If prognosticators of a commercial real estate crash in China are correct, the devastation will hit not only developers, but also upstream industries like construction, steel, and other commodities. Those on the ground, however, say that some firms in upstream industries are not worried about a decline in commercial real estate and are sufficiently hedged in other sectors to withstand a moderate correction.
Despite a belief that occupancy will soon catch up with office supply as more of the population moves to cities – in the second half of 2009 vacancy rates in office towers across China declined – the relatively weak condition of commercial real estate has already begun to hit the construction industry.
"Many construction firms are basically buying jobs. There are more projects now than right after the recession, but the competition with fees is still very tough," said Robert Benedetti, business director at project management firm SSOE China. "Prices are down 15-20% from where they were going into the downturn."
Big means vulnerable?
This situation has affected the larger construction and project management companies in particular. The big firms have to win lots of projects across all real estate sectors in order to keep their workers busy and retain talent, in an industry where employee retention is an endemic challenge. Smaller construction firms are more nimble; many have simply switched from commercial projects into other sectors that provide better opportunity.
"It is very easy for the builders that work in commercial to transition over to residential. I think the residential sector is where the action is in 2010. Those firms will likely find success in residential until the commercial market works through its overcapacity," predicted Benedetti.
Further upstream, the firms that produce the steel used in construction have done little to prepare for a correction in commercial real estate. Smaller steel mills that produce rebar and long steel for construction can take few proactive measures to hedge against a real estate downturn. It is far too costly to switch over to producing steel for automotive or shipbuilding, because these steels require different processes and equipment. The best these mills can do is to idle their production as a cost-savings technique until demand picks up again.
However, analysts believe total demand for steel will not change this year and that even larger mills will continue to produce the same percentage of steel for property construction.
"Our projections for 2010 are that real estate will continue to be the largest user of steel. In 2009, 41% of steel in China was used in real estate projects. We are expecting 41% again this year," said John Guise, China editor at Steel Business Briefing, an industry news source and research consultancy. "Steel firms are not really preparing for problems in real estate. They still expect building to continue."
In addition, the steel used for commercial property is the same that is used for residential property and infrastructure projects. The central government’s recent pledge to build 15 million units of housing for low-income earners will likely make up for a slowdown in commercial construction. Furthermore, most infrastructure projects from the original stimulus plan are not expected to be completed until 2011, creating further steel demand.
"Because there are so many infrastructure projects and the government is building all this public housing, steel firms aren’t worried," said Guise.
Other commodities are also affected by demand in commercial real estate, whether it is concrete for a building’s structure, aluminum for the window frames, or copper for the electrical wiring. However, the oversupply of office space in China is concentrated in the large, well-developed cities, where it has less of an overall effect on commodities. New commercial constructions in smaller markets tend to be more resource intensive since supporting infrastructure also has to be built.
"If you build a 50-story tower in Shanghai, they already have the infrastructure. If you want to build that same tower in a small city in Sichuan, they have to build roads and all the other auxiliary services," said Thomas Wrigglesworth, a commodities analyst with Citi in Hong Kong.
"A lot of the growth in capacity this year will be driven on a provincial level. What that means is that industries, such as cement, will increase capacity as long as there is profit to be made."
While a hypothetical crash in commercial real estate would hit China’s local commodity markets hard, there are international implications. Construction projects use local or regional products as much as possible, due to the cost of transportation and the low profit margin on most commodities. If demand for China’s commodities dropped sharply and inventory stocks shot up, though, it could impact global trade.
"Because China is producing such a high percentage of building materials, if domestic demand isn’t there, they will begin exporting their stock. When times are tough, companies sell below the cost of production. As defined by a UN or EU trade board, this is known as dumping," said Wrigglesworth.
It is unlikely that a crash in China’s commercial real estate could potentially threaten the stability of world trade, but this depends on the degree of correction – if any – and on the relative condition of its trading partners. However, if recent positive signs in the global economy are sustained, foreigners might once again be happy to buy China’s surplus.