VOL 13 ISSUE 6 JUL/AUG 2017 perenews.com FOR THE WORLD S PRIVATE REAL ESTATE MARKETS

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1 VOL 13 ISSUE 6 JUL/AUG 2017 perenews.com FOR THE WORLD S PRIVATE REAL ESTATE MARKETS CHINA S NEW CAPITAL Local asset managers have become active participants in China s real estate market, amid growing signs of stability in the domestic economy and capital controls. Arshiya Khullar finds out how the industry is responding to the new competition

2 China s new capital Local asset managers have become active participants in China s real estate market, amid growing signs of stability in the domestic economy and capital controls. Arshiya Khullar finds out how the industry is responding to the new competition Photography by Garrige Ho From left: Ivan Ho, Terence Tang, Christina Gaw and Aaron Wu After a stormier spell, the wind now appears to have turned in favor of China s real estate market. Currency volatility and equities market distress had prompted global investors to slow their investment plans in the country, but the last 12 months have seen green shoots appear. The property sector is one visible example. Total transaction volumes in China increased by 10 percent to $36.5 billion in 2016, making it the top investment market in Asia-Pacific, according to a report published by Colliers International in March. The volume of investments particularly strengthened in the fourth quarter, which saw a 32 percent year-on-year I don t think the domestic asset managers define their investments as core, value-add and opportunistic. They are driven by where they can get the capital, the requirement of that capital, and how it can be deployed Terence Tang increase to $14 billion. The participants at PERE s annual China roundtable agree that signals of relative stability have buoyed the investment climate. Terence Tang, managing director for capital markets and investment services in Asia for Colliers, says even the global microenvironment has improved greatly from early last year, when questions still loomed over Brexit. As foreign managers resume their pace of investments in the country, they now find themselves competing with a new and emerging breed of managers: local Chinese asset management companies. Christina Gaw, managing principal and head of capital markets for Hong Kongbased real estate investment firm 32 PERE JUL/AUG 2017

3 ROUNDTABLE ASIA Gaw Capital Partners, says the buying interest from onshore real estate investors has been very high in the last months. Property services firm JLL has estimated that Chinese investors deployed a total of $29.1 billion within their home market last year, a 50 percent increase from the previous year. In the fourth quarter of 2016, V Capital, the newlyestablished fund management platform of of Chinese developer China Vanke, acquired Central Plaza, a prime office tower in Shanghai, from US private equity firm Carlyle reportedly for around 2.4 billion yuan ($350 million; 320 million). Other examples from Q1 this year include the $232 million purchase of three buildings in Poly Greenland Square for 1.6 billion yuan by the state-owned asset management company of the Yancheng government; and Chinese investment trust Zhong Rong Trust s Silver Court acquisition for 3.5 billion yuan. Home-field advantage Tang says this growth of home-grown asset management companies won t be slowing anytime soon, and will help to institutionalize the real estate market in China. The rise of domestic capital within China epitomizes a trend across Asia. The growth in the purchasing power of local capital is also evident in South Korea and Hong Kong, driven by investors unwillingness to pursue deals in other politically and economically volatile markets in the West. Tang believes that in 10 years time, the entire Asian real estate market will be as institutionalized as Europe was 10 years ago. In China, however, both push and pull factors have contributed to the proliferation of these AMCs. The appeal of domestic deals, where these managers can avoid hedging costs and benefit from their local expertise, is the more obvious pull. But continuing regulatory curbs on capital outflows have also dissuaded them from undertaking any cross-border trade requiring conversion of yuan into foreign currencies. During the global financial crisis, Asian capital was very well positioned to go abroad. But in the past 18 months, it has not been easy to take capital out of China. That is also maybe why domestic capital is deploying more money for real estate onshore as they build up their real estate portfolio, says Gaw. The Chinese government has made a lot of efforts to keep the capital onshore. The Belt and Road initiative especially has solved a lot of problems such as overcapacity of investment for the government, adds Tang, referring to President Xi Jinping s ambitious diplomatic and economic trade program aimed at bolstering ties between China and the rest of the world. They have also started to export a lot more products, creating demand for renminbi goods. Indirectly, all this helps the real estate market in China. A growing part of the local managers pool are real estate developers looking to carve out independent fund management businesses. China Vanke s V Capital, established in 2015, is one recent entrant, but participants say examples abound. The developer-turned-manager trend is not uncommon elsewhere in the world. Even in China, as Tang points out, developers launched fund management platforms eight to nine years ago but this time around the intentions are different. Earlier it was being done to raise capital to supplement the developers own balance sheet capital in land acquisitions because it was hard to get equity capital. Now, they are looking at it as a new business line to expand their business scope and to have a constant revenue stream through fee income, he says. Even though these local AMCs are helping in the institutionalization of the industry, it cannot be ignored that this trend is causing some consternation among foreign investment managers. Some are even reassessing their buying strategies in response. KaiLong Investment Management is plotting JUL/AUG 2017 PERE 7

4 ROUNDTABLE ASIA Aaron Wu Principal of investment management China Life Insurance Wu focuses on real estate and infrastructurerelated funds and projects for China Life s overseas operation. He was previously in its Beijing headquarters for more than 10 years working on global markets research. Christina Gaw Managing principal and head of capital markets Gaw Capital Partners Gaw has over 16 years of investment banking and investment management experience in the Asia- Pacific region. Before Gaw, she was with Goldman Sachs and UBS. Terence Tang Managing director for capital markets and investment services in Asia Colliers International Tang has more than 28 years of experience in advisory services and principal real estate investment management. He has been involved in more than 200 real estate transactions worth a total of $8 billion. Ivan Ho Managing director KaiLong Investment Management Ho has more than 10 years experience in Greater China real estate investment and development. Since 2010 at KaiLong, he has focused mainly on fundraising, fund management and business development for the company. He also engages in acquisitions covering mainland China and Hong Kong. the launch of its second China-focused dollar-denominated private equity real estate fund. The firm is planning to raise around $500 million for the vehicle, which comes two years after the maiden fund was launched in Ivan Ho, managing director at KaiLong Investment Management, says the firm is now expanding its investment remit for the latest fund. Instead of pursuing only value-add commercial deals and business park investments in Shanghai and Beijing the firm s target investment markets until now it will also eye Hong Kong deals to counter local competition. I am worried that the market is flooded with both onshore and offshore capital. [As a result,] when we are on the road raising capital, we are being asked by potential investors whether we can lock a deal off the market and deliver an opportunistic return, Ho explains. Given the past development experience in Hong Kong, we are now participating more in smaller site developments in Hong Kong, which avoids direct competition with huge developers and Chinese enterprises for bigger sites. This will also provide not just higher returns but also higher liquidity and will produce a natural hedge for our fund investors. Gaw Capital Partners closed its fifth flagship fund, Gateway 34 PERE JUL/AUG 2017

5 Seat at the table: Chinese developers are increasingly moving into fund management Real Estate Fund V, on $1.3 billion, in addition to $500 million co-investment sidecars. The firm has so far deployed around 30 percent of the fund s capital. Gaw says her firm is now exploring more unique platform deals within China rather than typical value-added deals, where there is more competition. She cites retail outlet malls as an example. Last June, Gaw Capital and TH Real Estate partnered to launch a $1.2 billion China Outlet Mall fund that would be invested in designer outlet malls. The fund was seeded with two Florentia Village outlet malls in Jing Jin and Shanghai. There are also examples of managers upping their Time-out for outbound? Capital controls have undoubtedly caused a dent in the pace of Chinese investors overseas purchases, but the impact varies according to the origin, and type, of capital Since late last year, Chinese regulators have imposed a series of curbs to limit the outflow of the yuan in a bid to stabilize the currency, impacting the overseas investment strategies of managers. Gaw says she has been seeing Chinese investors pursue more small-sized outbound deals of around $100 million instead of those for $500 million and above because their offshore balance sheet can take care of smaller deals. When KaiLong Investment raised capital for its first and second single-asset vehicles for London since 2014, Ho says there was huge demand from mainland and Hong Kong investors. Fundraising has becoming more challenging since last year, and the firm had to accumulate more capital from Hong Kong families and Chinese investors that had offshore capital, as expatriating renminbi capital from China had grown more difficult. China Life Insurance, however, has been an active investor in US real estate in the last 12 months. That is because many of its overseas investments are being made from its Hong Kong-based investment platform, which does not involve any renminbi expatriation. The insurer s latest $350 million equity investment in 48 US single-tenant net lease properties in a portfolio owned by ElmTree Funds took this approach. Wu says insurance capital is guided by different factors than other institutional players when it comes to making investments. Yield-play is one of the key themes to serve our criteria for safety and liquidity for our assets, while other market players may still favor trophy assets, he says, discussing the firm s overseas investment strategy. In today s low cap rate situation, the quality of underwriting is very important. We need to consider a longer but lower return cycle in the US real estate market. And so, investors who discount a lower pace of rental growth into the underwriting model will likely end up being more successful in the long run. JUL/AUG 2017 PERE 35

6 ROUNDTABLE ASIA investments in non-traditional asset classes such as student housing, healthcare, senior housing and self-storage. In May, InfraRed NF made its first self-storage deal in China with a $28 million investment in China Mini Storage via its $360 million value-added and mezzanine fund. The firm expects to generate double-digit net operating income yields from this investment. Aaron Wu, principal of investment management at China Life Insurance (Overseas), the Chinese insurer s offshore investment arm in Hong Kong, says certain Chinese insurers have also started to shift more focus towards the senior housing sector in recent years. Chinese society is aging and highend wealthy people and enterprise owners are demanding better living in their later ages, Wu says, explaining the drivers contributing to the demand for senior housing assets. However, as Tang points out, niche investments continue to remain a risky proposition in China where operators of such assets may not have adequate experience. Irrespective of the asset class, the challenge of competing with local AMCs is further compounded because of two other factors. Firstly, as the participants explain, these AMCs do not see total returns as the final objective. I don t think the domestic asset managers define their investments as core, value-add and opportunistic. They are driven by where they can get the capital, the requirement of that capital, and how it can be deployed, Tang says. Some of them raise capital from financial products placed through securities and insurance companies and if you look at some of the product descriptions, they only promise dividend yield. This means that as long as managers can find a real estate product that can deliver yield on an annual basis, as required by the investors, they will buy it. The second factor is currency costs. Although the yuan has relatively stabilized, KaiLong s Ho agrees that as a foreign When we are on the road raising capital, we are being asked by potential investors whether we can lock a deal off the market and deliver an opportunistic return Ivan Ho manager using dollar capital in China, the firm still must consider hedging costs, which makes it less competitive than onshore capital. As an institutional investor, Wu agrees that a good hedging strategy remains critical to China Life s business. To Hong Kong insurers who have renminbi real estate exposure in their portfolio, when the renminbi depreciates even though the real estate valuation appreciates, there is still a probability to incur a loss, [due to which] they cannot meet insurance liabilities, he explains. Gaw says her firm is now more actively monitoring currency movements as compared with the first 10 years of operation when the currency was on an upward move. We don t naturally do a 100 percent hedge on our renminbi exposure when we buy in China. But these days, monetary easing and falling interest rates has created a better environment for us to use more onshore loans. This way our renminbi exposure is lessened, she says. Tang agrees with the approach. Until a few years ago, the blended cost of funds was about 4 percent. Today, it is no longer advantageous to use US dollar borrowing as the blended cost has gone up close to the cost of the funds in renminbi. The differential has become a lot lower, he adds. For the managers exiting their China assets, however, having an active onshore buying pool works to their advantage. Once we stabilize a value-added asset, it becomes core, and onshore buyers may be more attracted to it as they can buy and hold the assets for a long period. Foreign investors, on the other hand, are generally still looking for growth and would be more interested in value-added investment opportunities that offer higher returns. Also, foreign investors who do buy core and hold for a long term would expect to get dividends, and that is not as straightforward Alarm bells Roundtable participants list their key concerns for the next 12 months Christina Gaw Terence Tang Ivan Ho Aaron Wu Currency (renminbi) volatility Investing strategy of local AMCs and potential exit issues Flood of onshore and offshore capital in hunt for high returns Quality of underwriting in a longer but lower return cycle in the US real estate market 36 PERE JUL/AUG 2017

7 Weighing concerns: currency volatility and quality of underwriting are a worry for the four roundtable participants as it is for the onshore buyers who can get the renminbi dividend onshore, says Gaw. Risk factors But what happens when the local AMCs need to exit their own investments? That is one of Tang s key concerns for the domestic Chinese property market, especially if China increases interest rates to mirror the US Federal Reserve s policy. There is negative leverage in today s market. The cap rate in Shanghai, for example, is 4.5 percent today, but borrowing is between 5.5 percent and 6 percent. So, if rates go up further and rents don t increase, then it is risky. Some of these AMCs are raising financial We find that as long as we are going along with where the wind is blowing, where is government directive and focus is going, we are fine Christina Gaw products to finance their acquisitions and they have promised a high coupon rate on these financial products. These products, however, are only for a maximum period of three years, so they will need to seek other funds once these products expire. Yet on the macroeconomic front, it is optimism rather than risk that is the buzzword for now. Wu says the Chinese government and central bank still have a lot of ammunition to mitigate the forex impact on China s economic development. Gaw says the way the government has moved along with reforms has been smart and she remains optimistic about China in the medium to long term. We find that as long as we are going along with where the wind is blowing, where government directive and focus is going, we are fine, she says. Just don t go against the wind. JUL/AUG 2017 PERE 37