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The China Risk Puzzle

After years of glowing reports about the booming growth of Chinese real estate, a number of leading Western developers and private equity funds are preparing to enter the market.

Taubman Centers now has an Asian subsidiary that is actively looking for deals in China. Simon Property Group has announced plans to build up to 12 shopping centers with Wal-Mart, and Warburg Pincus has announced a partnership with Raycom, a Chinese real estate investment firm.

Their timing could be better. Earlier this year, the government introduced a number of requirements to slow down the market, including rules that buyers hold property for at least 12 months, and that banks reduce maximum loan-to-value ratios from 80% to less than 60%.

After years of double-digit growth, the pace for residential sales has slowed considerably. Apartment prices in Shanghai have dipped 10% to 15% this year, and condominium sales volume is down 70%, according to Cushman & Wakefield.

“I have never seen a government move so quickly to quench demand and do it so successfully,” says Michael Thompson, the Shanghai-based president of Cushman & Wakefield Asia Pacific, who remains positive about both the commercial and residential markets in Shanghai and China.

The number of properties on the block may be growing too, as the government pressures banks to shore up loans to developers of shaky projects before they default.

Colliers International reported in October that citywide office vacancies in Beijing are now at 17.65%, up 1% since the second quarter. Luxury residential stood at 26.5% vacancy in the third quarter, a 5.9% improvement over the second quarter. In the rental residential market, averages stood at $20 per sq. meter, nearly flat from the previous quarter.

Nor is the supply capped, even now. In Beijing alone, 1 billion sq. ft. of new space is expected to be completed by the end of 2006, according to Jack Rodman, a partner at Ernst & Young in Beijing, who specializes in Asian debt.

Rodman predicts a major shakeout over the next few years as thousands of developers — many of whom are unsophisticated — struggle to complete their projects. “From this bloodbath there will be a lot of opportunities,” he says. He predicts that buying distressed properties from troubled developers or banks “will be the best place to invest in [Chinese real estate] in the foreseeable future.”

Investors remain optimistic

In Beijing, some observers say a pre-Olympics ban on new construction in 2007 and 2008 will give that market time to absorb some of its overhang. In Shanghai, Cushman & Wakefield's Thompson notes that downtown office vacancies remain under 5%.

Even residential development still has its fans. Recently, private equity giant Warburg Pincus announced a $31 million investment with Raycom Real Estate Development Co. that includes a stake in Olive City, a 4.2 million sq. ft. mid-rise development under construction in northeast Beijing. Directly adjacent to the future Asian headquarters of Daimler Chrysler, Olive City's approximately 700,000 sq. ft. will be commercial and single-family condominiums selling at an average of $90 per sq. ft., according to Warburg Pincus managing director Philip Mintz.

Foreign retail developers are also pushing ahead. In July, Simon Property Group announced a partnership with Morgan Stanley Real Estate Funds and SZITIC Commercial Property Co. Ltd., a retail property subsidiary of the Chinese state-owned trust and investment firm Shenzhen International Trust & Investment Co., to develop up to a dozen Wal-Mart-anchored shopping centers, ranging from 430,000 sq. ft. to 750,000 sq. ft. The venture's first project will be a 500,000 sq. ft. center in Hangzhou, a city of 6 million people located two hours from Shanghai.

The Taubman Group is also looking seriously at China as part of a larger Pan-Asia strategy. Morgan Parker, president of Taubman Asia, says that his team is investigating “about a half-dozen” development deals in China right now, and will likely make a decision on whether to pursue one in the next six to 12 months.

The Hong Kong-based executive is bullish about the potential for shopping centers in China. Parker says that between 200 million and 300 million people are now in the consumption class, yet there are only approximately 300 shopping centers serving all those consumers.

As many as 100 centers were built in 2004, Parker estimates, many of them by inexperienced local developers. Between bad designs, weak tenant mixes, and over-enthusiasm for size, he argues that many of these centers may not succeed.

Experience brings hope

Many U.S. retailers see the country's lack of retail experience as an opportunity for savvy Western retail developers. “We ask all of the right questions and we ask them of the right people,” says Parker.

Many U.S. developers seem to be proceeding on this assumption, since yields are good but not extraordinary given the level of risk. Cushman's Thompson says normal yields for Chinese centers are between 7% and 10%.

Thompson says most acquisitions by foreign investors are now for failed properties they can turn around through refurbishment, re-tenanting, and the installation of experienced management.

Even if the foreigners are betting right, China is not a slam-dunk. “There is a real lack of transparency in terms of data and accessing that data,” Parker says. “What are the accessibility routes? What are the household incomes? All of those things that we take for granted require a lot more scrubbing and a lot more digging.”

A right answer may also not be the right answer for long. Parker says the number of parking spaces needed this year, for example, may be much lower than the number of spaces needed later on. “In China, things are changing so rapidly that the greatest local nuance that we have to deal with is how you can develop something that is sufficiently flexible to change.”

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