Real estate investors and developers are abandoning a two-year foray into China’s provincial cities and switching back to Shanghai and Beijing, where offices are fuller, rents are higher and home prices are stabilizing.
Of the $34 billion of direct investment in commercial real estate in 2010 and 2011 combined, 20 percent went to China’s 50 biggest second-tier cities, according to Jones Lang LaSalle Inc., up from 5 percent in the prior two years. That percentage for second-tier cities may decline in the “immediate future,” according to Michael Klibaner, China head of research for the world’s second-biggest commercial realtor.
A three-year building boom, fueled by government stimulus, has pushed up office vacancy rates in second-tier cities such as Chongqing and Chengdu to almost 40 percent, while rising land prices have squeezed homebuilders’ profit margins. Investors and developers are refocusing on Beijing and Shanghai, where prime offices are close to full occupancy and rents are on par with cities such as New York and Sydney, according to Cushman & Wakefield Inc.
“In a world of uncertainties, the best investment is the one that produces stable rents,” said Albert Lau, head of China at property broker Savills Plc. “When the whole world gets riskier, when financing is harder, if the market is difficult, you’d rather buy some good stuff rather than gamble.”
China’s economy expanded 7.4 percent in the third quarter from a year earlier, a seventh-straight quarterly slowdown, as Europe’s debt crisis crimped exports and the government’s property crackdown cooled domestic demand.
The capital Beijing, the financial center of Shanghai and the two southern business centers of Shenzhen and Guangzhou are ranked as first-tier cities, according to the National Bureau of Statistics. The second tier includes provincial capitals, while the third includes smaller cities.
In the wake of the 2008 credit crisis, developers and investors were lured to inland cities by cheaper land and rising incomes. China’s Premier Wen Jiabao, who is set to hand over power in March after a once-in-a-decade leadership transition that begins next month, has sought to curb property speculation in Shanghai and Beijing. That encouraged developers to seek opportunities elsewhere, where property policies were more relaxed.
China has over the past two years raised down-payment and mortgage requirements for home buyers, imposed a property tax for the first time in Shanghai and Chongqing, increased building of low-cost social housing and placed home-purchase restrictions in about 40 cities. Home prices have risen about 155 percent nationwide since reforms that privatized the country’s housing market in 1998.
Monthly prime office rents in Beijing and Shanghai are 690 yuan ($110) and 563 yuan per square meter, according to Cushman & Wakefield. That compares with 284 yuan in Nanjing, the capital of eastern Jiangsu province, which is the most expensive among China’s second-tier cities, according to the broker. One square meter equals about 10.8 square feet.
Fantasia Holdings Group Co., a Shenzhen-based developer, paid about 779 million yuan to buy Huawanli Investment, which holds a 17,138-square-meter site in Beijing’s central business district, according to a statement to the Hong Kong Stock exchange on Oct. 24. It plans to develop a business complex on the land, executive director Lam Kam Tong said by e-mail.
Fantasia plans to expand to first-tier cities such as Beijing and Shanghai, Lam said, citing better prospects for commercial properties in the biggest cities.
“There are more advantages than disadvantages to develop in first-tier cites compared with smaller ones,” he said. “With the high value-added development model, it can bring in a relatively higher gross margin to the company.”
In the western city of Chongqing, four largely empty office towers bearing names of the country’s biggest financial institutions, including China Life Insurance Co., the biggest insurance company, stand side-by-side along the Yangtze River.
Completed last year to anchor the city’s new Jiangbeizui business district, the skyscrapers with 150,000 square meters of prime office space stemmed from the central government’s 4 trillion yuan stimulus program in 2008 to revive the country’s economy. Today, about 85 percent of that office space is empty.
“Once the expectation of healthier market conditions take hold in the second-tier cities, you’ll see more interest in those assets,” Jones Lang LaSalle’s Klibaner said. “The fundamental of the markets is more attractive in tier-one cities now.”
Offices in Beijing and Shanghai were more than 95 percent occupied at the end of the second quarter, New York-based Cushman & Wakefield said. The six highest vacancy rates in the country -- all in second-tier cities -- ranged from 16 percent to 38 percent, according to estimates from the broker.
“In China’s second-tier cities we see less visibility on price and growth of the local office markets,” said Daan Van Aert, head of strategic real estate at APG Investment Asia Ltd., a subsidiary of APG Algemene Pensioen Groep NV, which manages about 314 billion euros ($411 billion) for the largest Dutch pension fund. “The returns at this stage don’t really seem to justify the risks for institutional investors.”
Preference for China’s biggest cities also applies to residential real estate. China Overseas Land & Investment Ltd., the biggest Chinese developer listed in Hong Kong, is now putting more resources back to first-tier cities after expanding in smaller inland ones in the past six years, according to the company.
Land prices climbed faster than home values in some less wealthy cities in the past two years, pressuring developers’ profit margins, according to Credit Suisse Group AG.
“Developers always wanted to have land in major cities, but the major cities’ land supply is limited,” said Jinsong Du, a Hong Kong-based Credit Suisse property analyst. “Therefore, they were forced to expand to smaller cities in order to continue to grow.”
Home prices in China’s second- and third-tier cities have fallen more than in major cities this year, led by the eastern city of Wenzhou, where prices of new homes were down 15.5 percent in September from a year ago. Prices in Beijing fell 0.5 percent, while those in Shanghai declined by 1.6 percent.
Developers that maintained or increased activities in the first-tier cities have outperformed peers that ventured inland.
“Under such a tough market environment, the strategy of developing high-quality residential projects in the core area of major mainland cities is correct,” China Overseas’ Chairman Kong Qingping said in August in a company statement after it posted 18 percent interim profit growth.
The state-owned developer rose 54 percent this year, the best performer among Chinese builders on the Hang Seng Index. Its portfolio covers 33 Chinese cities, as well as Hong Kong and Macau. In February, it committed $40 million with APG and ICBC International Holdings Ltd. for the first close of a fund to invest in new residential property developments.
Evergrande Real Estate Group Ltd., China’s biggest developer by sales volume, posted a 21 percent decline in underlying profit in the first half after the company sold fewer apartments in less affluent cities. Contracted sales of the Guangzhou-based developer fell 21 percent in the first six months to 35 billion yuan. Its sales from first-tier cities represent 1.2 percent of revenue.
Sunac China Holdings Ltd., the developer part-owned by U.S. private-equity firm Bain Capital LLC, revised up its sales target for this year to 30 billion yuan from 22 billion yuan as the company’s focus on major cities, including Beijing, Shanghai, Tianjin and Chongqing, pays off.
“I never believed smaller cities would have better developments than Beijing and Shanghai,” Sunac Chairman Sun Hongbin told reporters in Hong Kong in August.
China’s home prices won’t rise sharply for the rest of the year because developers are still facing tight cash flow, which will prevent them from cutting prices, Sun said.
“Building in small and medium-sized cities shouldn’t be a long-term strategy; the internal demand of such cities is smaller than big ones,” said Kenny Wu, a Hong Kong-based analyst at JI-Asia Research Ltd. “Developers swarmed into those smaller cities before for quick turnover and land-bank size, but development of those cities is unsustainable in a downturn economy.”