Home sweet home. In the wake of the government’s RMB 4 trillion stimulus package, China’s property market is on the road to recovery. But as sales volume skyrockets and housing prices reach the highs of 2007, is the country coming perilously close to another real estate bubble? A lot depends on what happens in the next few months, both inside and outside the sector, asserts Zhang Huagang, CEO of Shenzhen-based, Shanghai-listed Gemdale Corporation, one of the country’s largest real estate developers, whose sales volume jumped 86% year on year in the first seven months of 2009 to RMB 11 billion. In a recent interview with China Knowledge at Wharton, the 47-year-old, U.S.-educated executive predicts what lies ahead for the country’s real estate market and discusses Gemdale’s strategy for managing the upturn.


The following is an edited transcript of the interview:


China Knowledge at Wharton: As China’s fiscal stimulus measures take effect, its property market has continued heating up. Should the government maintain its macro controls?


Zhang Huagang: Whether you are in China or the United States, real estate always experiences substantial volatility. In the last couple of years, the entire global economy has experienced substantial volatility. The correlation between the real estate sector and the financial [sector] or even the overall economy is quite strong. If the economy overheats, you have to adjust the real estate market, and if the economy goes south, real estate will crash as well. Think of the subprime crisis in America. It began in the real estate sector – first the subprime loans brought on the financial crisis, then it proliferated to the economy, eventually reaching China.


At the beginning of 2008, China was still in the midst of macro controls as it wanted to bring inflation under control. But the subprime crisis spread to China and hurt its exports and so on. So in the second half of 2008, our leaders were doing everything they could to stimulate the economy. China adopted a very active fiscal policy and eased currency restrictions. As the two measures took hold in the real estate market, there were some rather obvious effects: from the beginning of last year, real estate started to heat up again and with Chinese New Year in 2009, most first- and second-tier urban markets started rebounding very quickly — and I mean fully rebound, not just started to heat up.


As for real estate prices in a lot of cities last year, some fell 30%, some 20% – Shanghai fell 15%. But starting this year, real estate prices rose more than 30% to 40%. Shenzhen’s prices have already increased more than 40%, and Beijing and Shanghai have increased between 20% and 30%, which means the real estate market has returned to its 2007 high.


China Knowledge at Wharton: What are the biggest factors spurring the increases?


Zhang: There’s no question that real estate’s fast growth this time has depended on two factors: the government encouraging consumption … [and] its fiscal policy … which in turn stimulated investment demand.


China Knowledge at Wharton: What do you think about the growth of real estate currently?


Zhang: Right now, growth is a bit too fast and a bit overheated, yet the whole economy — including industrial investment, consumption, etc. — has not increased…. [Real estate] is the only sector that has overheated, and that is a cause for concern for the economy. For example, everyone is concerned about the effects that asset inflation could have on the overall economy. We believe that later this year or in the first half of next year, the real estate market will undergo some very important policy readjustments.


What we see now is a lot of demand among real estate buyers, but … inelastic demand and its purchasing power has softened. This problem definitely needs management’s undivided attention.


China Knowledge at Wharton: What are your predictions for the property market’s control measures?


Zhang: Our regulators have already started adjusting the rules regarding second-house loans. At the end of last year and beginning of this year, we were thinking of every way to encourage second-house buyers. But now, we are going to tighten the policy. We believe the same trends from the second half of this year will continue … [during this time] the supply of urban real estate have been falling and prices have reacted by rising, but not by much. The first half of next year will resemble the second half of this year. But in the second half of next year, the market will be more dependent on the government’s broader economic improvements.


If the economy continues to grow steadily — say GDP growth of 8% to 9% — consumption next year will be sizable and you probably will not see a lot of policy adjustments. But if the property market is doing well and other industries are underperforming, the adjustments and their effects will be considerable….


China Knowledge at Wharton: Some would argue that China’s returns of over 20% on real estate have led to international capital pouring into the market. That combined with the increase in bank lending and the new Insurance Law means another property bubble might be forming. Is this a fair statement?


Zhang: I don’t think it is entirely accurate. Why? First, let’s consider insurance capital entering into the property market. The new law took effect on October 1, so insurance companies can now buy fixed assets. This measure is going to improve demand. But when insurance companies buy such assets, they are looking for income-generating properties — that is, assets they can use to charge rents. They generally will not buy residential property. However, they do want commercial assets, such as department stores, hotels, offices and so on, and they will definitely make an impact on this part of the market. But the reality is that commercial real estate makes up a rather small part of the whole market.


Second, commercial property prices are not very high. In Beijing, for example, [prices are] RMB 30,000 per square meter. A lot of housing is more expensive than that. Yet housing development usually costs about half that of office. That’s why commercial real estate prices are pretty low, and commercial assets’ influence on the whole market is not that great. Insurance capital entering the sector will have a healthy effect because the sector will have access to a new investment class, one that is very stable but with returns that are not too high. It will broaden choices for investors and provide a good return for insurance capital. I do not think there should be any concern about a bubble.


The third issue involves the inflow of international floating capital. For [our company], this is not an issue. We often have international projects, which are quite advanced for a China-based real estate enterprise. We have a lot of international partners we co-invest with, including the overseas real estate management fund we set up with UBS, to which we bring funds and investment them in residential development projects. Currently, the fund’s investors are long on the China property market. They are not hot money, which is to say they are not here today, gone tomorrow. They are not manipulating the market. Most of them are mid- to long-term investors. These investment projects generally have five- to seven-year horizons, and are not purely speculative but long term.


At the same time, in the course of our day-to-day business, we do not see a lot of foreigners buying residential real estate in China. There are a lot of renters, but not a lot of buyers. Profits are good in China’s real estate market, but taxes are quite high. The return on assets of China’s real estate companies is really not high — on average between 10% and 15%, but often not even 10%. Though our profit margin was 43% last year, our net profit on sales was about 10% and our net return on assets was also about 10%. A large part of that went to taxes. Foreign investors clearly understand the situation so China’s market is not as attractive [to them] as it may seem. On the surface, the sector is buzzing with excitement, but the reality is that its profitability is not explosive, and it really fits into a slightly above-average asset class.


China Knowledge at Wharton: With regard to UBS, could you describe how the two of you work together?


Zhang: As I mentioned, we cooperated with them to establish a real estate management fund, with both sides owning half the shares. Our responsibilities are quite clear. They will raise capital in international markets, and we will participate in these activities. In the domestic market, we will take the lead in selecting projects, and both sides will jointly decide whether to invest in a project. The roles of both sides are clearly defined, but by no means separate.


China Knowledge at Wharton: Let’s look at Gemdale’s domestic investment strategy. What are your development plans? Is your strategy the same for all locations?


Zhang: We are currently developing projects in 14 cities. We have covered all of China’s developed economic zones, such as [those in] the Yangtze River Delta, Pearl River Delta and Bohai Sea regions. At the same time, we have projects under way in Wuhan in central China, Xi’an western China and Shenyang in northeastern China.


China‘s real estate is in a growth phase and is not mature yet. In the course of our research, we found that every city is in a different stage of property development. Some cities, like Shenzhen, are quite developed while others, like Xi’an and Shenyang, are not very developed. From a development perspective, we are still concentrating on first- and second-tier cities, among the middle and high strata of the market.


We also have to assess each individual city basis to know whether, for example, it is suitable for office investments…. From a strategy perspective, we really pay attention to these things. We have a good city evaluation model, which we use to determine whether it is right for us to enter a city. If the model determines that we should not enter a city even if there are good investment opportunities, we will not enter it. This is rational decision-making.


China Knowledge at Wharton: Western companies believe that a company’s management system and superior production and service are implied in its brand image. In 2004, Gemdale unveiled its slogan, “The Science of Living”, and a new brand campaign. Since then, how successful has Gemdale been in terms of developing a brand persona catering to the higher end of the market? What are the biggest challenges the company has faced in trying to build the brand?


Zhang: The reason we wanted to promote that image was because of our position in the mid- to high-end market. Our customers have substantial wealth and are highly educated, so their demand for brands is pretty high and that demand would be increasing. …We chose the international company Ogilvy to help us design the brand strategy and the brand image, and we invited InterBrand to design the company visual image….


“The Science of Living” is not a new concept for Gemdale, because [it was already] in our DNA. …The slogan has refined what our brand means. Most of our customers now recognize that Gemdale is a brand associates with outstanding quality, particular in terms of innovation and use of technology.


Right now, our biggest challenges come from non-stop expansion, which requires a major change in our corporate culture and the way we manage the business — a challenge the entire real estate sector is facing. The [compound annual growth rate] of our revenue is about 45% and margins are increasing about 35%. It’s a pace that would hardly be sustainable in western companies, but this has been the case in China for seven consecutive years. This year, our revenue could grow more than 70%, with profitability growing even more, so inevitably that means our culture and the skills we need to run the company must change. It is a huge challenge, and it is not coming from our competitors but from ourselves.


China Knowledge at Wharton: As the company continues to expand, will you encounter even more challenges from a personnel standpoint?


Zhang: Of course. But we will find ways to improve, for example, training, which we have done a lot of already. In terms of recruitment, we go to China’s top universities every year and hire the best students to be trained at the company, and after several years, they become very strong team members. Starting last year, we began recruiting at America’s best schools, and we’re doing the same this year…. At the same time, we do a lot of internal development, including product-line redesign, engineering quality improvement, investment strategy and system refinement, corporate culture improvement, and so on to further advanc