Chengdu News

By Alex Frew McMillan

HONG KONG: When a group of large institutional property companies gathered for a real estate conference in February, it was no accident that they met in Chongqing rather than Shanghai or Beijing.

The topic of the meeting, "Second Tier and Beyond," has been dominating recent discussions among real estate investors in China: the reach beyond the most-developed urban locations and into the so-called second-tier cities, mainly the country's provincial capitals. And Chongqing, a river port in Sichuan Province, is the largest of these cities.

China-watchers say they have noticed the idea gaining momentum for years, with the trend really advancing since 2005.

"There is really a lot of interest in investing in these second-tier cities in China," said Frankie Lee, a fund manager for Asian property stocks at Henderson Global Investors.

Investors "are thinking broadly the same line of thought: to diversify their risk and get better opportunities, opportunities that are relatively ignored," Lee added.

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Alan Liu, regional managing director for North Asia for the real estate company Colliers International, agreed. "For Shanghai or Beijing, the results are inevitably lower because it is more competitive," he said. "So when they go out to the second- or third-tier cities, they find the returns are a little higher."

As an example, David Edwards, Asia-Pacific investment strategist for the property fund manager LaSalle Investment Management, said his company was "making our first investment in Shanghai, and then looking at Beijing and Guangzhou."

"But we have a lot of other places under review - we are looking at deals in a lot of second-tier cities," he added, including Chengdu, Qingdao, Dalian.

The second-tier cities may not carry the same cachet as, say, Shanghai, but that does not mean they are small.

Chongqing, for instance, has 4.1 million people living in the central city but when its surrounding areas are considered, it is home to more than 31 million, which makes it the largest population center in China.

It "is of a completely different order from most second-tier cities in the rest of the world," Richard van den Berg, the China country manager for ING Real Estate, said during a recent news briefing.

Van den Berg grew up in Eindhoven, what he calls a second-tier city in the Netherlands, with a population of a little more than 200,000. And he points out that the main cities in his homeland, Rotterdam and Amsterdam, each have populations of fewer than 750,000 people.

By comparison, even the smallest of the second-tier cities in China are huge. The country has 93 cities with populations of one million or more, and about 20 with populations of more than five million.

"If you run out of opportunities in the first-tier cities in China, you can go down a tier," Liu said.

"It's very much like development in the United States, where besides New York, Washington and Los Angeles there may be much more opportunity in Philadelphia, Minneapolis, you name it. I think there's that similar model."

There is no formal definition of a first-tier or second-tier city in China. But Xavier Wong, head of research at the Knight Frank real estate office in Hong Kong, said that to be considered in the second tier a city should have a population of about three million and a minimum gross domestic product that is the equivalent of $2,000 per capita, although the income requirement is stretched for large cities whose residents have lower incomes, like $1,363 in Chongqing.

In addition to Beijing and Shanghai, the high per-capita incomes in Guangzhou ($6,668) and Shenzhen ($7,534), the well-off cities just across the border from Hong Kong and at the heart of the industrial Pearl River Delta, have pushed them into first-tier status, Knight Frank says. Their property markets also are more developed, thanks in part to investment from Hong Kong.

According to Knight Frank's criteria, there are about 60 Chinese cities that can be considered second-tier or bigger.

Wong says that, in addition to the simple population and income guides, the cities also have a strong history of exports, a robust record of foreign direct investment and good policy initiatives.

Using all those criteria, he has identified 15 cities that he maintains will offer the best development potential over the next five years: Suzhou, Tianjin, Chongqing, Hangzhou, Wuxi, Qingdao, Ningbo, Nanjing, Foshan, Chengdu, Wuhan, Dongguan, Dalian, Nantong and Changzhou.

The shift in focus to the second-tier cities sometimes is described as a move inland. But nearly all of those cities are on or adjacent to the eastern coast, the heart of rapid industrialization in China. On Wong's list, only Chengdu, Chongqing and Wuhan lie a significant distance from the ocean.
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Van den Berg at ING cites many of the same destinations as his favorites. Chongqing, Chengdu and Tianjin are his top three development prospects, and he also likes Dalian, Wuhan, Chengdu and Changsha.

The range of possible second-tier destinations for developers is extensive, while the stock of existing higher-quality residential and office development is small.

"At the moment, there is generally a lack of good quality product," van den Berg said.

"I think China at the moment is the land of opportunities."

Steve Clinefelter agrees. As president of California Fitness, the Asian arm of the U.S. chain 24 Hour Fitness, he says his company is just about to start a push in China and is having trouble finding quality properties.

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"Our plan shows us with 20 clubs in the next five years in China, and that takes us to a number of second-tier cities," Clinefelter said. "We think actually we would have a better performance in the second-tier cities simply because all your costs are lower."

The lack of well-built, quality real estate in those secondary cities has the company looking at Beijing and Shanghai for its first, flagship stores. But Clinefelter continues to work on opening gyms in cities like Tianjin, Guangzhou, Shenzhen and Hangzhou. And, he said, that means his director of real estate has a critical role in finding ideal locations that, for the time being, do not seem to exist.

"We have to have a real estate site that suits us," Clinefelter said. "If you don't have the real estate, you can't grow, and if it does exist, you can't wait."

Of course there would not be opportunity without risk, and developers' focus on smaller Chinese cities does generate concern. Beijing and Shanghai are well-established property markets where transparency is relatively high, there are ways to compare pricing and there has been a long-running economic boom.

"The biggest risk in second-tier cities is execution," van den Berg said. "It's a local business. You can't do it from a distance."

As a result, ING executives say they consider a company's choice of a local partner for a development to be even more important than the city location. (While foreign developers can go it alone in China if they meet structural and capital requirements, many team up with local companies that know the market and sometimes are better able to deal with city officials and bureaucracy.)

The Chinese real estate market is driven by the central government but there are regional variations in rules, and central directives are often unevenly interpreted and enforced. So it helps to have knowledgeable local partners as well as local researchers, lawyers and the like, developers say.

A focus on smaller cities does simplify dealing with the changing real estate landscape in China in one way: It means that developers are less likely to fall afoul of the double dose of austerity measures that China introduced last year.

The central government introduced rules in May and August aimed at cooling a red-hot market and forcing developers to focus more on affordable housing rather than the luxury end of the market that they had favored.

The main points require developers to allocate 70 percent of all new projects to units of less than 90 square meters, or 970 square feet. Likewise, 70 percent of the sites available for residential development are to be used for affordable units that are small or midsize.

Projects in smaller cities tend to focus on more affordable units anyway because incomes in those cities are lower, said Kenneth Tsang, director of strategy and research for greater China at ING Real Estate.

Average prices per square meter for a midrange apartment are 2,500 to 3,000 yuan, or $324 to $388, in Chongqing and 3,500 to 4,500 yuan in Tianjin, compared with 8,000 to 9,000 yuan in Beijing and about 13,500 yuan in Shanghai.

That means properties in second-tier cities are still relatively affordable. Incomes are also rising at a higher rate in percentage terms in second-tier areas, while savings rates are high, so the demand for private property is rising more quickly.

ING says there is enormous private-sector demand for apartments, with 90 percent to 95 percent of the units in its second-tier city developments going to individuals, often in their mid-30s. Some are paying in cash saved by their extended families.

So developers hope they will benefit from a long-running trend that will last for years across China, as a middle class emerges.
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"In these second-tier markets, particularly given that they are experiencing higher GDP growth rates in many cases than the major cities, it fuels things" like retail and residential investment, "where you can get higher capital appreciation," Liu of Colliers International said. "With higher disposable income, people are inevitably upgrading their own residential circumstances."