Capitalizing on China's Real Estate Correction

A well-known Chinese curse, loosely translated, says: "May you live in interesting times." Indeed, China and the rest of the world are living in interesting times. For China, the music stopped when the U.S. financial system collapsed, bringing America's domestic consumption to a virtual standstill. China, which had become far too dependent on exports to fuel robust economic growth, found itself heading over a cliff as exports came to a screeching halt.

The impact that the collapse in exports has had on the Chinese economy cannot be overstated. In the past six months, thousands of factories, including more than 4,000 toy manufacturers, have been shuttered. Chinese stocks listed in Hong Kong have plunged more than 60% from their peak in October 2007. Approximately 20 million migrant workers have lost their jobs, and while there are signs the Chinese government's stimulus package is helping prop up the economy, Chinese leaders will count themselves lucky if China manages to achieve their 8% GDP growth target this year.

At the epicenter of this economic downturn is China's real estate market, which experienced unprecedented growth during the past eight years. Cities like Shanghai, Guangzhou, Shenzhen, and Beijing were awash in a sea of cranes and high-rise building construction. Growing exports fueled an influx of workers from the interior to areas like the Pearl River basin, and with them came increasing wealth and a demand for housing, offices, and shopping centers.

That boom has now turned into bust as aspiring homeowners retrench, canceling contracts for new apartments or, in many cases, demanding a reduced purchase price for apartments that they have already committed to buy. The situation is even bleaker in the commercial sector, as speculative building ran into the harsh realities of a global economic meltdown. The numbers speak for themselves as thousands of projects have been halted or canceled and real estate prices have already dropped by 30% to 40% in many cities.

Encouraging Signs

As the saying goes, though, "whenever there is a risk, there is an opportunity." So the stage is set for what may be the most opportunistic point in the history of Chinese real estate. While the correction in the Chinese real estate market may not be over, numerous fundamental issues will create one of the most lucrative investment opportunities that we have seen in recent times.

First, the Chinese government recognizes the fact that economic growth was overly weighted to exports and the government is now in the process of reorienting the economy to a more balanced growth model that has a heavier weighting on domestic consumption. While this task will not be easy, the Chinese government is well-equipped for the challenge with more than $2 trillion in foreign currency reserves and very little debt. The Chinese government has already fired the first salvo with a $585 billion infrastructure stimulus package, equal to 20% of total GDP in 2008. That stimulus package includes massive investments in roads, mass transit, bridges, nuclear power plants, education, and health care.

Second, Chinese banks do not have the exposure to subprime loans and toxic debt that other markets have. In fact, the exact opposite is true as Chinese banks typically demand a 30% down payment for residential property and up to 50% for commercial property. Additionally, asset-backed securities are still in their infancy, and the concept of debt is still regarded as a negative by Chinese society in general.

Third, the demand for housing in China far outstrips supply with an estimated shortfall of 6.8 million units. This stands in stark contrast to the U.S., where 20 million homes stand empty.

Finally, China is an emerging economy with an extremely industrious population that maintains some of the highest personal savings rates in the world. The Chinese economy and society is rapidly evolving from one that favored large state-owned enterprises with semi-skilled manufacturing processes to one that favors entrepreneurs and promotes highly skilled, sophisticated manufacturing and design processes. This will serve to create a much higher per capita income contribution going forward, which will have a significant impact on future GDP growth. So, while the Chinese economy may struggle this year, it will most undoubtedly pick up steam and head strongly into 2010.

Local Relationships Are Key

So how can you capitalize on the current correction in Chinese real estate? Based on our experience in the Chinese real estate market, we know that success will require focusing on quality over quantity. Just as important, the investment strategy must be more heavily weighted toward multifamily, mid-tier residential developments as opposed to commercial. Moreover, acquiring bankrupt developers is not an option in China, as the court system does not lend itself to simple dispositions of property. A well-capitalized fund or investor must leverage strong relationships within the Chinese real estate community that respects the need to save face.

Additionally, history has shown that a successful investor or fund manager must have strong relationships with local and national governmental authorities, as these are critical to getting deals done. It's also important to conduct rigorous market analysis and due diligence on the target investments. This entails finding a strong and reputable real estate service provider. Finally, patience and persistence are essential.

The music may have stopped for the moment in China but, that said, some of the most attractive dance partners have yet to arrive at the party. The challenge, of course, is to ensure that investors do not miss the unique opportunity.

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