40 that were selected (from a pool of 400):

These 40 people come from all over China; most of them are partner clients of soufun.com or high-end individuals chosen from voluntary clients

Guanxi…..

Most of the members are between 35 and 50 years old and are senior executives from the real estate and commercial service industries, retail enterprises or multinational corporations. Two-thirds of the applicants chose investment or home ownership as the purpose for purchasing houses.

… and more interestingly “about one-quarter of the first 40 house hunters have US green cards or business visas”

This CNN report provides some more color to the picture as well:

To back up this trip, and to advertise their new U.S. operations, a new site (in Chinese) has been set up to advertise their current listings in LA, Boston, Las Vegas, San Francisco, and New York. Many of the listings are under 1 million USD, and a nice selection of different property styles is on offer.

Politically speaking, Soufun sees this group as:

It is said that the group of wealthy Chinese individuals will be warmly welcomed by the US local governments. Everywhere the group travels, local governments, associations and real estate brokerage firms will provide comprehensive services such as housing information, house purchase procedures and legal assistance to the house hunting group. Local real estate agents have already done research on which housing products are suitable to offer Chinese clients.

Like I said in the post before this is a strategy that I think makes a lot of sense, and unlike the approach the Japanese took in the late 80s/ early 90s, the reasons for the purchases are much more reasonable and their view of the investment will be very different.

Again, were I a real estate agent in the area, I would spend the time to invest in some translation service and maybe some advertisement on Soufun’s website. They are clearly working within their network, and were you to have good properties and be willing to speak their language (i.e. advertise on the site/ sponsor the trip), there is little reason to believe you could not have 40 Chinese millionaires looking at your properties