Q&A: Lower-tier commercial markets

James Shepherd, Executive Director and Head of Research Greater China at Cushman & Wakefield, discusses the prospects for the commercial property market in lower-tier cities

It appears that demand for new commercial floor space is weakening and vacancy rates in many lower-tier cities are rising sharply. Is this what you are seeing?

That depends very much on which sector of commercial we are discussing, the city and sometimes even the specific district but in general yes, demand is cooling and vacancy has increased.

Do you agree that demand for offices in third-tier cities and lower is generally quite weak as most companies that make it big would prefer to set up headquarters in a larger city? What does the office market look in lower-tier cities?

Third-tier cities do not have the developed, high-quality office markets that we are familiar with in first-tier and some second-tier markets. Office accommodation in third-tier cities is typically made up of low-end strata titled developments or smaller components of larger mixed-use projects that are designated for office use. Businesses in such localities are often from the secondary industry sector with local manufacturing operations where their company offices would form part of a much larger manufacturing complex, and these are typically outside the downtown areas.

Buyers of strata titled offices in these markets would typically be business owners of local manufacturing companies. The China headquarters of larger organizations operating across China or across international markets will always be attracted to major business hubs but will often look to set up other operations in second and possibly even third-tier cities. Such businesses will look very carefully at technology infrastructure, the number of good nearby educational establishments and proximity to major markets, amongst other factors.

If even Shanghai is struggling to digest current commercial space, what is the outlook for lower-tier cities that are not as rich and are seeing lots of new floor area being added?

Each city needs to be considered on its own merits and clearly Shanghai is in a very different phase of its development than China’s second- and third-tier cities. The success of projects in less wealthy cities depends very much on the local supply dynamic, often at a district or catchment level, infrastructure development and to a large extent the product positioning – don’t be setting up a flagship Louis Vuitton store.

We’ve seen often in China that the retail market can be a “winner takes all” environment and you can frequently observe fantastic successes just blocks from spectacular failures based on what would appear to be relatively minor differences in location, design, positioning, management, visibility, infrastructure, access, marketing, specification, timing, tenant mix, etc. Developers that really take the time to understand retailing and retailers and do thorough market research at a local level will always come out on top.

Shoppers’ preferences are changing all the time, and at the third-tier city level that there is still room for a major shift in general consumer preferences, much more so than in first-tier cities. In many cases third-tier city disposable incomes are on the rise and money flow from family members elsewhere in China is likely to be increasing too.

Many regions in emerging parts of China are currently struggling with an economic slowdown. Although there are some signs of a slight recovery in the second quarter, growth is still weak. How will this affect the commercial property market in lower-tier cities?

China is still observed to be one of the world’s strongest economic growth stories, and recent improvements to the PMI will have an impact on third-tier cities which rely predominantly on manufacturing. Yes, we will have to increasingly get used to lower growth rates and cooling of the overall economy, but at the current stage the office and retail supply situation is having a much more profound impact on the commercial real estate sector than the overall state of the economy. For developers of commercial projects in these third-tier cities the prevailing challenges are predominantly led by fierce competition, reduced cash-flow from sales activities and the lack of readily available development financing.

What risks do investors need to look out for when investing in China’s second- and third-tier commercial property markets?

Less well evolved legal systems, varying degrees of implementation of policy, title issues, fewer high-quality investment opportunities, higher degree of stratification and unclear ownership structures. Often there are grey areas that can present both an opportunity and a threat. Commercial property projects in Shanghai would typically have comparatively clean asset structures, have possibly even traded multiple times previously and are set up and designed to be easy to transact, whereas projects in third-tier cities are not nearly as likely to benefit from such clarity.

Some cities are heavily exposed to specific industry sectors and also can experience tough competition from strong neighboring cities. In this case investors should ask themselves whether that particular city’s industry is going to see strong growth and generate a strong business environment or will plateau, or worse yet see their product markets collapse.

In mid-February local officials in Suzhou issued a limit on the amount of floor space commercial developers could sell before projects were finished, the first commercial property restrictions seen in the market. Is it a red flag for commercial property?

We believe that this has been done to protect property buyers, so we see this as a positive move. Given that it reduces the risk to investors we see it in some ways as a “green light” if anything. However, the fact that this policy has been introduced suggests some strata-titled investors have been starting to get burned. We also know that some construction projects have already halted in Suzhou, likely due to a lack of funding.

In this respect this change in policy raises some concerns for the struggling Suzhou property development market. Over and above this, the move will place increased pressure on strata titled developers of office projects who typically leverage heavily, and rely to a considerable extent on pre-sales cash flow. This could spell disaster for many developers who simply don’t have sufficient cash flow to complete projects, but in turn could present a buying opportunity for opportunistic investors to acquire partially completed projects at bargain pricing before seeing the project through to completion.