Institutional investors with big research staffs and bigger budgets are set to replace cowboy capitalists in buying up blocks of Shanghai real estate. An increasingly mature market is demanding a more sophisticated player, and the Morgan Stanleys and Carlyle Groups are building up their China land banks in an investment environment relatively hostile to small-scale players.
"In the next five to 10 years you're going to see an improvement in the way in which real estate is acquired, the way it's managed, the way it's valued, in order to satisfy the demand of new capital which is more institutional in nature," says Morgan Parker, head of the new Hong Kong office of Taubman Corp, a US shopping-mall-developing firm.
The market has already begun to change. Fears of a pricing "re-adjustment" in the possibly peaked, or at least plateaued, Shanghai market are keeping investors – big and small – on their toes, looking harder for the big returns. They are taking cover in high quality constructions in Shanghai and Beijing.
Not only is the market changing to lure international institutions, but also the presence of the institutions themselves is changing the market. These investors, bringing international expertise and truckloads of capital to the major urban centers, are helping to create a more substantial quality market.
In an uncertain market, one thing is for sure: "The days of 'if you build it they will come' are over," said Randall Hall, Savills, China CEO. A more sophisticated consumer class is demanding more from their properties, and in the over-supplied sprawl, it takes more to stand out.
Nowhere to go but down?
"I got out of the market mostly last year because the yields didn't make sense anymore, given the short term China risk," said Emile Yu, an individual investor from the United States currently living in Shanghai, who has reaped the rewards of speculation over the previous five years.
Shanghai's residential yields (rent received yearly calculated as a percentage of the price paid for the property) are down sharply at the moment after running as high as 30% a few years ago. The returns are now basically capital appreciation. Yu said most of the amateur speculators he knows, local professionals who bought a few apartments when it seemed like a good idea late last year and early this year, are now trying to get out and can't.
Most industry professionals are happy to see the short-term small-scale speculators go. The institutions say they have long-term designs and aren't worried about a potential price slump in the near future. Carlyle Group's Asia real estate analyst Jason Lee says Shanghai housing is one of the safest long-term Mainland investments.
But even some institutional investors are wary of the current investment climate. "I'm very bullish about the long term," said Gary Wang of Jade Capital, adding: "I'm not convinced now is the right entry point."
"Everyone is a bit nervous about getting the right product," said Carlyle's Lee. Good properties are getting harder to find in China's main cities, and quickly conceived apartment developments with a short-term shelf life no longer bring in the big bucks. Private equity is taking cover in luxury which has fared better than the mass market, with rental yields remaining as high as 6-7%.
Hot ticket territory
With residential on the wane, these days it is office and retail space that are hot. Macquarie Global Property Advisors of Australia spent US$98m to buy 95% of Shanghai's Xin Mao Tower, a luxury office building, in January. International investment giant Goldman Sachs in April paid US$107.6m for Pidemco Tower, a 24-story commercial building in Shanghai's centrally located Huangpu district.
While brand new buildings are constantly being built, grade A office space remains in short supply – Shanghai still has only half the space available in Hong Kong's more mature office market. In Shanghai, prime office real estate today boasts 2% vacancy rates and yields as high as 8%. Prices are high – US$5,000/sqm in Shanghai, compared to US$2,400/sqm in Beijing-and according to Nigel Barnes of DTZ, individual investors have occasionally "paid through the nose." But the institutions, with the ability to purchase a higher-end product, are buying up what Barnes sees as "excellent" investments.
Carlyle analyst Lee said Beijing's grade A supply is even smaller than Shanghai's -amounting to just a few quality office buildings. Carlyle, which is in the process of buying a Beijing office building, isn't necessarily going for luxury, but the current property it is negotiating to buy is up to international standards. Which means that against a backdrop of shoddily constructed structures, it stands out.
In retail too, international shopping mall developers like Taubman Corp and Simon Property Group, are heading to China and bringing international standards and an eye for quality. Local developers, who no longer have access to easy money at their local banks, are increasingly getting funding and industry expertise from their new international partners.
The projects that are worth developing get international funding, the ones that aren't fail. So the general trend is toward higher value developments, says Taubman's Parker.
Second-tier options
As maturing big city markets get crowded with big spenders, some investors are looking to China's second-tier cities as the new best bet. The vice president of China's Raycom, Ron Li, calls his company a "conservative" investor and says Raycom, which has no developments in Shanghai, views the municipality as too risky. But it has commercial and residential projects from Tianjin to Changsha.
Taubman, too, has plans to expand into these emerging markets. The fact that China has more than 100 cities with populations exceeding one million is a very exciting statistic for a mall-building company, says Parker, Taubman's Hong Kong office head.
Local governments from Chongqing to Harbin are setting aside land for low-income housing and preparing for further growth. But the potentially promising markets in emerging second-tier cities remain largely inscrutable to international companies. Carlyle's Lee acknowledged the huge potential returns in these less saturated cities. And after its deal in Beijing goes through, Carlyle hopes to find strategic local partners to lead them inland. Currently, though, it just doesn't make sense for them.
And the cowboy capitalists? Some may be heading for the hinterland, the vast areas of China beyond downtown Shanghai and Beijing. But Emile, for one, hasn't considered real estate outside Shanghai. "You have to invest in what you know," he said.