A healthy mix

A troubled macro picture for China and the emergence of its cities ex-tier I provide for private equity real estate folk a compelling outlook containing both growth and distress.

Yesterday’s China Market Briefing event hosted by law firm CMS Cameron McKenna at its office in London was a tale of two keynotes.

First a story of foreboding from Marina Petroleka, head of energy and infrastructure research at independent country risk and industry information provider Business Monitor International (BMI): “I’m not going to paint a rosy picture,” she opened.

Replete with one impressively complicated slide after another, Petroleka explained how BMI’s China economist had predicted worse growth prospects for China than the consensus – 7.5 percent versus 8 percent for 2013 (and 6.8 percent in 2014).

Passing off Q4 2012’s return to increasing growth as short-term and unsustainable, she accused the Chinese government of covering up cracks with a “veil” of attractive numbers before recounting the reasons for adopting a more cautionary approach to the world’s most populous country.

Invariably much of the blame fell at the feet of China’s property markets, particularly residential. Starting with its “big four banks” (Bank of China, China Construction Bank, Industrial and Commercial Bank of China and Agricultural Bank of China), Petroleka explained how these major sources of development finance were already over-extended and oftentimes committed to projects with poor cash flows and of questionable quality generally.

According to BMI’s numbers, Chinese banking sector assets have grown by $15.5 trillion to $22 trillion since 2006 to 265 percent of GDP.  With much of this bulk concentrated in areas of investment, real estate at the centre, the need for non-performing loan provisions will need to be substantially higher than the lowly 2.5 percent average presented by Petroleka.

Add to that the sheer volume of wealth management products offered to retail investors – valued at 80 percent of China’s GDP – off balance sheet, and the picture becomes more worrying in terms of the borrowing profile of many of the country’s developers. Overstretched and poorly underwritten debt from banks coupled with short-term and risky products bought by retail investors led Petroleka to predict a US-style sub-prime mortgage event in the making.

With her gloomy forecast still ringing in everyone’s ears, up stepped Jeremy Kelly, a regional research director at Jones Lang LaSalle. His was the seemingly unenviable task of presenting the property services firm’s annual China50 research denoting the 50 most attractive cities in China for institutional investment ex-tier I. “I perhaps might be a little more bullish than Marina,” he countered in his opening comments.

And so he was. Kelly sketched a compelling picture of China’s emerging real estate markets, describing how his firm was seeing evidence of rapidly increasing multinational and domestic corporate occupational demand outside of Beijing, Shanghai, Guangzhou and Shenzhen. He rattled off some compelling estimates – 80 percent of China’s institutional investment grade retail stock and 51 percent of its office stock are expected to be in the China50 by 2020, for instance – a soaring increase on historic and current levels. And he outlined a conscious shift in real estate demand from coastal cities westwards to rapidly sophisticating urban centres like Chengdu and Chongqing.

Retail and logistics property were his sector picks as he detailed the growth in people in China earning more than $5,000 a year. In light of a government that is wilfully switching its focus from exports to a consumer economy, Kelly’s arguments carried weight.

So digesting these two perspectives of China’s property markets, should private equity real estate folk be worried or compelled? We would argue the latter. A “healthy mix” of growth fundamentals across a plethora of real estate markets, as detailed by JLL, and distressed financial positions brought about by overzealous lenders and developers, as suggestible from the forecasts of BMI, is just the sort of market dynamic our part of the industry is supposed to thrive on.

Whether private equity real estate firms should focus on distress, growth or both in China will be just one of the many subject dissected on stage at the PERE Summit: Asia 2013 in Hong Kong between 27 and 28 February. To join the debate, click here.