China Real Estate: At Tipping Point

by KFH Research Ltd

China’s real estate market remains an anomaly and has charted exemplary growth in the last decade, buoyed by the country’s high economic growth and higher disposable incomes that has given rise to burgeoning demand for property assets.

Since early last year, the real interest rate in China has moved further into negative territory owing to the persistent rise in the consumer price index. Real interest in June 2008 was down to -3.77% (it hit a high of -5.37% in February 2008) as compared to -0.4% early last year.

To protect real purchasing power against inflation, consumers will seek to invest in property to preserve the value of real income. Given that real interest rates are likely to stay low or remain negative for some time, high investment demands will bring further growth to China’s property market.

In addition, the positive wealth effects arising from the spectacular rise in China equity markets in over the past couple of years, coupled with the strength of the yuan, have added to the sector’s allure among both local and foreign investors.

Shanghai, Beijing, Guangzhou and Shenzhen are among China’s Tier-I cities most sought after by foreign investors, given their high levels of urbanisation, mature property markets and extensive supply of quality buildings.

In Beijing, the real estate industry remains the backbone of the local economy. In 2007, investment in Beijing’s real estate market increased 16% y-o-y to 199.58 billion yuan (RM96.6 billion), despite a hold-and-wait strategy adopted by some investors.

However, concerns about asset price inflation fuelling investment bubbles have led to government restrictions such as tighter monetary policies to absorb some of the excess liquidity as well as investment policies to curb speculation.

These measures include the introduction of higher minimum down payment, higher sales tax on residential properties owned for less than five years, nationwide 20% capital gains tax and additional restrictions on foreign investments.

In 4Q07, China’s real estate investment witnessed a slowdown following the implementation of the land appreciation tax as well as additional restrictions imposed on foreign investment in the sector.

The tightening policies by the Government led to a mild correction in the property market in the 4Q07-1Q08 period, with transaction volume dropping by 51% q-o-q and 1% y-o-y in 1Q08. However, the partial recovery in March sales volume in major cities shows that fear of further deterioration is subsiding.

So far, the government’s tightening policies have been successful — prices have stabilised, while volumes have contracted. We believe the current correction is beneficial for the development of a sound and sustainable property market. We further anticipate strong competition and stricter restrictions on foreign investment in the Tier-I cities to result in foreign investors shifting their preference to Tier-II or Tier-III cities such as Chengdu, Chongqing and Hangzhou.

On the lending side, real estate loans appear to be less readily available than they were 12 months ago. Banks, encouraged by the China Banking Regulatory Commission, are tightening their criteria for lending and strict loan quotas have been introduced.

Recent increases in the reserve requirement ratio for banks serve as a further constraint on lending. Where loans are available, they are at lower loan-to-value ratios, and are charged higher interest rates. Ironically, latest figures show that domestic lending to the sector remained high at 28% in March 2008 (Dec 2007: 32.2%).

Given that China’s share of mortgage loans to GDP ranks amongst the lowest at 10.8%, the risk of incurring a US-style subprime mortgage crisis is well contained. Nevertheless, China’s real estate market is still subject to the consequential effects from a slowdown in the US economy, given the dominant role that US consumers play in driving the demand side of the world economy.

However, China’s real estate market is expected to continue to benefit from the country’s strong economic fundamentals. The real estate market will also get a boost from the 2008 Summer Olympics in Beijing. Nevertheless, we caution that valuations post-Olympics in Beijing and Shanghai’s real estate markets could see considerable adjustments to rentals and demand.

Residential outlook
Judging from the first fourth months of 2008, Beijing’s residential market has softened slightly as supply and transaction volumes have started to taper off. Prices, however, continue to rise, albeit much slower than in 2007. Supply and demand volumes during the period were 34% and 54% lower than a year ago.

Despite a decrease in transaction volumes, investments in the residential market, which has been on the rise since 2001, continued to grow in the first four months of 2008 to 21.6 billion yuan, up 4.3% from a year ago.

In Shanghai, the housing market is expected to encounter a mild correction in 2008. On the high-end side, the market remained active in 2007, despite government efforts to curb the present excessive liquidity through restrictive mortgage lending and limited land supply for high-end residential developments.

Growth was supported by higher demand for high-end properties as long-term investments, as well as the continuous inflow of expatriates. The new supply of luxury residential homes is expected to reach 3,659 units in 2008 versus 3,303 units in 2007.

Hong Kong’s Residential Price Index has continued on its uptrend into 2008. In 2007, the index grew 25.7% y-o-y to 145.9 points (2006: 9.2% y-o-y). As at May 2008, the index rose to 32.1% y-o-y to 161.8. In 4Q07, prices for luxury residential in The Peak recorded the highest growth among the traditional luxury districts. The average luxury residential price increased 6.4% q-o-q from HK$20,124 (RM8,557.79) per sq ft in February 2008 to HK$21,419 per sq ft in May 2008.

Office market still upbeat
China is currently moving towards a more service-oriented economy. This, coupled with the increasing number of multinational companies that have established a presence in China, is stimulating demand for quality office space, particularly in cities such as Tianjin, Nanjing, Wuhan, Qingdao, Dalian, Chongqing and Chengdu.

In Beijing, more than 1.6 million sq m of Grade A office space was launched in 2007, more than double that of 2006. New office spaces in the prime CBD and its vicinity accounted for nearly 45% of the total supply. In 2008, the Beijing Grade A office market is expected to see 1.3 million sq m of office space in the pipeline, in particular in the prime CBD, which is expected to put some pressure on the market.

Demand for office space remained strong in 2007, with the annual take-up increasing by 12.8% y-o-y to 0.8 million sq m. As a 1Q08, the total take-up of the Beijing Grade A office was 209,354 sq m. Most of the new lease tenants came mainly from the banking and financial sectors, insurance, professional services and high-tech sectors.

Average rentals in the Grade A office market remained robust throughout 2007, reaching US$23.80 (RM79.73) per sq m per month in 4Q versus US$22.60 in 3Q07. This year, we expect average rentals for office buildings to continue to sustain its steady growth, despite the large supply expected to come on stream, given the continued demand for high quality office space.

The liberalisation of the China’s banking sector and Shanghai’s emergence as a major financial centre has buoyed demand for office space in Shanghai. In the Grade A segment, net absorption amounted to around 263,000 per sq m in 2007 as tenants sought quality space in the city for expansion, upgrading and relocation.

In 2008, we expect the demand for Grade A office space to continue to increase, given the rise in business expansion plans, particularly from foreign banks, financial institutions, as well as professional firms.

The Shanghai Grade A office market supply is expected to increase to 843,300 sq m in 2008, mainly in Pudong area (608,900 sq m or 72%) of which the Shanghai World Finance Centre alone will contribute some 226,900 sq m, Jing’an (163,400 sq m) and Putuo (75,000 sq m).

The increased supply of Grade A office space will slightly push up the vacancy rate in 2008, and cause rentals to soften to approximately 2% versus 11.3% in 4Q07. The average rents in Shanghai’s office market continued to rise, increasing by 2.8% in the 1Q08 to 8.4 yuan per sq m per day (US$36.4 per sq m per month), underpinned by strong demand for prime office space in both the city’s eastern and western office precincts.

Focus on Tier-II cities
Given the limited availability of urban sites as well as surging land prices in Tier-I cities, foreign developers have increasingly shifted their investments towards Tier-II cities. Rapid urbanisation in Tier-II cities is expected to translate into steady demand for residential units.

In the office market, growth in the Grade A segment has been driven by interests from well-known developers, the entrance of multinational companies, as well as the push by the local governments to create more attractive CBDs. We expect the demand for Grade A offices to continue to increase in the coming years, underpinned by continual influx of multinational corporations which will stimulate the demand for quality office space in cities that have the potential to become a regional service centre.

The move also coincides with the government’s emphasis on Tier-II cities with strong economic prospects as part of the government’s efforts to narrow the wealth gap between eastern coastal cities and their western brethren. In recent years, the government has introduced tax incentives and encouraged infrastructure investments to attract companies into China’s interior.

For China’s next phase of development, the country’s Tier-II cities are expected to provide more opportunities for property investors, in particular cities with high population as well as per capita income.

There are currently 57 cities in China with a population of over one million and per-capita GDP of above US$3,000. Out of these, 14 are located in the Yangtze Delta, nine in the Guangdong province, and six in the Shandong province. These cities generated 43% of the national GDP in 2005.