What Chinese developers and investors can learn about development risks, capital stack and how to create a successful deal.


By Bill Nan Zhou

Many Chinese investors seeking opportunities in U.S. real estate have been successful in other businesses in their home market. There is a tendency to rely on this past success, but it is important to first understand the many differences between the U.S. and China markets.  Understanding the differences between these markets will allow investors to make smarter choices and find greater success in the U.S. real estate investment market.  

U.S. real estate can be divided into two distinct markets; residential and commercial. Residential real estate includes single family homes, town homes and condominiums.  While a residential home may provide a place in which individuals can invest their money, in addition to its functional use, it is not traditionally a place for institutional or quasi-institutional investors to deploy their capital.  The remainder of this article will discuss differences mainly between commercial investment markets in the U.S. and China, although many of these differences can be seen in the residential markets as well.

This article will focus on key differences when it comes to market maturity, market cyclicality,  “whole asset vs. condominium-ized” ownerships, the role of institutional investors, the role of government, risk and return profiles and the basic development model. This list is not exhaustive, but it does provide a basic platform for better understanding.


MARKET MATURITY  

All the key differences discussed later in this paper should be viewed through the lens of market maturity; the growth and establishment of the respective markets over an extended term. Fundamentally, the U.S. and China markets are at different stages in their growth, and consequently, pose different risks and offer different opportunities.  

The U.S. market has seen consistent, private real estate investment for generations; their legal structures have evolved to facilitate property ownership and investment and while new development continues due to economic and population growth, it represents a smaller percentage of product compared to existing real estate stock in the country.  Rapid expansion, similar to China’s present expansion, occurred in the U.S. over 70 years ago, immediately following World War II. Today, U.S. investors tend to be “demand focused;” they are most concerned with an investment’s ability to attract and retain rent paying tenants.  Whether building a new development, or purchasing an existing asset, the ability to keep the asset leased and producing a good income return, is a key driver of the investment decision and a large perceived risk with any given investment.  In a mature market such as the U.S., tenants have many occupancy alternatives in existing real estate stock. The ability to purchase an asset that is already built, already occupied or partially occupied significantly mitigates this occupancy risk and is viewed more favorably in the U.S.  Consequently, purchasing existing assets is much more typical and efficient in the U.S. From initial marketing to selection of a buyer is usually accomplished in 30 days or less, and pricing produces lower returns than new developments because these assets are perceived to have a lower risk profile.    

Conversely, China’s spectacular economic growth over the past 30 years, while similar to the U.S. boom post-World War II, is on an even larger scale.  The size of the population, the rapid growth of a middle class, the creation of disposable savings and changes in real estate ownership have made China’s unprecedented growth more concentrated and explosive. The subsequent demand for real estate to meet that growth, means years, possibly decades, in which development will remain a much larger percentage of the total real estate stock in the country. There is a seemingly insatiable tenant demand in China’s markets and that perception has been proven accurate over the recent past. This has created an investment mindset that assumes tenants will be abundant and will want to lease, or more likely, own any new development, producing a “build it and they will come” mindset.  Of all the risks associated with real estate investment the risk of demand/leasing is one of the two most often skewed between the two markets.


MATURITY’S IMPACT ON ACQUISITION

To date, Chinese capital, due to general business caution, has not been able to effectively participate in the acquisition of existing real estate assets. There have been notable cases when institutional Chinese capital has purchased existing assets; typically, they are “trophy” assets that come with a “pride of ownership”, large (by U.S. standards), and the seller has been willing to slow the sale process because of the large premium the buyer is willing to pay.  Only time will tell if these are good investments.  However, as Chinese capital increases its participation in the U.S. real estate markets, it will become increasingly important that it become more agile and work within the customary timing of most transactions. Paying a higher, premium price to participate in an efficient market will not produce the desired investment result over time. Finding and engaging a strong, trusted bi-cultural investment group is an important first step.


MATURITY’S IMPACT ON DEVELOPMENT

Another difference driven by the maturation of the U.S. and China real estate markets is that large scale development projects are far less common in U.S. markets than in China.  More mature markets tend to be in more relative supply/demand balance; the need for large scale development is less common than in growth markets such as China. Projects in the U.S. are sized based on perceived demand and in the U.S. demand is very different than in China.  This surprised many large Chinese investors, many of whom are developers themselves, when they first entered the U.S. market. U.S. real estate professionals have watched in awe (and disbelief) at the scale of many of these initial projects.  Many of these projects are under development; their success may hinge on their ability to bypass the U.S. debt capital markets, have significantly more equity than most U.S. developments, and most importantly, utilize equity raising processes in their home market, under their domestic legal statutes. Under U.S. capital constraints, it is hard to develop a large project unless the developer can prove to the capital markets that the demand is real and supportable. In a cyclical business, large projects inherently have more risks, because it is hard to control the economic condition at exit. Developers are equally capable of big ideas in the U.S., but they are frequently reined in by investors and lenders.


MARKET CYCLICALITY

China has enjoyed tremendous growth in real estate values; there is no need to worry about housing prices going down, especially in the “first tier” cities. Many Chinese investors believe that U.S. “first tier” cities will behave similarly. Unfortunately, the mature nature of the U.S. market makes the real estate industry more susceptible to cyclical declines in demand. Savvy U.S investors are paying very close attention to what stage of the cycle we may be in; their abundant, and sometimes painful, experience, make them attuned to the impacts of a down cycle. While no two cycles are the same, it is reasonable to expect that the market will slow in the future.  


INVESTING IN A CYCLICAL MARKET

Being mindful of cycle risks is not a reason to shy away from investing in a market, even at a late stage.  In fact, many professionals acknowledge that their willingness to continue to price the market effectively through a slowdown, and continue to acquire assets, produced their best returns. This requires a long-term investment strategy and ability to identify market pricing imbalance.   Opportunities exist in every stage of a cycle; prudent investors adjust their investment strategies to compensate for market cyclicality. For example, early in the recovery cycle there are opportunities to buy existing properties below replacement cost. As acquisition prices are pushed up, new development starts to make sense. Late in the cycle, mezzanine financing and longer-term hold strategies are more sound. In the depth of a recession when everybody is fearful, distressed acquisitions proved to be a smart investment strategy.

Additionally, individual cities in the U.S. will have their own cycles. Many U.S. gateway cities chased by Chinese investors do share the same benefits of good liquidity, similar to Chinese “first tier” cities, but that doesn’t always translate into gateway cities being the best place to invest. Every asset, regardless of location, construction materials, and tenancy is a good investment at the right price. The reverse is also true, the best real estate in a first-tier city is a bad investment at the wrong price.  As investors get more sophisticated, seek out and engage qualified investment professionals, and look beyond the perceptions of their home markets, they should be prepared to embrace an objective, open investment process designed to produce the best opportunities.  


“WHOLE ASSETS” VERSUS “CONDOMINIUM-IZED” OWNERSHIP

Another differentiating factor between the two national markets is the “direct ownership preference” that is common beyond residential real estate in the China market.  Chinese investors overwhelmingly prefer to own real estate, for both their business and personal needs.  In the U.S., renting space for both business and personal use is far more common.  These differences are manifested in different ways.  For example, in China real estate markets, it is not uncommon for high-rise office buildings to be sold in pieces, floor by floor, or even suite by suite.  With few exceptions, that is a very uncommon practice in the U.S.; even large corporations will frequently lease the majority of their real estate, choosing to own only those facilities deemed “critical” to the long-term success of the company.

While a seemingly small difference, it impacts and accentuates many of the other differences found between the two national markets.  Through trial and error, the U.S. market has gravitated toward whole asset investment; it allows for easier financing, greater control of quality and service, and most importantly, easier disposition of assets.  Conversely, it makes directly owning real estate an expensive proposition for the average investor.  This problem has been solved over the years by the development of investment vehicles that allow investors to combine their capital with others to reap the rewards of real estate equity ownership. These pools take several forms; public and private REITs, limited partnerships and commingled investment funds are all common in the U.S. market. Often, these pools are raised in advance by investment groups, and investors are asked to evaluate the investment team and strategy, not individual assets.  This method of capital raising and asset acquisition has been slow to attract Chinese capital, but it is very common and supported by centuries of real estate and financial law in the U.S.  Over decades, it has proven to be far easier to sell a financial instrument in the U.S. (like a partnership or fund interest), than to sell 70 square meters on the 11th floor of an office building in Shandong Province.

Chinese capital is slowly losing their aversion to many of these structures.  But, early Chinese investors in the U.S. tended to buy what they could afford individually; this approach may often lead to the purchase of lower quality assets in secondary locations. With a good portion of an investment return coming from appreciation, the quality of asset and location are paramount; but not always sufficiently considered; they are easily overlooked if the direct ownership preference dominates the investment process.    

Understanding where each market stands from both a long-term maturation status and a cyclical real estate condition provides a framework for investing in each nation and influences the perception of risk vs. real risk for investors. The difference in mindset, based on historic experience, between Chinese and U.S. investors is clear; being able to differentiate between the two viewpoints is essential to making better financial decisions.


ROLE OF INSTITUTIONAL INVESTOR

The evolution of the “whole asset” investment preference in the U.S. market stimulated the entry of large institutional investors that recognized the unique advantages of real estate ownership. In turn, these investors demanded business and legal frameworks that eliminated some investment risk and uncertainty.  Over decades, the market became more predictable, and with increased certainty, more institutional investors were attracted to the market.

Today, institutional investors play a critically important role in U.S. real estate markets. They often provide the capital (debt and/or equity) for new development and are large owners of investment real estate.  Active institutional investors in the U.S. include public and private pension funds, endowment funds, insurance companies, public and private REITs, private equity funds, institutional asset managers, sovereign wealth funds, and other quasi-institutional foreign capital. For many, real estate provides a good balance of current income and long-term appreciation.  Additionally, private institutional real estate investment has a low correlation to other investment vehicles, meaning its returns do not move in the same direction and/or to the same degree as other investment products.  For this reason, institutional investors typically allocate a percentage of their investment portfolios to real estate.  

Institutional real estate ownership exceeds $1.5 trillion in the U.S, according to HFF.  This large, diversified pool of institutional investors can be found in all product types, and consequently, creates a relatively liquid marketplace for an otherwise illiquid asset class.    

China’s real estate market is in the early stages of this process, and is likely to reach, if not exceed, a similar level in a much shorter time, but that may still be a decade or more away.  This is primarily due to a combination of factors; the previously discussed direct ownership preference which has created a real estate market dominated by “for sale” condominium interests, primarily in residential product, but also in other product types, the lack of an efficient mortgage market, and the absent of true REIT legal and tax framework, the high costs of capital relative to low cash yield from holding real estate assets, and the challenges of an entire market on ground leases.  

Additionally, other alternative real estate investments are still under development; REITs in China are still at the experimental stage and insurance companies are prohibited from participating in the biggest and most lucrative sector, residential condominium development.  Presently, the development of an institutional real estate investment market still has long way to go in China.


THE ROLE OF GOVERNMENT  

The role of the Chinese Government in the real estate market is hard to overestimate. Similar to their counterparts in the U.S, local, state and federal governments make the laws and regulations that govern the market, determine zoning and development standards. Though, the Chinese markets are much less restrained by community activist influence. The largest difference is that, in China, the government is the sole land owner, and its control is pervasive, extending to such terms as setting the minimum and/or maximum pricing for which a developer can sell his/her product.  The list goes on and on.  

While both U.S. and Chinese developers will spend time with local officials to develop a solid working relationship, U.S. developers ultimately own the land and have legal rights grounded in decades of precedent as to how they may utilize their land.  More typically in China, local authorities have unilateral control of issues surrounding land development; it is typically the single most important factor in the success of a development deal.   In the U.S., elected officials have a more limited role; their job is to enforce existing statutes, regardless of other influences.   Courting government officials is not a typical way to source a good deal, nor will government endorsement guarantee an investment will be successful.  

The good news for Chinese investors is that U.S. real estate is one of the most open, liquid markets that a foreign investor can enter, with low regulatory barriers.  Of course, foreign investment in U.S. real estate is still subject to FIRPTA tax, but even this can be mitigated with proper tax planning.


RISK AND RETURN PROFILES

Real estate risk and returns are evaluated quite differently within the two markets. The combination of current cash flow and long-term appreciation is capable of meeting or surpassing most institutional investor’s targeted return goals.  In the current investment environment, core real estate investments should yield a total return between 6.5 to 8.5 percent, core plus strategies should yield between 8.5 to 11 percent, value add strategies should generate low to mid-teens returns, and opportunistic strategies should generate high teens to over 20 percent total returns, on a gross basis before fees.  These are narrow ranges; the result of a liquid, transparent marketplace. Each of these ranges will shift depending on the city in which an investment is located. Gateway cities, like New York, San Francisco, Los Angeles and Washington, D.C.,  will produce yields closer to the lower end of each of the ranges, second tier cities, like Dallas, Seattle and Denver, will likely fall mid-range, and tertiary cities would likely fall near the top of the ranges provided.

In short, market conditions are creating the exact outcomes that should be expected.  In China’s high growth market, individuals are willing to accept a lower current cash return in exchange for a higher appreciation return, and greater total return upon disposition of the investment.  In the U.S.’ more mature market, the opportunity for greater appreciation can only be found in development investments, in which value is created through the development process.  More typically, U.S. investors rely on higher current yields and lower appreciation that delivers a more modest total return, but at a far lower risk.

Often, Chinese investors pay more attention to the absolute return, but fail to recognize the risks associated with a particular investment strategy. Achieving a good risk-adjusted return should be the goal, but often Chinese investors bring their macro-market perceptions with them to the U.S. and focus on the total return without fully understanding the risks in the U.S. market.   The same can be said for U.S. investors in China.


DEVELOPMENT MODEL

In addition to the macro-market differences described above, there are general similarities and specific differences in the development process that also impact the respective markets.    

Generally, value creation in real estate development between the U.S. and China proceeds through the same process.  While the list of important decisions that must be made is long, the major drivers to a successful development require similar steps in each market.  An investor must identify a good location for the chosen product type, secure governmental approvals, negotiate a fair investment structure with a qualified developer, and develop a market acceptable product of high quality.  But while these steps seem similar on the surface, a closer look reveals substantial differences.  

In China, buying land is typically the largest cost in the total budget. In some cities such as Beijing and Shanghai land costs can represent 70 to 75 percent of the total costs.  Land in this description means the acquisition of a long-term ground lease from a government entity. To compensate for this cost, developers want to maximize the buildable square meters allowed on the land.  Luckily, both the cost of land and the entitlement allotted to be built are controlled by the same entity; unfortunately, there is little incentive for the government to do anything that they are not inclined to do.  

Traditionally, land acquisition in China has required substantial upfront cash.  Leading with a large cash outlay will typically hurt the overall return, so most Chinese developers need to quickly deliver product so that the capital can be re-deployed (usually into another piece of expensive land). However, the cost of these outlays is mitigated in the domestic market by a developer’s ability to build with “progress payments.”  Progress payments are incremental deposits made by a buyer, either with cash or by a mortgage lender, throughout the development process. Utilizing this capital to build the asset isn’t allowed in the U.S., but is very typical in China.  China’s developers are known for producing some of the best project renderings and models anywhere in the world; it is to be expected when you can sell, collect deposits and spend the money, all based on a pretty picture. They are also known for generating incredible returns. U.S. development returns are typically between 17 to 25 percent internal rate of returns.  Most Chinese developers achieve well north of 25 percent; the largest factor affecting returns is the time in which the developers capital is actually invested.  U.S. developers will usually invest between 1 to10 percent and will be required to keep that capital in the project through final disposition which could be four or more years. They leverage their expertise in entitlement, product design and construction management, to keep their equity commitment low and attract both equity and debt capital.  If the project meets pre-determined success levels, U.S. developers have an opportunity to receive a “promote,” or success payment after the equity partner receives their capital and return.  Chinese developers invest substantially more upfront, but typically extract all their capital and much of their profit within a short investment window of 1-2 years, depending on the pace of construction.  

Conversely, capital outlays for land in U.S. markets, apart from Manhattan or San Francisco, normally range between 10 to 35 percent of the total costs. Hard costs are typically the largest component of the budget, normally between 60 to 70 percent of the total costs, and these costs do not vary greatly; potentially 5 to 10 percent up or down depending on market demand for labor and raw materials.  To develop the right product for the market and control construction hard costs is far more crucial in the U.S. because U.S. developers are far more exposed to a broad array of risks (entitlement, hard costs, timing, competitive supply).  Chinese developers have lower exposure to these same risks in their home markets because of China’s position as a real estate growth market, and the governments unilateral control of land supply, land cost, entitlements and competitive developments.  In the U.S., land sales are typically between two private individuals, and depending on the current entitlements on the land, a U.S. developer cannot afford to over-pay or they risk building an unprofitable investment. It is typical to say that land value is a residual value calculation. Once a developer, in any market, makes assumptions of what the future value of an asset will be, he must work backward through the costs and risks of delivering the project, and only then can he determine what he is willing to pay for land.  

Why are these differences important to understand from an investing perspective? Many Chinese investors in the U.S. are developers themselves. Understanding the U.S. model will help Chinese developers better understand development risks in the U.S. markets, investors better understand the capital stack, and both developers and investors find the right role to play.  Conversely, it would be helpful for U.S. developers to understand the goals and risk appetite of Chinese investors.  Like many areas of life, mutual understanding is often the road to mutual success.  

An understanding of mature market fundamentals is growing in China.  In the individual investment market, the government is attempting to inject discipline into the market which is lowering runaway appreciation.  Consequently, pricing can be expected to moderate in the future as appreciation expectations moderate.  The question is, at what point in its development is China?  It is difficult to say; much depends on the continued growth of a middle class, migration from rural to urban environments and the continued growth of the overall economy.  As these become clearer, China markets should become more attractive to institutional investors, both domestic and foreign.  Other differences may take longer to reconcile, but as China’s real estate market matures, we believe many characteristics of the U.S. markets will begin to appear in China.  Whether that happens in years or decades will ultimately depend on a broad package of changes.  Until then, smart investors should: heed the differences discussed above, resist falling prey to home market perceptions, and use local expertise in each market to maximize financial performance.

This article illustrates a portion of the differences between the two markets. Hopefully, it raises enough questions to compel current and future international investors to seek the expertise necessary to navigate through what is a very complex investment process.

(Editor’s Note: May vary slightly as published.)


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About the Author
Bill Nan  Zhou
Bill Nan Zhou
Asset Manager

Bill Nan Zhou is co-founder and managing partner of Elite Capital Partners. Zhou has over 20 years of merger & acquisition, financial management and investment experience. Prior to Elite, he served as chief financial Officer of two fast growing companies in California, and held various corporate finance and investment positions in a fortune 500 Company and a middle market M&A firm. He earned his MBA degree from University of Southern California.  Zhou serves on the multifamily national council of the Urban Land Institute. 

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