What signals does the influx of foreign PE firms into China's Tier 1 commercial real estate market reflect?

Buffett once said: “Be fearful when others are greedy, and greedy when others are fearful.” This is well-known, but those with the courage, decisiveness, and action to do so are always a small minority at any time.

While mainstream Chinese public opinion is still debating the imposition of property tax, the survival of real estate developers, the future trend of house prices, and the continued decline in commercial real estate rents, foreign private equity firms have swiftly and decisively 'bottom-picked' in Beijing, Shanghai, Guangzhou, and Shenzhen.

What does foreign PE sweeping up properties in Beijing, Shanghai, Guangzhou, and Shenzhen mean? What signals does it reflect? What impact will this have on China's commercial real estate and real estate funds respectively? At this crossroads, commercial real estate investment institutions need to conduct systematic research.

As an observer, I will only do a superficial analysis from the periphery.

Starting from the most basic news facts:

1. Blackstone is the number one buyer. In the first three months of 2019, Blackstone spent 20 billion yuan buying buildings. It first acquired a 50% stake in three shopping malls in Xi'an, Zhengzhou, and South Korea from American commercial real estate giant Taubman for US$480 million; then repurchased 69.54% of the shares of Hainan Real Estate Development subsidiary Hong Kong International Construction Investment for HK$7.023 billion; and acquired Shanghai Changtai Plaza for US$1.5 billion.

Shanghai Changtai Plaza, Pudong New Area

2. As of March 27, 2019 (January 1 to March 27, 2019 - Note), 16 foreign institutions have participated in 'bottom-picking' mainland commercial buildings. In addition to the world's top investment bank Blackstone Group, these foreign institutions also include well-known real estate investment funds such as CapitaLand, Link REIT, Ascendas, and Gaw Capital.

3. As of March 27, 2019, foreign institutions have completed 8 large-scale property transactions in mainland China, with a total transaction value exceeding 30 billion yuan.

Based on the basic news facts, let's make the following extensions and predictions:

Blackstone Is the timing ripe for the decisive 'bottom-picking'?

Founded in 1985, Blackstone has always been considered a 'weather vane' in the global asset management field. Its investment style is 'steady, accurate, and ruthless', daring to seize opportunities, place heavy bets, and make quick in and out moves. It has always enjoyed a high reputation in global alternative asset management.

On February 9, 2007, Blackstone Group used US$3.5 billion of its own funds to leverage US$31.7 billion in social funds to acquire the largest commercial property group in the United States - Equity Office Properties (EOP). Simultaneously with the acquisition negotiations, it began to divest and sell, divesting and selling 5.67 million square meters of relatively poor assets out of 9.3 million square meters of EOP's key properties, generating US$28 billion. Blackstone still retained the most valuable assets.

Subsequently, the US sovereign debt crisis broke out in 2008. By then, Blackstone had recovered 3/4 of its costs, repaid most of its debts, and made a profit, successfully avoiding the disaster. This 'blitzkrieg'-like real estate acquisition case has been recorded in history. Blackstone's precise control over project selection, bottom-picking timing, and exit timing is evident.

From a realistic perspective, the current simultaneous 'bottom-picking' of Chinese commercial properties by foreign institutions is by no means accidental.

In August 2017, I pointed out in the article “The Vulture Feast is Coming, Are You Ready?” that “Since 2014, investment opportunities in Chinese commercial real estate, especially some non-performing assets, may have arrived. The unusually hot real estate market in the second half of 2015 alleviated some of the investment risks of commercial real estate and non-performing assets. However, since the second half of 2016, the sluggish market environment and deteriorating business environment have continued, and a new golden age for the disposal of urban commercial real estate and non-performing assets is about to come.”

I believe that “Since the second half of 2014, a group of foreign PEs, as well as vultures, have been continuously circling over China.”

According to the report “Real Estate Private Equity Funds: Triggering a New Wave of Capital Allocation in Asia-Pacific” released by CBRE at the beginning of 2018, it is estimated that by 2020, real estate private equity funds will complete approximately US$53 billion in capital allocation in the Asia-Pacific real estate market, and China is expected to absorb US$14 billion of this, becoming the largest investment destination.

According to data from the China Securities Investment Fund Association, the number of foreign-funded private equity institutions has increased since 2014. In 2014, Permira registered as a private equity fund manager. Subsequently, foreign institutions such as Fidelity, UBS, and Value Partners successively poured in, but the number of institutions established at that time was in the single digits. According to incomplete statistics, from 2017 to the present, 12 foreign institutions, including Fidelity, BlackRock, Schroders, Fubon, Permira, Value Partners, Invesco Great Wall, Neuberger Berman, Aberdeen Standard Investments, Allianz China, Yuan Sheng, and Bridgewater, have registered with the association as private equity securities investment fund managers.

From the data: 8 transactions in the first three months of 2019, with a total transaction value exceeding 30 billion yuan, with 16 foreign institutions participating. Frankly speaking, this may only be considered as a 'dive' by more than a dozen vultures, but the 'scramble for food' trend may not be far off.

Foreign The fierce 'dive' of foreign PE, what is the confidence behind it?

There is a saying in the real estate fund circle: “Primary school students play with residential properties, university students play with commercial properties, and doctoral students play with industrial real estate.” The saying reflects that different property types have vastly different requirements for the comprehensive capabilities of 'players'.

Blackstone, established in 1985, has consistently positioned real estate investment as one of the four pillars of its alternative asset management business. Thirty years of experience have resulted in a series of successful projects, including REIT-EOP (Equity Office Properties Trust) and Hilton Hotels. In the commercial real estate investment field, Blackstone has developed a comprehensive "buy-repair-split-sell" strategy. Its successful experience in the mature US market will be advantageous for its entry into the Chinese market.

Over the past 20 years, due to the nascent and initial development stages of China's urbanization, most real estate developers have focused on the residential sector. After 2008, some large-scale real estate developers began to venture into urban commercial properties (including office buildings, commercial plazas, or urban complexes). After more than a decade of development, several well-known commercial brands, such as Wanda Plaza, Joy City, and Yintai Center, have encountered various operational and developmental challenges.

Residential real estate relies on factors such as location, planning, and property management capabilities. Commercial real estate demands more from investment and operations teams, focusing on "integrating key elements and enhancing value." This requires teams to possess a thorough understanding of the domestic commercial property market, strong resource integration capabilities, and, in some cases, robust tenant recruitment and operational skills.

The most prominent issue in traditional Chinese commercial real estate is the substantial upfront investment in land acquisition, construction, and decoration for commercial plazas, often exceeding tens of billions of yuan. This is frequently accompanied by inadequate post-construction leasing and operational management capabilities, with revenue solely reliant on shop rentals. Consequently, the payback period for most domestic commercial real estate projects ranges from 10 to 15 years, or even longer. Such long investment cycles place significant financial strain on commercial real estate developers.

Compared to domestic real estate developers, institutions like Blackstone and CapitaLand possess more precise project assessment and investment attraction capabilities. This means they have strong valuation enhancement capabilities. After acquiring commercial real estate, they can quickly increase foot traffic, improve rental returns, and enhance cash flow through renovation, transformation, and repositioning. Once the project shows signs of improvement, they quickly sell it at a higher brand premium.

Compared to the traditional model of long-term commercial real estate holding, Blackstone's "buy-repair-split-sell" approach shortens the investment cycle to three to five years, significantly increasing the return on investment.

Zhang Lei, founder of Hillhouse Capital, once said, "Investment is the realization of cognition." Cognition is based on ability and experience.

In this regard, foreign institutions like Blackstone and CapitaLand may possess the "bold bottom-fishing" courage that other domestic institutions lack. This also highlights that the key to the success of Chinese real estate funds and PE institutions lies in their active project management capabilities.

Foreign “Catfish”: Ushering in a Golden Age for Prime Commercial Real Estate?

According to Cushman & Wakefield's white paper "Towards 2020—Investment Strategy Outlook in the Post-Trillion Yuan Era," the investable commercial real estate market in China reached US$3.4 trillion in 2016, ranking second globally. By 2020, the total value of China's real estate investment transactions is expected to reach 260 billion yuan, a 45% increase compared to 2016, indicating substantial investment market potential.

Based on the white paper, Cushman & Wakefield used a sample of 286 cities in China to categorize commercial real estate into three stages: start-up, growth, and maturity. Among these, 170, 112, and 4 cities are in the start-up, growth, and mature stages, respectively. Beijing and Shanghai significantly lead other Chinese cities in transaction volume and activity, approaching or even surpassing major markets in the Asia-Pacific region. The four Tier-1 cities are expected to enter a stable period around 2035.

In my view, the housing system reform initiated in 1998 marked the first concentrated release of housing demand among Chinese residents, leading to a 20-year boom in China's commodity housing market. However, with China's increasing urbanization rate, the Chinese real estate industry will gradually enter the stock era, and the commercial real estate market will be exceptionally vast. To some extent, it could be said that China's commercial real estate is entering a golden age. Its immense size and billions of dollars in commercial value are unmatched by any other country or region in the world. There are two main reasons:

First, in the foreseeable future (the next three to five years), there is little new land, office buildings, or serviced apartments entering the market in prime commercial areas of Tier-1, and especially near-Tier-1 and some Tier-2 cities. Therefore, the renovation and upgrade of existing properties in core areas represent the most promising investment opportunities with substantial potential for profitability.

Second, looking ahead 10 to 15 years, the commercial real estate markets of more Chinese cities will enter the mature stage. The combined effect of increased demand and higher transaction activity will effectively support the asset value of high-quality Chinese commercial real estate.

The influx of foreign PE institutions in 2019 can be seen as introducing a significant number of "catfish" into China's commercial real estate investment market. If domestic real estate investment institutions remain complacent and hesitant, they will miss numerous opportunities. To some extent, the "dive" of foreign PE into Tier-1 city commercial real estate may accelerate the start of a golden age for China's prime commercial real estate.

In the next one to two years, foreign PE institutions may make even more rapid and concentrated "dives." Whether domestic investment institutions can compete with foreign institutions and secure projects may seem to depend on external factors such as capital strength and project judgment, but fundamentally, it hinges on the ability to actively manage projects (i.e., the courage to acquire projects at a price others dare not pay, and the ability to achieve above-market returns through superb leasing and operational management).

Simply put, the key is to hone internal skills and strengthen the fundamentals. The key to "snatching food" from the "vultures" lies here.