Ebb and Flow: The Changing Dynamics of Chinas Real Estate Investment Market

Introduction
A year and a half ago we wrote about the rise of domestic institutional investors in Chinas real estate market. In the intervening period, much has changed and yet much hasnt. As expected, Chinas insurance companies were finally given the green light to invest in direct real estate assets, although this took longer than we had anticipated and has yet to materialise into many significant transactions. On the other hand, real estate investment trusts (REITs), which, for years have seemed to be only six months away, we believe will continue to remain under consideration for the foreseeable future. Additionally, the activity level of foreign institutional real estate investors rebounded significantly in 2010, as they shifted from net sellers to buyers in Mainland China. In this paper, we will take a closer look at changes in the regulatory landscape, lending environment and market outlook across the residential, office and retail property sectors. In addition, we look at the shifts in the composition of market participants which is creating new opportunities in Chinas real estate investment market. We will examine: The return of foreign investors. The implications of Chinas insurance companies entering the market. The development of REITs and RMB funds. The market fundamentals creating a healthy investment environment.

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Foreign investors buyers return

In 2010, en bloc real estate investment transactions reached a record USD 15.02 billion, an increase of 34.6% compared to the year before (Figure 1). Foreign players shook off the effects of the global financial crisis. Those from other parts of Asia Pacific purchased en bloc real estate assets worth a record USD 5.1 billion, eclipsing the USD 3.5 billion purchased in 2007. Indeed, investors from Hong Kong and Singapore showed themselves to be nimble, well connected and aggressive in China in 2010, and we have seen more clearly than ever the importance of China to the regions investors. In 2010, for the third straight year, purchases by foreign investors from outside Asia were less than USD 1 billion after peaking at almost USD 3 billion in 2007. One interesting difference between the two foreign investor groups has been how investment purchases by US- and European-based investors have been extremely concentrated in Shanghai (Figure 2) while Asia-based real estate investors have shown a willingness and ability to purchase assets all over China. With a relatively limited trading stock of buildings in Shanghai weve seen office assets like Platinum and Cross Tower trade on an almost annual basis these foreign investors will be severely limited if they keep to such a narrow view of direct investments going forward.

Figure 1. En bloc real estate investment transactions in China by source of capital

China Real Estate Investment Transactions 16 Purchases (USD Billion) 12 8 4 0 2005 Domestic 2006 2007 2008 2009 2010

Foreign (Intra-Regional, Asia Pac)

Foreign (Inter-Regional)

Source: Jones Lang LaSalle

Figure 2. Investors from outside Asia have focused heavily on Shanghai

Real Estate Investment Transactions in Shanghai as a percentage of those in all of China 80% 70% 60% 50% 40% 30% 20% 10% 0%

Purchases in Shanghai

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Foreign (Intra-Regional, Asia Pac) Source: Jones Lang LaSalle

Foreign (Inter-Regional)

There is genuine concern in the government about hot money inflows now that the Chinese yuan is once again appreciating against the US dollar. In November and December 2010, the State Administration of Foreign Exchange (SAFE, ) and the Ministry of Finance and Commerce (MOFCOM, ) issued regulations indicating that foreign investments in real estate considered to be speculative in nature may not receive the required government approvals. In our view, currency appreciation has not been and will not be the major driver of real estate investment decisions in China. As we will see in this paper, investors both foreign and domestic have strong market fundamentals on their side. Consequently we do not anticipate the SAFE or MOFCOM regulations will pose major obstacles in the year ahead.

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Surprisingly, total purchases by domestic investors decreased by 7% to USD 8.9 billion in 2010. Much of the decline can be explained by the high base established in 2009 when state owned enterprises (SOEs) purchased a large number of en bloc office buildings for self-use. In particular, financial companies scrambled to buy an upcoming piece of Shanghais Pudong skyline and Beijings Financial Street. In 2010, office asset purchases declined from 61% of total transactions to 37%, while retail and mixeduse projects increased from 26% to 58%. But it may also be attributable to some other factors, including the aggressiveness of investors from Hong Kong and Singapore, the spillover effect of rapidly tightening residential market policy, and a lack of clear direction from the government. On the one hand, domestic institutional investors have been cautioned not to contribute to rapidly rising land prices and on the other hand, they are expected to contribute to maintaining healthy growth. In 2009, the Central Government was clearly using large increases in bank lending to stimulate the economy. In that environment it was relatively easy for domestic investors to aggressively purchase assets, especially since valuations had fallen significantly during the crisis. Now, two key things

are combining to take the wind out of their sails. Firstly, the easy financing is going away, which highlights the current limitations of domestic capital markets to provide funding alternatives, such as syndicated loans, securitisation and other vehicles prevalent in mature markets. Secondly, there are the political considerations of being seen to contribute to asset price inflation. In the face of foreign investors chasing the rapidly strengthening fundamentals, as we will discuss later, domestic investors seem to have lost their guidance and competitive edge.

Go with the official flow

Noting the nature of Chinas political economy and the governments desire to utilise the market to underpin a more harmonious and equitable society, it is likely that any initiatives that support the stated objectives of providing more supply of specifically desirable asset classes will receive solid political and financial support. Key amongst these is government support for affordable housing and the development of elderly care facilities. There is also significant scope ahead for the development of modern educational and

Despite the high-profile struggles of some investment banks two years ago, in reality foreign investors never left China. The combination of the global financial crisis, the need to raise capital to cover investment losses in other parts of the world and the approaching end of some funds investment window may have made it seem as though they were leaving. Morgan Stanley, one of the earliest and most successful real estate investors in China, was a significant net seller of real estate assets in 2009 not just in China but globally. However, these sales were primarily tied to the winding down of their MSREF VI fund which, according to their own statements, incurred record write-downs as the value of property around the world plummeted during the financial crisis. The funds assets in China, though, were among the few bright spots and Morgan Stanley itself remains strongly committed to China as it begins investing MSREF VII1.

1. Wall Street Journal, Morgan Stanley Property Fund Faces $5.4 Billion Loss, by Anton Troianovski and Lingling Wei, 14 April 2010

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healthcare facilities. Given their alignment with government objectives, we may expect some innovations in funding and development financing for these emerging asset classes like REITs, funds and trusts, and securitisations to emerge in the future, with uniquely Chinese characteristics that adapt them to the local market situation. Let us first review the insurance sector as one of the most high-profile changes of recent years and a key topic of our earlier paper, The Rise of Mainland Chinas Institutional Investors.

Table 1: Key regulations regarding insurance company investment in property Can invest up to 10% of total assets into property and property related financial products Can invest in commercial property (office, retail, healthcare), for self-use, and for elderly care use Minimum 5 year holding period on property investments No residential development investments or investments in non-listed developers Must report property investments to CIRC on a quarterly and annual basis Real estate investment management team must be of a certain minimum size and qualification, though out-sourcing is permitted as a supplement Investment in overseas real estate assets is permitted

Insurance companies get the green light

In August and September 2010, the China Insurance Regulatory Commission (CIRC, ) issued modified rules on investment by Chinas insurance giants including the long-awaited details regarding investment in real estate (Table 1). The promulgation of these regulations came nearly one year after the law was adopted permitting their participation in the market. One of the key details in the new regulations was insurance companies being able to invest up to 10% of their total assets in property and property related financial products, a limit at the upper end of the expected range. Total insurance company assets in China were just over RMB 5 trillion (USD 770 billion) at the end of 2010, and growing 25% per year (Figure 3). With a restriction on investment in residential development projects, Chinas insurers could theoretically purchase the entire tradable stock of commercial real estate assets several times over. In fact, with RMB 985 billion (USD 149 billion) in new capital accumulated in 2010, a 10% allocation to real estate (Figure 4) would have enabled Chinas insurance companies alone to buy the equivalent of all the en bloc real estate investment transactions done in 2010. Clearly, however, this did not happen. But what will this mean for the market and why havent we seen much activity from the insurance companies so far? First, commercial real estate generally and real estate investment specifically,

Figure 3. The total capital of Chinas insurance companies has grown large quickly
China Insurance Company Capital 6 Total Capital (RMB trillion) 5 4 3 2 1 0 60% Growth (y-o-y change) 50% 40% 30% 20% 10% 0%

Source: China Insurance Regulatory Commission, Jones Lang LaSalle analysis

Figure 4. At 10% of capital, insurance companies have the potential to make significant real estate investments
New Insurance Company Capital for Potential Real Estate Investment 30 25 RMB (billion) 20 15 10 5 0

Source: China Insurance Regulatory Commission, Jones Lang LaSalle analysis

1Q 0 2Q 6 0 3Q 6 0 4Q 6 0 1Q 6 0 2Q 7 0 3Q 7 0 4Q 7 0 1Q 7 0 2Q 8 0 3Q 8 0 4Q 8 0 1Q 8 0 2Q 9 0 3Q 9 0 4Q 9 0 1Q 9 1 2Q 0 1 3Q 0 1 4Q 0 10

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are relatively new industries in China. Insurance companies are in a highly competitive market for both the talent to build their real estate investment management teams and for the assets themselves. Several groups, such as Ping An, PICC, Taikang and China Life, are making good progress in terms of building their real estate investment management capabilities. However it takes more than just people for an insurance company to invest in real estate. Internal risk management, compliance, investment portfolio management and asset-liability matching infrastructure are needed. Real estate asset management and property management capabilities are also required. It will probably be at least another year before we see insurance companies showing up in the market in a big way. Nonetheless, the sheer volume of capital they have to potentially invest in real estate assets has impacted the market. Investment yields across commercial real estate in China are at their lowest levels ever, even as interest rates have begun to rise. For existing owners of real estate this has been a boon and the insurance companies demand for assets promises a secure exit strategy for years to come. On the other hand, there is a real risk that commercial real estate markets in Tier II cities, which already have a tendency towards oversupply, will see a new speculative building cycle. This will be the case if insurance companies do not employ rigorous evaluation, due diligence and approval standards in their investment decision making.

be a suitable long-term investment asset, one that maintains and grows in value over time, it should be designed and built as a quality product and then be professionally maintained. High quality property and asset management capabilities, or service providers, will be essential in preserving the value of these investments. In fact, one could argue that until the pendulum in China swings meaningfully toward valuing income generation and asset quality over its capital appreciation potential, Chinas insurance companies should exert as much effort looking for investment grade assets overseas as they do looking within China. Today, the relative risk and return profiles for real estate in more mature Asian and Western markets remain quite attractive following the global financial crisis. This kind of international investment naturally raises a different set of contingent risks such as currency and political risks. However, it is noteworthy that under current regulations, such activity is already approved (see Table 1).

REITs and RMB Funds

We mentioned at the start of this report that REITs seemed as though they had been six months away for several years and enthusiasm about their imminent approval waxes and wanes like the seasons. Today there is no reason to believe that hurdles to the approval of REITs are any closer to being resolved. It is still not clear if they will fall under the China Securities Regulatory Commission (CSRC, ) or the China Banking Regulatory Commission (CBRC, ) and be listed versus non-listed vehicles. We believe the government is still concerned about the introduction of additional large pools of investment capital fuelling asset price inflation. For this reason alone, they may choose to keep REITs on the sidelines indefinitely. That could spell trouble for domestic groups who have been accumulating assets to put into a REIT, expecting their approval months or years ago. One possibility that could materialise in the near term is the creation of a REIT-like structure to finance low-rent housing development.

Quality making the investment grade?

As Chinas insurance companies build their capabilities to invest in real estate in a big way, so too should developers be looking at the quality of the commercial products they construct. A lack of investment grade stock will surely be another limiting factor for insurance companies going forward. Insurance companies are core investors for which real estate as an asset class is ideal as a long-term investment to offset their long-term liabilities. But for real estate to actually

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While REITs are not traditionally a vehicle for development projects, this type of scheme in China would be virtually indistinguishable from a government bond. The government determines the yield or margin by setting both the land price and the rents. It even provides an implicit guarantee on the REITs cashflow through its income subsidies to the tenants. The major risk lies in the developers ability to manage the cost of construction. There have been media reports of a potential REIT similar to this being considered in Tianjin. RMB funds, and their ability to invest in real estate assets, also stand on ambiguous legal ground with regulations being developed on a pilot basis in Shanghai, Beijing and Tianjin as these cities try to attract and develop a domestic private equity industry. A number of prominent foreign fund managers have established the relevant on-shore fund management enterprise entities (FEIMCs) to set up RMB funds, with Prax Capital notably raising an RMB 600 million real estate fund in

Shanghais Pudong New Area in 2009. Under regulations effective March 2010, Carlyle Group and domestic company Fosun formed the first foreign invested partnership (FIP), which many others have since emulated2. The excitement, though, is in the way the regulators seem to be responding to the needs of this fast developing industry in real time, at least in government terms. Weve seen announcements on inbound currency convertibility and the impact of the percentage of foreign capital on the funds treatment as a domestic investor. However, uncertainty remains, in part, because unlike many aspects of hi-tech and clean-tech investing, real estate is not categorised as an encouraged industry for foreign investment. Still, there is tremendous excitement among foreign fund managers because of the huge pools of domestic capital that can be tapped, such as the insurance companies, pension funds and high net worth individuals, and the chance to operate on an

What of the 78 SOEs who were required to exit the real estate industry by Chinas State-owned Assets Supervision and Administration Commission (SASAC, ) last March? In December 2010, China Security Journal reported that banks were notified they should only make development loans to SOEs if they are among the 16 approved to remain in the real estate industry3. In February 2011, SASAC provided an update, saying that 20 more of those SOEs will have fully exited the real estate industry by the end of the year, in addition to the 14 from 20104. We have believed, since SASAC first announced its intention to bar from the real estate industry those SOEs whose main business was not real estate development, that the key issue was the rapidly rising price of land. By removing these cash-rich buyers from the market for land and development, they hoped to be able to curtail both the money chasing the land auctions and the hubris driving bidders eager to be dubbed Land Kings. We believe this shows the government has taken a multipronged approach to taming rising housing prices and we do admit a sense of relief that the SOEs exit from the market has thus far been an orderly one.

2. Troutman Sanders, RMB Funds in China by Edward Epstein and Kim Tung, November 2010 3. Caixin online, China Tightens Controls on SOE Property Lending, 6 Dec 2010 4. Xinhua, 20 more SOEs to fully exit real estate business, 22 Feb 2011

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Figure 5. Strong demand has lowered vacancy rates in Chinas Tier I cities
Grade A Office Market 1,400,000 Grade A Office Supply and Demand (sqm) 1200,000 1000,000 800,000 600,000 400,000 200,000 0 30% 25% 20% 15% 10% 5% 0% Vacancy

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Beijing Supply Net Take Up

Shanghai Vacancy (RHS)

Source: Jones Lang LaSalle (Real Estate Intelligence Service), 4Q10

Healthy office markets

In the office sector, just as the market was beginning to rebound in 2009, we saw the SOEs be very active in purchasing buildings out of the future supply for self-use. Today the office markets in Chinas Tier I cities are healthy, having enjoyed record amounts of net take-up in 2010 (Figure 5). Vacancy rates improved, dramatically in Beijings case, and rents rose across the board. While its much easier for an owner-occupier to purchase a brand new building, since they wont have to wait for any lease expirations, investors prefer stabilised assets with proven tenant appeal. As more investors become convinced of the improving fundamentals and outlook for the office market (Figure 6), interest has grown steadily in this sector. However, there are simply not that many tradable office assets for institutional investors to purchase. As a result, we have now seen some assets, like Platinum and Cross Tower in Shanghai, trade three or more times as capital values have risen and cap rates compressed. Bolder investors are now looking for value in emerging areas within the Tier I cities such as newly accessible areas peripheral to the CBD. As the metro systems are built out, they are seeing development of Grade A quality buildings.

Figure 6. Grade A Office rents are on the rise

Grade A Office Rent Grade A Office Rent (RMB / sqm / year) 6,000 5,000 4,000 3,000 2,000 1,000 0

Source: Jones Lang LaSalle (Real Estate Intelligence Service), 4Q10

1Q 05 3Q 05 1Q 06 3Q 06 1Q 07 3Q 07 1Q 08 3Q 08 1Q 09 3Q 09 1Q 10 3Q 11 0 1Q 11 3Q 11 1Q 12 3Q 12

Shanghai

Beijing

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Shenzhen

equal footing with domestic investors. For most real estate fund managers, their future in China is in raising capital onshore and then investing that capital in China and eventually offshore.

Fundamental Opportunities
So with all of these challenges, where are the opportunities in Chinas real estate investment market? How will changes in the market participants, as well as the markets fundamentals, create opportunities for investors going forward?

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Others are looking at ways to add value to existing buildings either through capital improvements to upgrade well located Grade A and B buildings or by greening existing Grade A buildings. In Tier II cities, where whole new CBDs are under development, we have seen developers turning to the strata title market in the face of relatively thin leasing demand. In some cities, investors with a long investment horizon, such as insurance companies, may be able to take advantage of relatively low capital values to buy into promising markets.

story is a highly compelling one and real estate fund managers and their investors are eager to be involved. The retail sector also has a lot of supply in the pipeline, similar to the office sector, but success in the retail sector is much more dependent upon successful asset management. Shopping centres are living assets, needing to adapt and evolve as market conditions and consumer tastes change. We believe the opportunity remains for experienced managers of retail assets to capture outsized market share even in the face of the coming supply. This is especially the case for those who have strong relationships with domestic and international mass-market brands.

Retail Chinas consumption story

Similarly, on the retail side, terrific market fundamentals have attracted investor interest. One important distinction, however, is that unlike the office sector, where investors are primarily interested in the Tier I markets, in the retail sector, investors have shown interest in well located assets anywhere in China. This can be attributed to a number of factors, an important one being the Central Governments policies to increase consumption across the entire economy, as well as steadily rising urban incomes across the country (Figure 7). In short, Chinas consumption Figure 7. Rapid income growth fuels consumption
Chinas urban income and consumption growth 21,000 18,000 Per Capita (RMB) 15,000 12,000 9,000 6,000 3,000 0

Residential tighter lending environment will create opportunities

Much attention has been focused on the Central Governments demand suppression policies and their efforts to restrict price appreciation in the residential market. From an investor perspective the interesting part actually lies elsewhere. In July 2010, Fitch Ratings released a blockbuster report on off balance sheet lending by Chinas banks5.

Consumption Growth Income Growth

35% 30% 25% 20% 15% 10% 5% 0% Growth (y-o-y chamge)

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Source: CEIC, China National Statistics Bureau, Jones Lang LaSalle analysis
5. Fitch Ratings, Chinese Banks Informal Securitization Increasingly Distorting Credit Data, by Charlene Chu, 14 July 2010

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It indicated that in spite of the reduction in headline lending quota set by the CBRC for 2010, the rapid increase in these informal securitisations more than offset the reduction in reported lending. With banks now required to bring all off balance sheet lending back onto their balance sheets by the end of 2011, the reduction in onshore liquidity that was meant to begin in 2010 will now surely happen in 2011. This comes at a time when residential developers are in the midst of a very capital intensive part of the development cycle, having purchased everincreasing amounts of land in 2009 and 2010 at ever-increasing prices. Combined with government policies to encourage them to start construction more quickly, build faster and complete projects sooner, the effects of the reduction in liquidity could be dramatic. For over a year, developers have been required to put down larger deposits after prevailing in land auctions. In some cities development loans and proceeds from presales must be deposited into escrow accounts that can only be used to complete construction of that specific project. The profits are released to them only when the project is finished. By the end of 2011, we expect residential developers will be launching new projects

positioned for buyers at lower income levels as policy headwinds remain strong in the upper end of the market. There is strong potential for transaction volumes to increase significantly for developers that follow this strategy because the depth of demand among owner occupiers further down the income scale is enormous. However, because of the increase in land prices over the last two years, margins will certainly be squeezed and ultimately distress will become more readily apparent among over-geared developers. We see opportunities for investors in this scenario. Firstly, there is an opening for equity joint ventures in some of these distressed situations and opportunities for developers who are able to take over entire projects from weaker players. Secondly, we expect an increased willingness on the part of residential developers to consider more reasonable pricing on the sale of some of their commercial, incomeproducing assets from their existing portfolios and future pipelines. Ultimately, less domestic liquidity means a return of cash as a competitive advantage in China and an even more active investment market across all asset classes in 2011 and beyond.

Looking ahead
There are clearly opportunities for investors given the strong market fundamentals. Foreign investors will aggressively chase the momentum in Chinas retail and office property markets, even as the global economic environment remains challenging. As the torrent of onshore liquidity returns to pre-crisis levels and signs of distress emerge, their capital will once again be relevant. Nonetheless, China remains a very challenging business and regulatory environment to operate in. We expect domestic and foreign real estate investment managers to be creative in their approach to Chinas unique status and brand of state-enabled development going forward. Official encouragement for developing social housing and for foreign investment in hospitals, along with growing market-based demand for elderly care facilities, will add to these opportunities for institutional investors. Rapid government driven progress in RMB funds and REITs, along with insurance company investments will bring these new sectors to the fore. As insurance companies ramp up their operations, their presence will be increasingly felt in the market. Dont be surprised if the government forces them back to the sidelines of the commercial markets if asset prices rise too quickly. Lower investment yields, along with limited investment grade stock, will lead to new opportunities for raising capital from domestic investors destined for overseas real estate markets. Chinas real estate investment market promises to be as dynamic as ever in the years ahead. Please look out for our next report on Guangzhous real estate investment market later this year. In future reports we will update you on the latest developments in the market whos buying what and where and key issues like the impact of pilot property taxes.

Michael Klibaner Head of Research - China michael.klibaner@ap.jll.com +86 21 6133 5707 A National Director, Michael works with a team of 35 researchers in Jones Lang LaSalles nine offices in China covering 20 Tier I, II, and III markets across the office, retail, residential and industrial sectors. With 17 years of business experience, Michael has an extensive background in finance and consulting. Michael is the Chairman of AmCham Shanghais Real Estate Committee and a frequent commentator on Chinas property markets.

David Hand MRICS Head of Investment - China david.hand@ap.jll.com +86 10 5922 1101 An International Director, David is one of the most experienced international commercial property professionals in China. Based in Beijing since 2001, as the former managing director of the Beijing business, he led a team of 200 professionals and was directly involved in the investment, property & shopping centre management, leasing, research and consultancy businesses. A frequent media commentator, David is also an Executive Education Instructor on Chinese real estate investment at Harvard University (GSD).

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COPYRIGHT JONES LANG LASALLE 2011 All rights reserved. No part of this publication may be published without prior written permission from Jones Lang LaSalle. The information in this publication should be regarded solely as a general guide. Whilst care has been taken in its preparation no representation is made or responsibility accepted for the accuracy of the whole or any part. We stress that forecasting is a problematical exercise which at best should be regarded as an indicative assessment of possibilities rather than absolute certainties. The process of making forward projections involves assumptions regarding numerous variables which are acutely sensitive to changing conditions, variations in any one of which may significantly affect the outcome, and we draw your attention to this factor.