This article is sponsored by GoHigh Capital.
For most outside observers, China’s real estate market is all about new development – the skyscrapers, malls and warehouses that characterize the nation’s growing cities. But in larger and earlier-developed cities, there is a significant amount of mature real estate, some of which is ripe for redevelopment or repurposing. Also, China’s real estate boom has led to some misaligned development – the wrong building in the right place. Taking advantage of these circumstances can be profitable, explains Josh Zhou, executive partner at Chinese investment manager GoHigh Capital. However, these complex transactions require careful structuring, asset management capabilities and financing – and strong government relationships.
Why should investors consider value-add and repositioning projects?
When the market is pushing ahead, when everything is in high-growth mode, it is easy to achieve strong returns from straightforward investments. However, because the market is more competitive with more foreign and local investors becoming active, we have to go further. Core real assets in China are now performing like core assets in other major markets, so you need to work harder for your returns. Also, as the China property market matures, we will see more older buildings that are in need of work for any number of reasons, so more opportunities will emerge. Looking further ahead, we see more opportunities for distressed asset deals. This will partly be related to the slowing of the Chinese economy, which was already happening due to financial de-risking and the effects of the trade dispute with the US.
Which sectors and building types offer the best opportunities in China for repositioning?
This business is very asset-specific, so any sector or asset type might have potential. But the most straightforward way to engage in value-add projects is office renovation and repositioning. Office is very popular and is still the first choice for institutional and private investors. For example, our Shanghai Jing’an GoHigh Tower project saw us acquire the building, refurbish it and increase rents by more than 50 percent. There is also potential for retail to office conversion, such as our Beijing Xinjie GoHigh project. We acquired a retail asset in Beijing and converted part of it to office use. There are also opportunities in retail refurbishment, converting hotels to office space or perhaps converting serviced apartments to condominiums.
More recently, we have been focusing on deals that are relatively large and complicated, because here we can use our experience to add value. And of course, more complicated deals mean less competition. So our Beijing Daxing Joybreeze project, a retail refurbishment in Beijing, was a substantial lot size and required a great deal of capital expenditure. As well as upgrading the retail space, we restructured the debt and brought in a new operating partner.
Which city markets offer the best opportunities for these types of projects?
Most of our projects have been in Beijing and Shanghai, simply because these are the most liquid markets in China – 75 percent of commercial property transactions occur in these two markets. Guangzhou and Shenzhen have far fewer transactions, and second-tier cities are a long way behind. Liquidity is our first priority and it is much lower in second-tier markets. Values can go down very quickly in secondary markets due to that lack of liquidity, which might be an opportunity but is also a risk. We do see some opportunities in retail in smaller cities, but you need a very strong operating partner that has local teams in the markets you are targeting. For example, we have partnered with Grandjoy under COFCO Group, one of the best shopping mall operators in China.
What are the major obstacles you are likely to come across in repositioning an asset or gaining change of use? How can you deal with these?
If you are looking to change the use of a property or redevelop, you need to secure permission from the government, so government relationships are very important. If you have those relationships, you can avoid pitfalls. Also, you need to talk to the government before your acquisition. Something else to consider is, if you want to convert a shopping center to an office, for example, you will need to remove all the tenants. This is hard to negotiate for foreign investors and actually difficult for local operators too. We have found that building experienced teams in this area is invaluable. Cost control is also extremely important – you need to buy at the right price and stick to your budget for the renovation.
Without proper planning and estimation, budget overruns can be a disaster.
Buying at the right price does not mean squeezing the last cent out of the seller. We try to behave as both a buyer and advisor. The structuring of these deals is often very complex and by co-operating, we can create a structure that makes a bigger pie for everyone. When you co-operate with the seller you lower risk.
Of course, complexity is itself an obstacle for some investors, but it is what we want. We are not afraid of dealing with historical tax, legal or debt structures because we have teams experienced in dealing with these issues.
What is the financing environment for value-added transactions?
Again, because each deal is unique, so is each financing situation. More complex deals naturally involve more complex financing. If we can buy at a good price, it gives us a chance to use a little bit higher leverage because the overall implied loan-to-value is not that high. We use both senior debt and mezzanine finance in our transactions, when we find the risk-return profile justifiable. Debt is not always that easy to come by for this sort of transaction. Chinese banks in general prefer to back large developers or state-owned enterprises with big ticket lending. So, this is a situation where a strong track record, sound underlying assets and good relationships with banks means you can secure financing.
What are the typical deal sizes on offer and what range of returns can be gained from repositioning deals?
There is a big range of deal size in the market. For the transactions GoHigh has invested in, the amount of equity invested ranges from 50 million to 2 billion yuan and a total deal size of up to 4 billion yuan.
However, we are looking for larger and more complicated deals today, so that means a lot sized at least 1 billion. We have a track record of delivering high returns, averaging an IRR of more than 20 percent since our inception in 2009. While we expect more fluctuations in the market going forward, our target returns remain at 18-20 percent.
Slicing and dicing
China’s CMBS and quasi-REIT structures offer new exit opportunities for investors
GoHigh Capital has been a pioneer in real estate securitization in China and has been involved in both commercial mortgage-backed securities and in quasi-REITs, securitized structures, which are part of the nation’s development of real estate investment trust products.
It is not often that someone can be said to have literally ‘written the book’ on a topic, but in the case of CMBS and GoHigh Capital executive partner Josh Zhou, it is correct. Alongside Chinese regulators, Zhou co-authored the rulebook for China’s CMBS structures, which differ slightly from the US model.
GoHigh structured the first Chinese CMBS issuance in 2016 and has since been involved as an advisor and special servicer to subsequent issuances. The market has grown from nothing to 270 billion yuan ($39 billion; €34.2 billion) in 2019, but Zhou says the potential is enormous. “So far, it is a tiny fraction of the overall China real estate market, where debt is mainly bank and trust lending. In the US, CMBS issuance amounted to $1 trillion at the end of 2019.”
A unique development of the Chinese securitization market has been quasi-REITs, which are listed products backed by commercial and residential real estate assets. These have mainly been debt products, but some more recent structures have included an equity tranche. Quasi-REITs tend to have a five-year maturity. Zhou says: “Our experience in these structures opens up multiple alternative exit possibilities for our investors as well as en-bloc or strata sales. In the future, these may well include equity REITs.”
The ultimate development for China would be a true equity REIT structure, widely regarded as an important step for the institutionalizing of a nation’s real estate market. Zhou has been involved in the ongoing process of development, testing and consultation for a China equity REIT.
Case study – Aegean Square, Beijing
Aegean Square is a typical example of the sort of sizable and complex repositioning deals GoHigh is targeting
Located on the north third ring of Beijing with a total gross floor area of approximately 100,000 square meters (just over 1 million square feet), it was originally used as a shopping mall. On acquisition, the building came with a master lease until 2029 at a very low rental level. As well as purchasing the asset, GoHigh played an advisory role to the seller on how to restructure the project ownership structures to facilitate the acquisition and was able to secure the deal at a 25 percent discount to market price.
Subsequently GoHigh worked to unwind the master lease with the shopping mall, unlocking huge rental upside possibilities. The project will be repositioned from retail to office space and GoHigh expects it to be re-opened in its new guise by the end of 2021. Pre-leasing discussions are underway with a range of office tenants. GoHigh has obtained a M&A loan from onshore banks and another working capital loan for renovation is in the pipeline.