Nick Cao: Make A Killing In Retail Properties In China's Tier-Two Cities

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In this episode of China Money Podcast, guest Nick Cao discusses China's commercial property sector, which has gone through an explosive growth phase after early 2010, when home buyer restriction policies dragged down the residential property market.

Q: Since the government launched home buyer restrictions, the commercial property sector has been going rapidly. Some are concerned about a bubble. Are you?

A: It depends. I would say China's commercial property sector is still less developed than the residential side.

We see two different groups in the commercial sector. One is the large developers in China, such as China Resources and China COSCO. They moved into commercial properties before the tightening measure was initiated.

But the other group is forced into the commercial sector because their residential sales have stalled. And they operate the commercial sector as if they are still running residential properties. Lots of these (commercial properties) are poorly designed. Some of them are in tier two and tier three cities.

Take the city of Shenyang. There are oversupply issues. We see ten large shopping malls within two kilometer distance. So that’s scary and there are a lot of concerns for investors.

But, overall I wouldn’t say it’s a bubble because in China, there still lacks good quality shopping malls (in many cities).

Q: For the past few years, the transaction volume in commercial property has doubled. Do you see that continue?

A: I would say, yes. Because China's economy is moving from manufacturing-based to services-based, so this generates stronger demand for office space. Some international firms are expanding into second tier cities in China, which requires high quality office space.

Also, the government is promoting domestic consumption. That’s demanding more retail shopping malls. Moreover, the insurance industry in China is just allowed to invest in commercial real estate so (investment) demand will still be quite high.

Q: We have seen residential property prices double in the space of one to two years. Will the same happen in commercial property?

A: No, I don’t think it’s going to happen that fast. It’s all case-by-case. For example, if there were two shopping malls next to each other, their prices would move very differently (depending on how well they are managed).

Q: But we often read reports on ghost shopping malls across China. It seems as if you still believe that the fundamentals of commercial real estate is strong demand driving up supply?

A: When you talk about ghost shopping malls, you still have to look at it case by case. In China's tier two and tier three cities, it’s still very hard to find good quality shopping malls.

Yes, there are lots of them that are vacant. But that's because the developers don’t know how to run a successful shopping mall.

Q: So where do you see attractive investment opportunities in the property sector right now?

A: It’s mostly still in tier one and tier two cities. In tier one cities (Beijing and Shanghai), the problems are that supplies are limited. As we know, foreign investors are not allowed to buy assets. They can only buy offshore equity, and those have already been acquired by investors already.

Most of the opportunities are available in second tier cities. There is very limited competition in the retail sector. If you have strong capabilities in running a retail mall, there are great opportunities.

But of course, In China, the leasing term, general market practice and the tenants are very different. so foreign investors really need strong local partners to succeed.

Q: So, how much price appreciation do you see in commercial real estate?

A: For retail properties, you can get eight percent yield on retail properties in good locations.

Q: Now, for local investors, they face fierce competition on the ground. How do they grab the best opportunities?

A: Local investors have better resources for local financing and they also have a longer term investment horizon. Foreign investors don’t have local financing resources and may want to exit in three to five years, which limits their ability.

Four years ago, the whole investment market was dominated by foreign investors. In the last few years, we see that domestic investors have taken up 60 percent of the transaction volume. We see that continue to grow.

Q: What are some common mistakes foreign investors tend to make?

A: Today, at this price level, foreign investors are looking at joint-venture at tier two cities. They face market risk and counter-party risk.

Some of the local city governments are also less sophisticated. Maybe you invest into a project. Soon after, the local government would release large supply into the market, which would negatively impact your project. So, you must find a tier-one, strong and large developers as your local partners.

Q: Lastly, for the residential sector, do you see prices continue to go up after those restrictive policies are relaxed?

A: Yes, it’s still positive. In the next ten years, Shanghai's population will grow another five million. They all need housing. In tier one and tier two cities, properties in prime locations will have good potential for price appreciation.

But we see prices of those suburban areas with large housing supplies probably staying static, if not decreasing.

Our Guest Today:
Nick Cao is the China head of investment and capital transaction at global real estate consultancy, Knight Frank. Nick has six years of experience in real estate investment and has advised on six billion RMB real estate investment deals involving office, retail serviced apartments, hotels and joint-ventures. Mr. Cao graduated from the London School of Economics.

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