Moving on up

As competition increases in Shanghai and Beijing, second-tier markets are the toast of China—and cities like Qingdao and Hangzhou are turning into the next hot hotel markets. By Aaron Lovell

Before the Marco Polo Hotel Group opened its first hotel in China, the Hong Kong-based company was approached by a business partner who had family roots in the port city of Xiamen, located on China's Eastern coast. He owned a hotel there and was wondering if Marco Polo would be interested in managing it.

While Marco Polo took on the property, it was the early 1990s and foreign real estate investors were just beginning to emerge in the major markets of Shanghai and Beijing; the country's second-tier cities were seen as backwaters.

“There was no international hotel in Fujian Province, much less Xiamen,” says Kevin Sun, Marco Polo's director of development, who is responsible for finding new markets for the firm. “Now, [the hotel] has become a landmark.”

But things continue to change in the second-tier cities of China. The Marco Polo hotel in Xiamen, which opened for business 11 years ago, is now undergoing a major renovation. As more competition has entered the market from Sofitel and Sheraton, the owner has decided to upgrade the hotel to a five-star, luxury property. It's indicative of the interest in hotels across China's secondary markets.

While cities like Xiamen—or Wuhan, Kunming and Chongqing—might not sound familiar to many Western ears, at least not yet, they're increasingly becoming shorthand for opportunity and the hope of outsized returns in Chinese property, especially in the hotel sector. Higher levels of foreign and domestic tourism are fueling the shift, as is the increased competition seen in Shanghai and Beijing, which is pushing opportunistic investors further afield.

“There has been an auction system implemented [for land] in most primary cities,” says Andreas Flaig, the Beijing–based executive vice president and head of China for Jones Lang LaSalle Hotels, who notes that land is more plentiful in second-tier areas. “You can still get land quickly, get land cheaper for hotel development and you can get permits quicker.”

There is also plenty of speculation that China will become the world's largest tourism and travel market in the next two decades. The country is playing host to a number of high-profile conferences, expositions and sporting events, including the 2008 Olympics, which will be held in Beijing. International tourism has expanded from approximately 72 million overseas arrivals in 1999 to around 120 million in 2005. And domestic tourism is growing as well. Many real estate observers point out that tourism in the major secondary markets is comprised largely of domestic travelers, many of whom now have more money than ever before.

“The domestic market has a certain affluence that isn't far behind the foreigners that travel through China,” says Flaig. “They're driven to brands. They're driven to experience something different that they haven't experienced in the past.”

To accommodate the growing demand, the Chinese government has begun a number of large transportation infrastructure initiatives, including upgrading the highways and train connections between the country's large cities. Most major cities have long since lost their old communist-style airports in favor of large, well-designed transportation hubs, linked by road and rail to nearby cities. By 2010, the government plans to have 190 certified airports, up from 142 today. By 2020, it aims to have 220.

In addition to being famous for the Tsingtao Brewery, which produces the world-famous Chinese beer, the city of Qingdao seems to be at the top of many hoteliers' lists. And for good reason: It is one of the fastest growing tourist markets in the country. According to Colliers, the number of domestic tourists grew by 13.5 percent in 2005, while the increase in international tourists was 31 percent.

Located on the Shandong Peninsula and overlooking the Yellow Sea, the port city will host the sailing competition during the Beijing Olympics. While this will no doubt attract tourists and raise the city's profile, perhaps more importantly, Qingdao also serves as an important transportation hub. The city has 500 kilometers of expressways, domestic rail links to many other major metropolitan areas and an international airport, as well as burgeoning IT and light industry sectors.

“Qingdao attracts many international and domestic tourists due to its seaside setting and nice, cool weather,” Margaret Ng, head of research for Richard Ellis in Greater China, says in an email. “There are parks, golf courses, beaches and buildings left behind by the Germans—a unique setting for tourism development.”

The climate is also a draw. “I'm looking at a market that is unaffected by seasonality,” Sun says. “It has very good weather.”

In addition to beaches and historic colonial German-style architecture—the Germans controlled Qingdao from roughly the turn-of-the-century until after World War I—the city has developed in recent years as an important port.

Yet despite its appeal, Sun says that Qingdao has relatively few international hotels. “There's no over-supply,” he says.

Flair agrees there is room for more players in Qingdao. “It has both commercial and leisure appeal,” he says. “And there are two [international hotel] brands in that city that are running close to 80 percent occupancy.”

In fact, according to Colliers, occupancy at the city's five-star hotels averages more than 90 percent during the Labor Day Golden Week. The firm also says international hotel operators have been able to achieve higher occupancy rates than local or national operators.

Another popular tourist destination among China's second tier is Hangzhou, the capital city of Zheijiang Province, located about 180 kilometers southwest of Shanghai. In addition to attracting visitors to its West Lake area, the city also has a thriving commercial center with a healthy conference and exposition business.

While it currently takes approximately two hours to get to Shanghai from Hangzhou, the commute could be cut down to 30 minutes if a proposed high-speed rail link is completed. “That would make Hangzhou a suburb of Shanghai,” says Flaig.

“Hangzhou is a scenic ancient city,” adds Ng of Richard Ellis. “The West Lake, one of the city's most famous tourist destinations, covers an area of 60 square kilometers and includes some of Hangzhou's most famous historic and scenic places.” These include ancient pagodas and cultural attractions.

Flaig says these sorts of tourist draws are very important to hotel owners because having natural attractions like West Lake means a hotel can have a healthy weekend business—whereas other secondary markets might see a steep drop-off in travelers between Friday and Monday.

But for hotel investors in a second-tier city like Hangzhou, location can be incredibly important. “If you're not within the West Lake area, you're in pretty bad shape,” Sun says. Outside of that area, he says, a hotel would want to be a part of a successful mixed-use development or near a new central business district being developed by the government.

Sun says there are also some players looking at the hilly areas outside the city. “Mountain resorts could be another attraction for the upscale market because of the scenery and the weather,” Sun says.

In addition to being a tourist destination, Hangzhou is also known throughout China for its conferences and exhibitions. Around 10 percent of visitors to the city come for business, while another 7 percent are attending exhibitions, according to a report by Jones Lang LaSalle. As Sun puts it, “Whenever there is a conference, you can't find a room.”

Ng says that occupancy hovers around 80 percent during the Labor Day holidays in May and National Day holidays in October.

With such a need for new hotels, competition in Hangzhou is already heating up. By next year, 2,860 five-star rooms will be added to the 2,960 that were available in June 2005. In addition to properties under the Carlton, Marriott, Hyatt, Shangri-La and Accor banners, a new 500-room Marriott in the Bingjiang District is slated for completion this year, according to a report from Jones Lang LaSalle.

Interest in the second-tier of Chinese cities is not limited to Qingdao and Hangzhou. In addition to owning or managing hotels in Hong Kong and Beijing, Marco Polo's Sun says that his company is weighing management projects in other secondtier cities. (The firm already manages properties in Xiamen and Shenzhen.) Other hotels firms are also looking at entering the second-tier, though oftentimes with very different strategies.

Shanghai-based buyout shop H&Q Asia Pacific recently announced a joint venture with RREEF, the private equity real estate arm of Deutsche Bank, to develop more than 20 hotels under the Hilton Garden Inn brand. In addition to Beijing and Shanghai, the investor group is looking at sites in the Northern city of Tianjian, as well as cities in the Yangtze River Delta and Bohai Bay regions.

These firms are looking to take advantage of what they perceive as an underserved niche for business travelers, a pricepoint above the domestic budget chains but below the five-star international hotels. In order to target business travelers, Chih Wang, managing director at H&Q, says the focused-service hotels provide amenities like wireless internet access, 24-hour business centers, breakfast service and comfortable rooms.

“Living well, working well and sleeping well—that's what we'll be focusing on,” he says.

The budget and mid-tier hotel sector has been dominated thus far by domestic hoteliers like Home Inn, a joint venture between the Beijing Tourism Group and Chinese travel agency Ctrip, and Jin Jiang, the country's largest homegrown hotel group, which recently received a $30 million investment from Barry Sternlicht's Starwood Capital.

Meanwhile, overseas groups have been quick to pick up on the promise of the second-tier cities. French hotel giant Accor recently launched a 154-room, three-star hotel in Tianjian and it currently has plans to expand its Ibis brand into Sichuan Province, inking a deal with Chinese partners to develop hotels in three or four cities, including the provincial capital Chengdu. According to Richard Ellis, the Ibis brand is going to be Accor's main platform as it moves into the non-primary cities of China and it plans to open a total of 10 to 12 hotels in Sichuan before 2012.

Meanwhile InterContinental Hotel Group is looking to bring its Holiday Inn Express brand to some of the hotter secondtier markets like Zhengzhou, Huizhou and Xi'an, while the US-based Super 8 chain is looking to expand its franchising strategy across 26 Chinese cities. The company hopes to open 1,000 hotels under the Super 8 banner by 2016.

While secondary cities can be lucrative for investors, they comprise a set of unique risks and concerns not necessarily found in the primary markets of China. Both legal and political challenges are increasingly a non-issue in established markets like Shanghai, but laws can still be selectively applied across the provinces.

“You don't assume one rule applies just because these are national policies,” said an executive at a large Hong Kong-based developer, speaking to a conference in Chongqing about second-tier property law earlier this year.

Secondary cities are also less transparent, notes Ng from Richard Ellis, particularly when it comes to knowing what other projects are slated for a particular market. She adds that human capital may also be a concern for a large hotel firm entering a relatively new market.

While secondary markets can offer hotel owners and investors a chance to capture a bigger market share, the same supplyand-demand rules apply as they do anywhere else in China. Sun points to Nanjing, a history-rich city located 300 kilometers from Shanghai that now sports 12 international hotels.

“Demand [in Nanjing] isn't that high,” he says. “There is a price war between these hotels.”

Flaig at Jones Lang LaSalle cautions that construction costs in the secondary cities can be very similar to those found in the primary markets. Therefore, the cost of building a five-star hotel could be out-of-sync with the operating cash flows that the property will generate. In the past, domestic or state-owned players would build very nice hotels in markets where demand for luxury lodging product was limited.

“Too much money was spent making it too good for the market,” Flaig says. “Average rates are still low [in many cities] and justifying a five-star hotel can be tricky.” He says a prime location on West Lake in Hangzhou or on the beach in the tropical city Sanya, located on Hainan Island, could be the exception to the rule.

Then again, as seen in the city of Xiamen, where the Marco Polo-managed hotel is being boosted to a five-star property, fundamentals in the secondary markets are moving fast. There could be plenty of opportunity for hospitality investors, if they know where to find it.