How will China’s property markets perform in challenging economic conditions?

Amid already challenging macroeconomic conditions, Chinese developers recently have become the main targets of government tightening measures. After a year of record sales, capital raising and land acquisition, many developers now find themselves short of cash. The Chinese government’s concern has not been to lower overall housing prices but to ensure the availability of affordable housing supply. One action the government took to achieve this policy goal was to increase rural land supply in anticipation that developers will use it to develop affordable residential units.

However, buoyant land prices in the second half of 2007 acted against such government actions and effectively turned land meant for affordable housing into future high-cost residential units. In response, the government cut off developers’ finances by tightening domestic loans and by restricting foreign direct and indirect (via capital markets) investments into Chinese real estate companies. Compared with just a quarter ago, when developers had little interest in partnering with property investment funds, today these same developers are scrambling to secure investment from anyone and everyone.

In contrast to the tight real estate investment and capital markets, occupancy demand for real estate remains high in all sectors. According to our latest first-quarter data, office demand continued to be strong in the major cities as rental levels showed significant increases in Shanghai (up 3.1%) , Beijing (up 1.7%), Chengdu (up 4.6%) and Tianjin (up 3.0%). The feedback from our leasing teams has been that, with the exception of a few large international banks which suffered significant losses recently, the majority of corporations are sticking to their expansion plans. Even for corporations that might be rethinking their expansion plans, we believe this to be a temporary delay rather than a reversal of their China business strategy. On the residential side, contrary to media reports of a market rebound in certain cities such as Shanghai, we found no evidence of a substantive rebound. In fact, the reported rebound proved to be mostly seasonal and was consistent with market performance during the same periods in 2006 and 2007.

While it is too early to determine the full impact of the US economic downturn on the Chinese economy, we maintain a positive outlook on mid-term to long-term real estate demand. However, demand growth might not necessarily translate into future rental growth. In fact, we are concerned that the increasing pace of renminbi appreciation will begin to pull against rental growth.

For the office sector, even though we saw solid rental increases in the first quarter of 2008 on the back of the strong leasing market, tenants are likely to have tighter cost controls going forward and be more reluctant to accept increases in both the exchange rate and real rent.

For the luxury and high-end residential leasing markets, where expatriate housing demand growth is slowing and supply is plenty, we are already seeing rentals softening. The only sector in which we do not expect the strong renminbi to have an impact on rentals is the retail sector. Since retailers make their sales revenue in local currency, the currency gains from sales should offset currency losses in occupancy costs.

In conclusion, our view is that the current market slowdown is largely a result of uncertainty surrounding macroeconomic conditions, both domestic and abroad. Inflation is expected to ease in the second half of the year while the economy remains on a pace to achieve over 9% annual growth. With real demand staying strong, we believe that current market conditions provide a good buying opportunity for investors. Given the government’s tight control of real estate capital markets, we believe it will be the foreign investors with access to renminbi and domestic players with strong balance sheets that will come out ahead.