Boom and Bust: China’s Commercial Real Estate Woes

China’s rapid economic expansion over the past decade turned the country into the place to be for multinational companies. To accommodate the influx of international businesses, developers took out loans, land was cleared and construction sites and cranes dotted the skyline of every major city.


 


It wasn’t only the supply of high-end office buildings in prime business locations (Class A) and lower-end office buildings (Class B) that boomed. More and more shopping malls — a relatively new concept in the country — sprung up, replacing department stores in cities.


 


But when the financial crisis hit, many multinationals pulled their offices and employees out of China or moved to less expensive spaces, while the hordes of shoppers that retailers were expecting to flood the malls tightened their purse strings. Now, major cities throughout the country are home to empty skyscrapers and shopping malls that are virtually empty, apart from store clerks and security guards. Meanwhile, construction continues. How did this scenario evolve, and what are the commercial real estate industry’s prospects?

Beijing and Beyond


How much space is vacant is a matter of debate. Shirley Hu of real estate broker CB Richard Ellis predicts that by 2010, the supply of commercial office space will increase in Beijing by roughly 1.5 million square meters (16 million square feet) and in Shanghai by 1.9 million square meters (20 million square feet), driving up vacancy rates to approximately 30%.


 


But vacancy rates in commercial real estate may be as high as 50%, says Jack Rodman, President of Global Distressed Solutions LLC based in Beijing, and Senior Advisor at Crosswater Realty Advisors, a Los Angeles-based real estate advisor firm serving institutional investors. According to Rodman, calculations from brokerage firms often don’t include strata-title buildings (those sold and rented by different landlords by floor or unit, similar to condominium ownership models), though some could be considered Class A commercial space; newly built buildings if they are not yet open to leasing; or nearly built buildings awaiting certificates of occupancy. “These buildings are theoretically not open, but … if a building can be brought to market in six months, then it’s better to include it in the supply.”


 


The supply of Class A commercial office buildings in Beijing over the past two years increased an estimated 5.6 million square meters (60 million square feet), Rodman points out. The supply of Class B or non-strata buildings that will be sold to investors could add another 3.7 million square meters (40 million square feet), he says, noting this excludes government buildings, such as the new CCTV tower in Beijing, and buildings being built by financial services and oil companies for their own use.


 


The amount of space wasn’t as worrisome during the boom years, between 2003 and 2007, when demand drove up the average annual absorption rate to roughly 465,000 square meters a year. China was hot, and everyone wanted in — from international investment banks and law firms to accounting firms and real estate brokerages. “But for the last two years, you haven’t had any of that,” says Rodman. “I don’t think there’s been much net absorption at all. I believe there’s a very large and very real problem here.”


 


And it isn’t limited to Beijing, he adds. “Shanghai’s office market is as bad as this.”


 


Other cities are also struggling with high vacancy rates in commercial real estate that mirror those in the capital and financial center. “Hangzhou definitely has an oversupply of commercial property,” says Wu Weiming, CEO of a commercial property developer in that city.


 


It’s not just commercial office space that is sitting empty. In Beijing, the shiny new shopping malls have occupancy rates of roughly 60%, compared with between 70% and 80% in previous years, says Wendy Zha, retail real estate sales representative at CB Richard Ellis in the capital. “Also, the older shopping malls that haven’t been fully occupied are still leasing space.” The overall retail market vacancy rate is between 30% and 40%, she notes.


 


The oversupply of retail space is most pronounced in Beijing, where developers rushed to complete large shopping complexes before the last year’s Olympic Games, says James Macdonald, senior manager and head of China research at Savills China, a branch of the London Stock Exchange-listed real estate service provider. “But supply [in Shanghai] may increase over the next six months in preparation for the next year’s World Expo.” In the meantime, Shanghai’s retail market is still relatively healthy with a city-wide vacancy rate of prime retail space of 3.3%, he says.


 


Cheaper to Rent


Commercial real estate rents began declining in Beijing and Shanghai in the third quarter of last year, says Macdonald. Leasing prices (“headline” or “face” rents) have dropped on average from RMB189.8 (US$27.80) per square meter per month to RMB147.9 (US$21.66), down 17.2% year on year. “That’s quite a sizeable correction,” he says.


 


But in an effort to keep tenants and woo new ones, many landlords are signing leases offering 12 or more rent-free months on a five-year lease, so that net effective rents are down 40% to 50% in Beijing, according to Rodman, who has compiled photos of the city’s empty office buildings in a lengthy slideshow. Still, many buildings remain empty, he says. From his office window, which faces the heart of Beijing’s business district, he can point to at least six empty high rises, most of which have been ready for leasing for months, if not years, but have yet to be put on the market by developers.


 


Beijing retail rental rates, meanwhile, have dropped by roughly 20%, “which is quite big,” says Zha, although she believes some developers are deliberately holding prices up even as retailers try to insist on low rents.


 


In Shanghai, rents are “falling to levels not seen since the second half of 2006,” says Hu. “We are beginning to see tenants position themselves to take advantage of market conditions and implement longer term occupation strategies.”


 


Hold Those Prices


The problems began in the boom years of 2003 and 2007, says Rodman. Developers had easy access to bank loans and market leasing rates at the time were RMB200 to RMB250 (US$29.30 to US$36.60) per square meter per month, supporting building values of RMB25,000 to RMB30,000 (US$3,660 to US$1,545) per square meter annually for Class A space. But when the bottom dropped out of the rental market, landlords did not draw up leases that reflected the drop, and prospective tenants, many of them from foreign firms that were feeling the squeeze from the financial crisis, were unwilling or unable to pay the prices developers were asking for.


 


Rodman believes two reasons explain why developers have been keeping leasing prices at pre-crash rates. “One, they are under no pressure from banks to repay their loans, ergo no motivation to lease at today’s current rates. And two, writing a lease at half the rent that supports the valuation … could trigger a writedown, incurring losses for the banks. [Meanwhile, there] has been a lack of transparency and reliability, and a lack of veracity in market information that the brokerage community made available to owners, developers and tenants,” he says.


 


Developers also haven’t been very market savvy, says Zha, particularly among those who moved into commercial real estate from residential. “In residential … they can hold the price and wait it out, eventually selling at a higher price. In retail, it’s different. When a mall has been on the market for too long, it’s not hot anymore. Also in retail you spend more money on maintenance and retailers won’t wait for you. It’s not like individuals who buy apartments. In the beginning, they didn’t really get it. But now more and more developers understand.”


 


High residential land price has also into play, says Hangzhou developer Wu. City governments dictate commercial and residential areas, and the current high land prices placed residential land out of reach for many developers, who turned to commercial property. “They then shift it to some kind of special apartment space later on,” he says.


 


Knock-On Effects


The economy is affected in a number of ways, says Rodman. “We ignored the problem with collateralized mortgage obligations [CDO and CLOs] in America. Everybody knew about it. It blew up on us. Not only did it blow up on us; it blew up on everybody else.”


 


What’s more, “the rest of the world recognizes that they have a huge problem with commercial real estate rents coming due,” he says, noting warnings from financial experts like Warren Buffett of US$3 trillion to US$4 trillion of real estate loans coming due in between 2010 and 2012. “[China] is the only market in the world that doesn’t think it has an oversupply or that commercial real estate values have not declined,” he says. “Yet there are no transactions to support it. We’ve only had three commercial office building transactions in Beijing over the past year, and two of three buildings were sold to Chinese insurance companies.”


 


The biggest banks in the world are Chinese, he points out. If they’re carrying loans on their books that the collateral (i.e., the property) doesn’t support and there’s a change in regulation or in the economy, “then you would have a real loss of confidence in the financial system,” he says.


 


A crash in this case would require a government bailout, pushing up debt until it started to resemble Japan’s. With the highest debt-to-GDP ratio among the world’s developed nations, Japan “ignored [the problem] from 1986 to 1990 and it has never recovered.” “If you want to ignore it, ignore it. But recognize that other people ignored the problem and it had a very detrimental effect.” he says. 


 


What the Future Holds


Finding occupiers for future retail property projects in Beijing during the current financial situation will be difficult, says Hu. But the government’s stimulus efforts to boost domestic consumption will help ease the problem. In Shanghai, the 70 million visitors expected for the Expo will also help. “However, forecasts including future prime retail projects for 2009 show that both Beijing and Shanghai will have a relatively larger supply compared with the last several years, with an estimated 1.39 million square meters for Beijing and 722,000 square meters for Shanghai,” she says.


 


According to Savills’ Macdonald, office-building vacancy rates in Beijing are expected to continue rising, exceeding 25% by the end of this year. “Net take-up recovered in the third quarter to levels comparable to 2007,” he says. “However this is not enough to absorb the new supply.”


 


In Beijing, the oversupply of commercial space will force down rents and occupancy rates, says Rodman. This will increase the risk on defaults on bank loans to real estate developers and affect future real estate investment prospects. “As developers find it more difficult, there is a potential for some of them to turn to the strata-title market or look for [institutional investors that buy an entire building].”


 


In contrast, in Shanghai, “companies are occupying the space,” according to Macdonald. “The oversupply is by no means an accident. There are expectations for immense growth in Shanghai over the next 10 years, and having available office space for companies will be an essential part of ensuring the economy can grow.”


 


Although tough times may still lie ahead, the government’s stimulus package will spur growth in demand for office space by domestic companies, says Hu. Foreign enterprises investing in China, especially in sectors relatively unaffected by the recession such as renewable energy and pharmaceuticals, are expected to need office space in Beijing, while auto and electronic manufacturing will benefit from the increasing consumption in China in the long term.


 


“The huge amount of supply building up is not the main problem, rather the weakened economic conditions that have affected demand is,” says Macdonald. “As with the rest of the world, China is putting immense effort into maintaining growth. It is widely believed these efforts will help to get the economy expanding again and once it does, demand for office space will return to normal.” The central government’s goal of making Shanghai an international financial center by 2020 won’t hurt either. It should “further brighten the office market’s long-term vision, although the current oversupply is not likely to be alleviated in the immediate short term,” he says.


 


Over the next two years, 30 projects totalling more than 2.5 million square meters (27 million square feet) of mid- to high-end retail space will be launched, says Macdonald. “Given that the annual take-up volume between 2006 and 2008 was 800,000 square meters, vacancy rates should continue to rise over the next two years, especially given that the rate of expansion has slowed since the start of the year,” he says. 


“The amount is increasing and development is taking a longer term view. Although some projects have been delayed … the next couple of years are still expected to see supply schedules met,” he notes. “The supply issue is likely to remain for at least the next three years.”

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