On the public school playgrounds of the 1980s Midwest, conventional wisdom held that, if every man, woman and child in China jumped up at the same time, the earth would be knocked off its axis as they landed. In other words, by sheer dint of its size, China's population was itself a deadly weapon.
Setting aside the myths of the school yard, the demographics of mainland China remain an object of mystery and a thing of power. It has certainly fueled the country's phenomenal growth—turn to the business pages of any major newspaper and the China story will no doubt feature prominently. It's the story of the move from the agrarian economy of Mao Zedong to the economic reforms of Deng Xiaoping, the country's successful capitalist transformation over the past twenty years and the development of a thriving manufacturing industry fed by US and European desire for cheap goods; it's also a story of population.
While official statistics put the population of China at 1.3 billion people—far and away the most populous nation on earth—some observers think the actual number is closer to 1.5 billion, a fifth of the world's total. While these numbers are impressive, perhaps more interesting are China's much-heralded shifting demographics: the traditionally rural society is increasingly becoming an urban one as what has been called the greatest human migration in history takes place. It is predicted that, by 2010, more Chinese will live in cities than rural areas.
In his 2005 book China, Inc.: How the Rise of the Next Superpower Challenges America and the World, journalist Ted Fishman notes that between 90 million and 300 million people will eventually leave the countryside and move to find work in one of the country's many large cities. At the low end, he points out, that number matches the entire workforce of the US; at the high end, it equals the working populations of the US and Europe combined. According to China's National Bureau of Statistics' 2004 yearbook, 82 percent of Chinese people lived in the countryside in 1978. By 2003, the number had dropped to less than 60 percent.
This shift can be particularly felt in the real estate markets of China's major cities such as Shanghai, Guangzhou and Beijing. Much has been made of the thousands of office blocks and condominium towers sprouting up in Shanghai—The New York Times recently estimated that the city has seen more than 4,000 skyscrapers built with plans for an additional 1,000 to be completed by 2010. Areas of Shanghai that were once sleepy corners have been plowed over and replaced by towering buildings, themselves signs of the Middle Kingdom's optimism about its future.
But China's population story extends well beyond its major cities. The statistics bureau lists 174 cities with more than a million people, including 11 metropolises with more than four million. By comparison, the US has nine cities with more than one million people; Europe has 36. With so many cities growing and, in some cases, sprouting up practically overnight, it is no wonder that investors are looking beyond mainland China's largest cities to these fast-growing second-tier towns. While these burgs might not attract as many Western expatriates or affluent Chinese—the target buyer for many of the residential projects going up in the primary cities—they are attracting attention from a diverse mix of real estate investors including local Chinese developers, Hong Kongand Singapore-based property groups and even some Western private equity real estate firms.
SECOND TO ONE
“Demand in second-tier cities predominately comes from local residents with increasing salaries searching for better-quality housing,” says Randall Hall, chief executive officer of Savills China, a branch of the international real estate services firm. “[Demand] also comes from migrants from third-tier and rural areas.”
As the local population expands not only in number, but also buying power, China's second-tier cities are seeing an increase in interest from retailers and expanding foreign multinational companies. The Beijing Academy of Social Sciences recently released a study ranking Chinese cities by their strengths as major economic centers. Predictably, Beijing, Shanghai and Guangzhou topped the list, but the study also named second-tier cities like Chengdu, Tianjin, Nanjing, Qingdao and Wuhan. According to Hall, these cities have “large populations and strong economies based on solid manufacturing industries [and] can position themselves as regional centers for multinational and domestic firms.” He adds that Hangzhou was recently ranked by Forbes as the best city in which to do business in China.
The second-tier cities seeing strong economic growth and drawing the interest of real estate investors are located throughout China. Tianjin, for example, is often cited as an attractive secondary market; and as one of four district-controlled municipalities in China—a high-level city closer to a province than other urban areas—it is already well on its way to becoming a primary city. In addition, Tianjin's location, an hour-and-a-half away from Beijing, implies it could conceivably blend into greater Beijing in the future. Another city catching the attention of investors is Shenzhen, located in the southern province of Guangdong, which borders the special administrative region of Hong Kong. Once a sleepy fishing village, Shenzhen was the first Special Economic Zone, created in 1978 by Communist Party paramount leader Deng Xiaoping, in an effort to compete with Hong Kong, then a British colony.
“The competition in Beijing and Shanghai is quite intense. Developers have started to look at the second-tier, so this will fuel the market in those cities.”
China's growing middle class and an increase in home ownership have also helped the residential market develop. In addition, the limited opportunities for Chinese nationals to invest their money abroad is leading many of them to look inward and spend their capital on a new home. Dennis Yeskey, head of real estate capital markets at Deloitte and Touche, notes: “There are a lot of wealthy Chinese and they can't take their money out of the country.”
The urban-rural divide in China—highlighted by the ongoing migration—is a major issue in China, one the government has sought to address. Last fall, local news reports indicated that the Chinese government was experimenting with relaxed rules, allowing for more people to move to cities. Jason H. Lee, a managing director in The Carlyle Group's Hong Kong office and head of the Asia real estate group, points out that the government has an interest in making sure growth is spread evenly around the country, with cities like Tianjin particularly primed for growth. “The Chinese government is looking to build up other cities [outside Shanghai and Beijing],” he says.
WHO'S ON FIRST?
As established foreign companies expand outside the hustle and bustle of the coastal metropolises, real estate investment in secondary cities is also on the rise. Perhaps not surprisingly, local Chinese developers and Hong Kong- and Singapore-based real estate firms have been the first to identify and cash in on the trends.
Yeskey, of Deloitte and Touche, says that the local and regional groups have long been active in the second-tier markets—and therefore ahead of their US- and Europe-based counterparts. “They're moving quicker than the West, because they've been there longer,” he says. “You see a lot of Chinese developers. That's not slowing down.”
In recent years, a number of developers from Hong Kong and the surrounding region have joined the fray in the secondary markets, including groups like Hutchinson Whampoa, Shui On, CapitaLand, Wharf Holdings and Keppel Land. Late last year, Keppel Land, the property arm of Singapore-based multinational Keppel, completed a deal for a residential development in Chengdu; the group reportedly hopes to complete similar deals in fast-rising cities like Chongqing, Shenyang and Changchun. Keppel also recently closed a deal to develop projects in Tianjin, along the Tianjin-Binhai railroad.
Last summer, Hutchinson Whampoa, which has 38 projects across the mainland, teamed up with fellow Hong Kong-based developer Cheung Kong Holdings, to expand the firm's residential strategy from the city of Wuhan, the capital of Hubei Province and the most populous city in central China, into the city of Chongqing, also a provincial-level municipality, via a $60 million, 470,975-meter mixed-use project. Around the same time, developer Shanghai Forte Land announced a large-scale mixed-use project in Chongqing.
Market participants say that the US and European investors that are expanding beyond the coastal cities are, by and large, investors who have already established themselves in China, usually with successful investments in Shanghai and Beijing.
Carlyle's Lee notes that there is an increasing bifurcation within US and European investors looking at China. Those entering China for the first time and with a core strategy tend to stick to investments in Shanghai and Beijing, while firms that have good relationships with local operators and developers are able to transition into the second-tier cities. Lee sees this bifurcation as a positive development in the growth of the Chinese market.
Like all emerging markets—and some not so emerging ones— local operating partners are crucial to successful investments in the second-tier markets of China. Last year, Warburg Pincus announced a $31 million strategic partnership with Raycom Real Estate Development, a Chinese commercial and residential developer. The partnership has started work on a Beijing development, but is also looking at investments in Shenzhen and Hangzhou.
“You see a fast cycle. Developers are selling out of projects as soon as they are completed.”
This is something Carlyle is also keeping in mind as it continues to develop its portfolio throughout China and across sector types—the firm is in the process of developing a number of strategic partners around the country. “If you are going to take advantage of the second-tier cities, you've got to develop partnerships in the major cities [with groups] who have broad platforms throughout China,” Lee says.
WATCH OUT FOR FALLING PRICES
Second-tier Chinese cities attract opportunistic investors because they are, by nature, more risky investment environments than the largest urban areas. Because of their position on the spectrum of risk and reward, these cities present a whole host of advantages— and, of course, challenges.
“What people are finding attractive about second-tier cities is that the cost of land is significantly less, so there is more room for appreciation in terms of pricing,” Lee says.
Not only are second-tier cities benefiting from high-growth rates, they also remain relatively less competitive than other markets. Notes Jimmy Chang, head of corporate financing for Deloitte & Touche in Beijing, “The competition in Beijing and Shanghai is quite intense. Developers have started to look at the second-tier, so this will fuel the market in those cities.”
Chang adds that the margins are typically higher in the secondary cities relative to Beijing or Shanghai.
Savills' Hall agrees, adding that as developers expand their geographic scope, the second-tier markets are benefiting. “International developers are finding it increasingly difficult to find good sites in primary cities such as Shanghai and are now turning to secondary cities to find new markets and new opportunities,” he says. “In doing so, these developers are bringing with them new benchmarks for the markets in these cities.”
While more appreciation, higher margins and less competition may sound like music to the ears of developers and investors alike, developing a project in a secondary Chinese market isn't a walk in the People's Park. One major concern about the second-tier, according to people investing and building in these markets, is the general lack of liquidity.
“Obviously, liquidity is not as good as in Shanghai or Beijing,” says Chang. “In the interior cities, it is an issue.”
Another major concern comes in the form of urban planning. Shanghai, for example, has well-defined major office and residential districts in an established urban core, allowing investors a modicum of certainty about picking spots for development. In lessestablished cities, investing becomes much more speculative, as the city center or office district could take shape far away from a firm's project—thus making the investment less centrally located and less valuable.
Deloitte's Chang points out that regulations and laws can vary from area to area, making local developers who are familiar with the investment landscape essential.
Lee says, “For these secondary cities, the strategy needs to be really simple. Primarily building and selling, rather than trying to buy and hold income producing properties and waiting for an exit market to develop.”
This is different, Lee adds, from the more developed markets of Shanghai and Beijing, where a viable buy-and-hold play is starting to take shape.
WHAT IS NEXT?
As a growing population, better margins, less competition and cheaper land make China's second-tier more popular with residential real estate investors, property players are also beginning to look at other sectors, including industrial and retail plays.
Morgan Parker, president of Taubman Asia, the regional arm of the US-based shopping center developer, says that few Chinese real estate players have the necessary capital to hold properties once they have been developed.
Parker says that he largely sees two real estate plays being undertaken in the second-tier Chinese cities: ground-up development and the repositioning of well-located, but poorly managed assets.
“You see a fast cycle,” he says. “Developers are selling out of projects as soon as they are completed.”
As the residential market continues to mature, developers are seeing other opportunities in China's second-tier. For example, Parker says that, while the retail sector has yet to pick up in the secondary markets, some successful residential developers are already beginning to try their hand in developing retail space in the secondtier.
They are looking to do the same thing,” he says. “Build retail centers and then condominium-ize them.”