This article was sponsored by White Peak Real Estate Investment. It appeared in the Residential supplement with the June 2019 issue of PERE magazine.
For many investors, developing residential property in China’s second and third-tier cities sounds like a risky proposition, however a structured and data-driven approach takes a lot of risk out of the process says Johan Temse, investment manager real estate at AP1, a Swedish pension fund with total assets under management of SKr340 billion ($35 billion; €31 billion) and a 13 percent real estate allocation, and Jesper Jos Olsson, chief executive of Swedish investment manager White Peak Real Estate Investment. Together, they have been investing in this sector for close to a decade. Here they discuss how they make it work, with PERE’s Mark Cooper listening in.
Playing to themes
Jesper Jos Olsson: White Peak has been investing in China for 13 years now and we follow a hybrid model where we are the investment manager of a number of real estate funds catering to predominantly Swedish institutional investors and uniquely we also have a 400-plus employees strong in-house development platform. Our focus is to build middle-income residential housing for sale. Currently, we develop and invest in around 20 projects in 11 cities, which are often defined as second and third tier, across three provinces – Shandong, Hebei and Liaoning – primarily in northern and eastern China.
Johan Temse: China is obviously one of the world’s fastest growing economies. It is a huge market with very well-developed infrastructure. From a macro view, we like that. When we invest in property, we always try to identify themes, and one very strong theme we like right now is urbanization. This is a global trend, but one I believe is particularly strong in China. At the same time, we are also seeing a rise in the middle-income class in China together with strong GDP growth. These fundamentals are attractive for AP1 as a long-term investor, particularly as population movement to large cities will continue for the foreseeable future.
Housing affordability is also stronger in China compared to some markets in Europe. Household debt is relatively low and there is a desire among the middle-income class to achieve a higher life quality in terms of improved housing conditions in more convenient locations and closer, for example, to better schools for their children. This is creating high demand in the residential space, and as investors we are well positioned to take advantage of these shifts going forward.
JJO: If you look at China just a decade ago, it was only 46 percent urban. Today, it is close to 60 percent and we can expect that to increase to 70 percent or more over the next decades. And this is the reason White Peak started looking at the market 15 years ago. We spotted this trend already 15 years ago and continue to see urbanization as a long-term opportunity.
JT: Although there are still some doubts whether Asia generally could be regarded as an institutional market, AP1’s view is that China is one of the markets in the region where there is very good transparency as well as a legal system that functions very well when it comes to making property investments. This is another reason why we like the market.
JJO: There is a misconception that China is extremely complicated, irrational and opaque. In fact, it is pretty straightforward and open. Something we learned early on is that in China, data is readily available for the whole supply and demand of land, including inventory and the production pipeline of property. This makes China unique. I do not think there is anywhere else in the world where every piece of land that is auctioned already has designated planning in place, and the certainty that it will start construction according to a pre-agreed time schedule. And every apartment sold is registered in a database. When the data is available, the next step is to analyze and validate the data. It then requires the deep understanding of the local market and buyer behavior, which we have developed gradually over the last decade.
So basically, it is possible to build very sophisticated data models around supply and demand. This allows us to have quite specific data underwriting of these different local markets and base our investment decisions on supply and demand. We can run modelling based on, for example, what kind of products people like and what purchase price sells the most. These are some unique features of the Chinese residential property market that most foreign investors might not be familiar with.
JT: Governance, sustainability and corporate social responsibility are also rapidly becoming top agenda items now. And it is not just a box-ticking exercise for us. We believe a focus on these issues is resulting in better returns from our investments in China’s residential market. We push all our managers to participate in the GRESB survey, and we benefit from White Peak’s dedicated approach to these issues – we can demonstrate good returns and a good GRESB score.
Looking at Asia generally, real estate investors and managers are a little bit behind the curve on these issues, but White Peak has, naturally, taken a Swedish approach to ESG in China. Strong ESG performance helps when bidding for land plots and also we are finding the end customer is now keener to buy from developers that take the responsible environmental approach to residential projects.
JJO: We partner with cities that value good urban development and because of our focus on doing things the right way, for example by having fewer accidents on our work sites, we experience fewer lawsuits from customers; we pay more tax; we train our people better and we are more transparent. This makes us a better partner for institutional investors like AP1. The key in China today is really to be a low risk partner. And that is not complicated. You can push for an extra percentage point of IRR, but we have been generating opportunistic returns and this is while using minimal debt, so there is no need to take unnecessary risks.
JT: And from the investor perspective, one of the attractions of China is the sort of the risk-adjusted return we can generate from the residential sector in the second and third-tier cities. The combination of low operational risk and low financial risk continues to provide us with high returns making the market attractive for us.
JJO: And our data-driven approach, which as I mentioned before is so critical to our development and investment decision-making, also really helps us to drive those returns for AP1 in China. To give you an example, in terms of location, our strategy is to develop residential real estate in the least urban districts of the biggest cities in our markets. So in Shandong province, for instance, that means the less urbanized areas of Qingdao and Yantai. We think this is where most growth will take place. You put a large amount of supply and demand metrics into a database and then you can figure out quite quickly what works. In most of these cities, income growth has outpaced property prices over the past 10 years and continues to do so.
This increased affordability is very positive for us. In contrast, it is difficult to find development sites in China’s Tier 1 cities like Beijing and Shanghai. There is a real misperception about city tiers in China. We do not consider a second or third-tier city as a secondary market. These are cities with populations of five to 10 million and in a region similar to the size of Europe. That means almost any city market in China offers attractive investment potential.
Case study: Building a Scandinavian-style eco city in China
In December 2018, White Peak acquired two land parcels of the Yantai Hammarby Eco City Project, which aims to integrate Scandanavian innovation, lifestyle and sustainability in China’s rapid urban developments. Jesper Jos Olsson comments: “White Peak is working with our international and Chinese partners to build a sustainable, high-quality project, which will display advanced environmental technology, and contribute to creating a healthy, green, connected and smarter environment for future generations.”
Location: Yantai City, Shandong Province, China
Developer: White Peak
Investor: White Peak Fund IV
Lead designer: Sweco International AB
Acquired land size: 92,000 square meters
Number of apartments: 1,870 units
First-phase product mix: Residential, loft, retail and sports stadium