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Cracking the Forbidden Market

China tops most corporate agendas these days — no one ignores a country that's just become the third-largest exporter in the world. That is, unless you're in real estate.

In the real estate world, old ideas about China still seem to hold sway. “There is an amazing blind spot about China,” says Michael W.J. Thompson, president of the Asia-Pacific group of Cushman & Wakefield. Given its rapid economic growth and the U.S. corporate consensus about its future prospects, the Shanghai-based broker says he finds it surprising how slow Western developers have been to enter the China market.

One of the few Western developers active in the market is Prologis, a global logistics and warehousing giant that's now developing three projects in Shanghai. The projects include a 1.7 million sq. ft. warehouse in Suzhou Industrial Park that's 100% leased, an additional 400,000 sq. ft. warehouse, and an announced project in the vast new deepwater port of Shanghai where the firm has reserved 3.5 square kilometers on which it plans to build out 15 million sq. ft. of facilities.

Why did Prologis decide to go in where so many developers still fear to tread? CEO Jeff Schwartz is modest about the impetus behind the move. “We didn't decide to go to Shanghai,” he says “…I didn't wake up one morning and say that I think it would be a good idea for us to be in Shanghai. Every one of our major global customers has either already gone to China or is thinking about it…we're serving our customers,” he explains.

But the Aurora, Colo., firm is the exception. Most large real estate investors are still only getting acquainted with China, even though China is putting up new buildings almost as fast as it fills Wal-Mart's shelves. Andy Xie, a Morgan Stanley economist, estimated in a recent research note that the total volume under construction reached 1.5 billion square meters in 2004. In Beijing alone, about 1 billion sq. ft. of new commercial and residential space is either being built or is in the pipeline over the next three years, estimates Jack Rodman, managing director of Ernst & Young's Asia Pacific Financial Services Practice. That's a lot of space. By comparison, the Beijing-based accountant says, Manhattan has about 250 million sq. ft. of commercial space altogether.

Ronald Schramm, an adjunct associate professor of finance and economics at New York's Columbia Business School who specializes in China, says development is booming not only in Beijing and Shanghai, but is now growing throughout the rest of China. That's saying a lot in a country of 1.3 billion people that has nearly 100 cities with more than 1 million in population, and some have many more. Of the 100 biggest cities in the world, 18 are in China. By comparison, only two are in the U.S.

At least 25% of the gross domestic product is now in construction, Schramm estimates. And that government figure is probably understated, he says. By comparison, construction in the U.S. is estimated to be about 5% of the gross domestic product.

Not all of that is government money. Schramm notes that Chinese families typically save up to 40% of their incomes and yet have few investment alternatives outside real estate. There's also at least 50 years — make that 5,000 years — of pent-up demand. As Zhang Xin, president of SOHO China, one of Beijing's largest developers, explained at a panel discussion on China at the fall Urban Land Institute (ULI) meeting in New York in November, people get very excited when they tour her chic model units because they “used to live in state-allocated, very scruffy space.”

Local developers are working around the clock in Shanghai to meet the demand for office and residential space. Gary Hack, an urban planner who has worked extensively in China and is dean of the University of Pennsylvania School of Design in Philadelphia, says that in Shanghai, construction often continues 24 hours a day by 500,000 unskilled rural laborers who now work in the city.

Look twice before crossing

Some China-watchers think it may be a bubble to end all bubbles. Morgan Stanley's Xie, in a recent note, wrote that he believed property sales are “vastly inflated” due to negative real interest rates. In Shanghai, one of the hottest markets, apartment prices rose by 17.7% in the first three quarters of 2004, according to government figures recently reported in the China Daily. In Beijing, average housing prices now range between $843 and $963 per square meter, far outstripping the average income of about $1,200 a year, according to a People's Daily report.

Others see many years of rapid growth ahead. Hack believes that two factors are likely to drive the markets over the next 20 years: rapidly rising incomes — 10% to 15% a year — and urban growth that's expected to rise from 40% to 50%, swelling the population of China's cities by 150 million.

Yet, foreign investment is surprisingly limited, at $9.1 billion in 2003 and less than 8% of total construction, according to the latest National Bureau of Statistics estimates. Observers say that the largest share of deals is being made by Asian players in Hong Kong, Singapore and Japan.

Among Western investors, most recent deals have been for build-to-suit factories, offices or storefront leasing, not pure investment. In November, Estee Lauder leased approximately 2,100 square meters and IBM leased 29,200 sq. ft. of office space in Shanghai, according to Michael Silver, president of Equis Corp., a Chicago-based tenant representation service.

What's holding U.S. and European investors back? In the past, some of it had to do with legal restrictions. Only this fall did it become legal for foreigners to own retail space in central cities. However, Thompson says that ignorance and misconceptions have kept many Western investors from looking closer.

Solving the enigma

Should you go in? Even the most knowledgeable Western developers in the market say it's tough. “The number of times that I was prepared to throw up my hands and pack my bags are too numerous to recount,” says Jim Buie, executive vice president for the western U.S. and Asia-Pacific for Hines, the U.S. developer with the most experience in China.

A pioneer in the market, Hines built its first project in 1996, a 500,000 sq. ft. apartment building for expatriate executives. Its largest project under way is Park Avenue, a five-building high-end residential condominium containing 2.7 million sq. ft. in three, 30-story buildings, one 16-story building and one 10-story building.

While it's hard to generalize about a market the size of China, which after all has over four times the population of the United States, there seem to be a number of key factors potential investors should consider.

Fierce and local competition

Even though regulations keep easing, the advantage seems to be offset by the growth of more competition. “It's probably at least as difficult as it has been,” says Buie of Hines. The San Francisco executive says Hong Kong and Singapore developers are already there “and going gangbusters.” A number of domestic companies are also getting started, some of them led by Chinese nationals who were educated overseas. “Nobody's waiting around for the Americans to show up,” he says.

High volatility

Market fluctuations can also be more extreme in Asia where volatility over the last eight years has been dramatic, warned Kurt W. Roeloffs Jr., who heads the Asia Pacific and America's group at Deutsche Bank, at the ULI last fall. “How do you put together a long-term business plan and survive that kind of environment? It's very difficult. You really have to re-engineer your business model if you go to the East.”

Such market swings and the difficulty of getting long-term financing have led many developers to build and sell unit by unit. Even in the retail and office setting, financing through pre-sales seems to be a relatively popular alternative, particularly as individuals have easier access to long-term financing for real estate than companies, a reflection of the government's decision to turn down the economy's heat.

One advantage of the pre-sale model, says Soho's Xin, who is also a pre-sale builder, is that it makes doing competitive research a much simpler matter. “See how fast they're building. If they're building slowly that means they're pre-selling very slowly. That means they're about to be dead and you guys have a chance to buy them out,” she told the ULI seminar.

Only one major seller

All the land in China is still owned by the government: private property is actually just a long-term lease of 40 to 70 years, according to Yingxi Fu-Tomlinson, a partner in the Shanghai office of New York law firm Kaye Scholer.

This information imbalance tilts very heavily against the buyer. “Because the supply of the land is controlled by one single source, that one single source really doesn't have a lot of interest in letting people know what the pricing is,” explains Fu-Tomlinson.

While there are some restrictions on where Westerners can buy — central business districts, for instance, are technically off limits — a bigger player or someone with a project the government considers desirable might be an exception, according to Fu-Tomlinson.

Foreign investors can also work around these rules by creating joint ventures with local partners, either a company with a connection to the government or a state-owned company.

In the past, good connections with the government meant access to better parcels, Fu-Tomlinson says. Now, however, the government is making a transition to a public auction system for property. But the system is just getting off the ground: the first auction was held in December.

As with much of the Chinese economy, the property system is still a work in progress. Some very basic questions still remain unanswered by the government. Right now, for instance, there's no provision for lease renewals once the current leases expire. “Nobody really knows,” says Fu-Tomlinson. After all, the system only started in the 1980s.

Society is in flux

In Shanghai, Fu-Tomlinson says, relocation packages for residents of buildings slated for demolition or renovation can add up to 50% of the purchase price. Sometimes the negotiations are arduous and can can drag on for several months, or degenerate into angry street protests and occasionally even high-profile court battles. It's such a problem that investors make distinctions between two classes of land: “raw and cooked,” according to Fu-Tomlinson. “Raw” property is a parcel where the residents have not been relocated yet and “cooked” property is land where the residents have already been moved.

While the Chinese government is reportedly very eager to resolve tenant disputes peacefully, some experts worry that as the country's “socialist market economy” develops, disputes are going to become increasingly bitter. For a country whose last century was marred by civil war, multiple revolutions, and spasms of totalitarian violence, the stability of property rights aren't necessarily a given. Most observers, however, give the current government high marks for its handling of the country's rapid rise to global economic power. Buie of Hines describes the government's development of infrastructure over the past 10 years as “nothing short of miraculous.”

Outsiders at a disadvantage

Beyond government as landlord, developers also have to deal with the government as regulator. The national government, city government, and local zoning offices, all have constantly changing regulations, like their counterparts in the U.S. and sometimes conflicting agendas. For example, a village might be eager to attract a plant and ready to sell some land, but the state zoning authority will actually have the final say over whether a parcel can be converted from agricultural to industrial use, Fu-Tomlinson says. Navigating those disputes can be challenging — though some developers scoff that it's not unlike doing business in California.

Nor does the government have the patent on murkiness. Chere Burdette, managing director of Studley's international services group in San Francisco, argues there's a reluctance to part with information as part of the business culture. “As negotiators, the Chinese tend to play their cards closer to their vest,” she says. “Every piece of information is considered valuable. There's just not that free flow of data like you find in the U.S.”

Burdette says that unlike India, Malaysia, and Singapore, contracts and forms are not routinely translated into English. Other market experts also say that things like comparable sales reports and market figures are sometimes difficult to obtain.

But perhaps the most important factor isn't information. Many deals are done or facilitated through guangxi, a Chinese word that means both relationships and understanding. “There are the rules and then there are the relationships,” says Burdette, “and getting things done often requires the latter.”

To navigate around these difficulties, most experts suggest working with a law firm that has a deep understanding of the marketplace. Another frequently recommended tactic is to develop a joint venture with a local concern. For example, Hines had a 5% partner in its first project and equity partners in subsequent developments.

Silver linings

Given all the limitations, is there a role for Western developers in China at all? Yes and no. “If you try to compete head to head with Asian developers and investors, you'll be killed in a flash, quite frankly,” says Cushman & Wakefield's Thompson. “You don't have the guanxi, you don't have the understanding, you don't have the speed of decision-making.”

However, there are needs for quality, B-grade office space, which are not being met, he says, because developers automatically try to build Class-A. In retailing, most areas have been anonymous developments, because that's the model Asian developers know. There's an opportunity, he says, in the historic parts of Shanghai, to build some themed shopping centers akin to San Francisco's Fisherman's Wharf or London's Covent Garden.

The only opportunity for Western developers, Thompson says, is to take what they've seen in other markets, and “identify emerging trends which are not immediately apparent to Asian developers.”

Bennett Voyles is a New York-based writer.

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