Opinions on the true condition of China’s commercial real estate sector exhibit a singular lack of consensus. Skeptics point to new-built ghost cities and office complexes devoid of tenants. And yet construction continues apace.
At present it appears that developers – particularly state-owned ones – are not reading from the same script as increasingly price-wary regulators. Across the country, state-owned enterprises (SOEs) continue to drive development. In 2009, SOEs bought up the bulk of the new property developments in Beijing. This year, state-owned Shanghai New Huang Pu Real Estate and Shanghai New World (SHA:600638) recently won a joint US$500 million bid on prime land for commercial development in Shanghai in February. Bubble worries be damned.
Some analysts believe the SOEs have read the tea leaves right. For one thing, they say Beijing’s increased focus on tightening credit to the property sector will not have much impact on lending to commercial developers.
"While the law may not make much distinction between different elements of the property sector, the intent is to cool down the residential market," said Michael Cole, managing director of Right Site Asia, a web portal aimed at bridging investors, developers, industrial zones and consultants in the property sector. "I would expect the new measures to be implemented more leniently for commercial projects."
In addition, others believe that regardless of credit policy, commercial investors are more patient than those in the residential sector. Stephen de Kyper, managing principal of CresaPartners, a commercial property consulting firm, believes that commerical developers are less interested in quick plays. "Lenders and developers look at commercial and industrial properties with a longer view," he said. Granted, this longer view requires cash.
The stock market’s attitude toward real estate also appears to be improving. While developer stock prices underperformed the MSCI China Index for most of 2009, a March report from Royal Bank of Scotland shows a nascent recovery. Stocks of China’s big real estate developers moved up by an average of 11.7% between February 1 and March 5 of this year, after declining an average of 16.3% in January.
However, optimism is anything but universal. Jack Rodman, president of Global Distressed Solutions, said that despite the change in sentiment, private and foreign investors have yet to open their wallets. He pointed out that while Morgan Stanley analysts recently upgraded the Chinese property sector, the company’s real estate investment arm has been steadily shedding Chinese assets. "You don’t have foreigners coming in to buy [property] at these prices," Rodman said. "There’s no yield. That’s an irrational market."
Supporting Rodman is a fourth quarter 2009 survey released by the Royal Institution of Chartered Surveyors, which showed an unexpectedly large amount of distressed commercial property in China – although the report also cites an increasing level of interest from specialist funds.
The government is also uncomfortable. In March, state media reported that the State-owned Asset Supervision and Administration Commission (SASAC) is preparing to create another asset management company, China Guoxin, with a registered capital of US$2.93 billion. In the same month, Beijing ordered 78 SOEs to divest their real estate assets. While state media reports said that Guoxin will be primarily involved in restructuring inefficient SOEs, Rodman suggested that the company might also be used to take on moribund properties that SOEs can’t find tenants for. He noted that many of the loans provided to real estate developers in the current stimulus package are in fact rollover loans for property companies that could not pay off their debts.
Trust in trusts?
In a more conservative lending environment, where will developers go for capital? The first and most obvious option is the trust companies. These institutions were originally created to help local governments raise money for infrastructure projects. Unlike banks, Chinese trust companies don’t have to use their own capital or put loans on their balance sheets; instead, they are able to securitize income-producing assets held as collateral and resell the notes through retail banking channels.
While the trusts fell into disgrace for a period after their high tolerance for risk led to a few going bankrupt, they were rehabilitated through a vigorous curriculum of regulatory reform and may have a role to play today.
Trust companies’ activities in helping local governments raise funds as part of the stimulus package and enabling banks to improve their balance sheets by temporarily shifting certain assets off the books have already drawn media scrutiny. According to Stephen Chen, senior director of China Investment Properties at CB Richard Ellis (CBRE), some of the trust companies are already quietly engaging in lending to property developers.
"There’s been a lot of talk about creating real estate investment trusts (REITs) to invest in real estate, but frankly, the trust companies have already been involved in the real estate business through trust financing and other semi-REIT products," he said.
Even so, thanks to the regulatory reforms, trusts must now be more careful of their reserve ratios and of the kinds of collateral they can accept, Chen said. Tenantless buildings, presumably, will be a tougher sell.
At the same time, the trusts also have relationships with the banking structure and with implicit political agendas. Many trust companies are subsidiaries of large holding groups that also own banks which, according to Chen of CBRE, helps them to take on higher levels of risk.
This very connectivity could play out in either direction. According to Rodman of Global Distressed Solutions, trusts can also play a role in disguising non-performing assets through off-balance sheet transactions. "I look at the trust companies the same way I look at Enron," he said. "A lot of stuff was packaged and sold to the trust companies, and I think there needs to be some investigation. I think the trusts had guarantees from the lenders, why else would they take all that stuff?"
But Beijing is aware of the loopholes trusts once provided speculators, and future clampdowns on bank lending will almost certainly be applied, in some form, to the trusts as well. In March, the Ministry of Finance (MoF) threatened to "nullify" all loan guarantees by local governments, citing concerns that localities were using "alternative investment vehicles" to evade clampdowns on conventional bank lending. Two particular types of guarantees were mentioned, and one was the use of land as collateral. The MoF is clearly concerned that municipal governments – some of which have debt ratios over 400% – are still abusing alternative lenders like trusts.
The role trusts might play in supporting continued construction in the face of hardened bank lending policies is therefore unclear. Yet there are other legal options outside the banking system: Developers also have the option of partnering with other companies and wealthy individuals. Alvin Lau, a managing director for CB Richard Ellis (CBRE), notes Kaisa (1638.HK) as an example. Kaisa, which successfully listed in Hong Kong last December, recently partnered with Hainan Air to work on property projects.
But Rodman is also skeptical of routes to alternative funding channels. Before the global crash – and during a rebound last year – Chinese real estate developers regularly tapped the Hong Kong capital markets for cash. Today it is increasingly difficult for them to sell equities or debt. Real estate firms issuing bonds recently have been forced to offer interest rates in the neighborhood of 10% and upward to get attention.
However, there are some positive signs that consumer demand for commercial and industrial space is recovering. A source at a Shanghai-based relocation firm said that his firm is experiencing an upsurge in expatriate employees coming to China. Vacancy rates are also on the decline. "In [Shanghai’s] Pudong, overall market vacancy is at 11.1%, down from over 20% a year ago," said Greg Hyland, head of investment at Jones Lang LaSalle (JLL) in Shanghai. "Yes, a lot of developments are underway, but 40% of supply is preleased or sold."
Even so, using the state of the Pudong market as a bellweather for the industry nationwide is inadvisable, and the fact that 60% of the new supply is unleased or unsold isn’t exactly good news. Similarly, the fact that commercial real estate pricing remains below the stratospheric valuations of residential properties provides cold comfort, given that most developers are exposed in both sectors.
Still, if one accepts the recovery thesis, clearing all that excess inventory (and paying back all those loans) will take some time, and it is unlikely to be painless. "In the past we kind of created a legend that there will be continuous booming demand for commercial property because the economy has sustainable growth," said Alvin Lau of CBRE. "Now I think it is very hard to say."