Research article


There’s long-term value to be had from limited office supply in prime locations, while demand for residential space has been boosted by recent interest rate reductions.

Chinese real estate markets saw a slow start in 2015 but investment picked up in response to rapidly falling interest rates (five-year loans were down 165 bps in 12 months to 4.9% in October 2015). The large issuance of domestic bonds at comparatively lower coupon rates, coupled with other supportive measures from the government also meant lower costs on development debt finance.

Domestic purchasers continue to dominate the Chinese market but some international investors have been building war chests in anticipation that slower economic growth will create pockets of distress and buying opportunities. Others hope to unlock new opportunities in niche markets using approaches learned in other international markets. So far, most, investment has focused on the first-tier cities, particularly Shanghai. Here, we present some alternatives for these investors.

Figure 1

FIGURE 1Investment volumes excluding development sites (deals larger than RMB100 million)

Source: Real Capital Analytics, Savills Research

Core tip: Premium Grade A offices in Shanghai Lujiazui & Beijing’s Financial Street – long term hold

Shanghai’s office market fundamentals look weak because significant volumes of new supply are expected but much of this is located in decentralised and non-prime locations. Prime locations, especially in Lujiazui, will see very limited supply but we expect demand to be strong from financial institutions which are expanding rapidly on the back of the Shanghai Free Trade Zone policies.

Beijing’s Financial Street has similar characteristics, with limited new supply and strong demand from financial institutions. Both these markets represent some of the most expensive commercial real estate at close to the top of their current rental cycles. Nevertheless, these areas are unlikely to be dislodged in the mid- to-long term and present tremendous long-term value - if the asset can be pried away from current owners. We anticipate that hurdle rates of 7-10% should be supportable in these markets.

Core plus tip: Grade B office projects in central Shanghai & Beijing – short to medium term

One of the mainstays for core plus investors is the investment in slightly dilapidated office buildings in central locations and spending some capital to bring them closer in line with Grade A standards. We think this will hold true in 2016. Although certain failures in the original design may be impossible to overcome (slab height for example), relatively simple value-add steps can sometimes increase rents and capital values by 10% to 20%. Building maintenance, while improving, continues to fall far short of international standards so buildings which are sometimes only ten years old appear much older and there is potential to add value by improving this. We anticipate that hurdle rates of 10-12% should be supportable in these markets.

Core plus tip: Equity injections to Logistics operators – long term

Logistics have been a favourite of investors for the last two years on the back of the rapidly growing e-commerce market and demand from third party providers (3PLs). The market is dominated by a handful of international and domestic players who have established large market shares and make it difficult for other investors to make inroads - apart from in the more specialised logistics fields.

Investors still looking to get into these markets are partnering with some of the mid-size developers to provide the capital to grow rapidly and carve out more market share. Alternatively, equity injections into some of the larger players has also been a route for larger investors. Developers focusing on leading cities with scarce land supply will be better positioned in coming years as only limited new supply is expected. However lower-tier cities are expected to see burgeoning supply in the coming years.

Opportunistic tip: Residential development in central/mature locations of 2nd tier cities – short term

The residential market can be extremely fraught in China with policy changes throwing curve balls to developers and investors alike. Recent policies and interest rate reductions have stimulated demand, especially in first-tier cities, pushing prices in leading cities to new heights. Smaller cities however are still plagued with oversupply that will take several years to digest.

Nevertheless, opportunities are once again presenting themselves in second-tier cities that have started to see prices rise on the coat tails of rapid price growth in first-tier cities. Land premiums have started to rise but continue to remain affordable when compared to the irrational prices that residential land is selling for in first-tier cities. Our top picks include Hangzhou, Nanjing, Xiamen, Wuhan and Suzhou. 14-16% hurdle

Alternative tip: Niche markets – especially eldercare & healthcare – long term

There is a lot of money floating around in China at the moment; however a large portion of this is passively invested so is chasing traditional asset classes all the way up to the top of the market cycle. The smart money however is looking at mid- to-long term plays in niche markets. These can be tricky areas as there are few established players and business models are still in a state of flux - and some of these industries have had false starts in the past.

For the braver investors out there, niche sectors represent the best bet for higher returns. Key sectors to look out for are the eldercare and healthcare. Rising incomes, an ageing population, as well as a creaking state system that cannot accommodate the growing needs of a burgeoning urban population, are creating unprecedented demand against extremely constrained supply. The state is opening up the sector to competition and this creates a number of opportunities for private companies.

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