Chinese real estate

The New York Times writes about Chinese State-Owned Enterprises (SOE's) growing investments in real estate and how this adds to bubble symptoms in the real estate market. The article also states that the Chinese central government is trying to ebb the flow of capital into real estate, but that it has so far not been successful. This is not news; since the beginning of the year the central government has indeed signified that non-real estate-focused SOE's will need to exit real estate businesses (but not within the near future). However, the New York Times does point out that SOE's are using sophisticated legal structures to fund real estate developments and that their cleverness allows them to continue real estate ventures.

We will see what instrument(s) the government uses next to block SOE involvement in real estate, in order to cool down a hot and heated market.

Chinese real estate

It does appear that China will launch its first REITs in the second half of 2010. This is a positive development, not for the injection of new capital to the real estate market, but for the development of a sophisticated investor market.

Firstly, the Chinese government appears to be taking a cautious path; only a couple REITs will be allowed so that the government can monitor securities firms sale practices, market demand, and REIT managers' abilities to operate. This is the right way for the government to proceed since these three areas are unknown, not least of which is the ability of domestic asset managers. Only a couple REITs will list and only selected domestic institutional investors will be allowed to purchase shares (or units). This will prevent a mass introduction of new capital into the real estate market.

Secondly, the goal is to create a set of professional asset managers where previously there has been none. Part of the lack of asset managers is due to the bubble-like real estate industry which is developer-heavy and amateur investor-heavy. I imagine the large banks and insurance companies will be allowed a head-start to form asset managers, followed by the more savvy and long-term-focused developers.

Chinese capital allocations to real estate

During the financial crisis of 2008, I mistakenly thought part of the Chinese stimulus package would be the creation of various real estate finance vehicles (ie REITs, CMBS), but this is not happening. In fact, the reverse appears very much the Chinese government's current course of action. The question is how the central government plans on diverting the real estate market in the near future.

A massive amount of capital has already found its way into real estate; the stimulus package caused capital to move in the following direction, from government-sponsored banks -> large corporates and state-owned enterprises -> real estate. Due to lower global consumption, many companies were almost forced to take on loans without a need to invest or re-invest in factories or the like. Due to strict capital controls, this abundance of capital has only two outlets in China, real estate and public equities. Real estate has become the beneficiary of choice for both individual and corporate investors with perceived capital gains. This flow of capital to amateur real estate players has caused several bubble-like phenomenon, one of which is the sale of new Grade A office and multi-use developments by strata-title. In the residential property market, soaring apartment prices have caused middle-class angst and concern. One manifestation has been the popular Dwelling Narrowness television drama.

The government is responding; both to appeal to the masses worried about housing costs and to counter a speculative commercial market. Recently, the government has taken steps to reduce flows to real estate, including an order to slowly push large SOE's with non-real estate core businesses to exit real estate positions. In addition, the government continues to change capital gains taxes with an eye on reining in speculation. It remains to be seen whether the central government can control local governments in respect to new developments and new supply of real estate; local governments are a big beneficiary themselves of a booming real estate market through land auctions.

Real change will happen as the central government directs a guanxi (connections) driven business into a professional-managed industry. Part of this requires more mature financial markets, and talk of a Chinese REIT is still just that, talk. The government continues a comment period with major law firms and financial institutions. The next presumed step will be to allow insurance companies to invest in real estate. Presumably, the introduction of government-sponsored institutional investors (in this case, insurance companies), will encourage the creation of professional asset managers who will operate real estate for long-term yield, not short-term capital gains. In fact, this may be the central government's preferred strategy, since presumably the central government will maintain stronger supervision of insurance companies rather than public-listed REITs.