China property firms turn to PE as lender of last resort

Perhaps more than any other sector in China, real estate is the prisoner of policy headwinds. With few investment options and bank deposit rates that lag inflation, property investment is the default destination for many people's savings. This creates an incredibly volatile market and the government is constantly dialing up and down regulation in a bid to control prices.

The economic stimulus measures implemented in the wake of the global financial crisis including a credit boom that property developers used to rollout massive expansion plans. The ensuing hangover - best described as a relative claw-back in liquidity - continues to this day. More than a few real estate firms are turning to private equity to fill the gap.

"I expect the tight liquidity environment for Chinese developers to remain in the next few years," Stanley Ching, senior managing director and head of real estate group of CITIC Capital, tells AVCJ. "While volume of real estate market has been expanding at a rate of 20-30% every year, the growth of capital market for real estate sector is in no way comparable; this opens the window for private equity funds to support such demand-supply gap."

Chinese real estate developers have been traditionally highly-leveraged. According to HSBC, industry participants' average net gearing ratio reached more than 60% last year, up from 40% in 2009. However, a combination of macro cooling measure such as interest rate cuts and hikes in bank reserve ratios and policies specifically intended to reduce real estate lending, has denied these firms their primary source of capital. Attempts to carve out new funding channels, particularly through products issued by trust companies, have also been thwarted by regulators.

Growing distress

An obvious result of such tightening is the growing number of distressed developers. Some small- and medium-sized players have overextended themselves in recent years and are now having difficulty meeting their debt obligations, with a raft of trust products due for repayment in the coming months. Worse still, a number of these developers cannot guarantee returns from pre-sales to repay loans due to slowing property prices. According to Standard & Poor's, average housing prices are likely to drop 10% during 2012.

It is, however, an opportune time for private equity real estate funds. The likes of SoTan China Real Estate Fund, a $400 million vehicle co-managed by Tan-EU Capital and ShuiOn Construction and Materials (SOCAM) represent a much-needed alternative source of capital, so they can negotiate favorable economic terms. The fund just made its first investment last month, acquiring a 102,000 square-meter site in Tianjin's Wuqing district at a 20% discount to market value.

"The current distress has allowed us to purchase assets at attractive pricing and we are looking at discounts as much as 40%-45% in some instances," says James Buckley, executive director of fund management at Tan-Eu Capital. "The restrictions imposed by the government, coupled with tighter bank lending and narrower cross border financing channels have caused developers' balance sheet position to deteriorate. This provides good opportunities over the next 12-18 months for private equity."

While trust products are relatively short-term and more risky, the longer-term horizons of private equity encourage the development of a more mature property market in which developers can rely on consistent sources of funding to support on-going projects.

Mass participation

SOCAM is not the only Hong Kong-listed real estate company to partner with private equity funds. China Overseas Land & Investment has teamed up with Industrial and Commercial Bank of China (ICBC) to launch a $500 million vehicle targeting residential property and have reportedly raised $230 million for the new vehicle in February. The move comes after they closed their first joint-fund in 2010 at $286 million.UBS has also partnered with Gerndale, one of China's biggest developers, to establish a $100 million real estate fund.

These arrangements allow developers to leverage their balance sheets while the private equity firms- which don't always have people on-the ground - are taking advantage of their partners' local networks and expertise.

"Developers often borrowed short-term capital in the old days: they built and sold quickly before returning money to their lender within a year or two," says CITIC Capital's Ching. "The market is getting mature that they now realize the importance of long-term money in their capital structure."

More importantly, with the US and Europe struggling, China is one of few large-scale markets globally that can be relied upon to deliver long-term positive returns. For all the recent concerns about China's slowing economic growth, urbanization and industrialization - which contribute to rising incomes - will continue to support the property demand for years to come.

According to Jones Lang LaSalle, foreign private equity investment in Chinese real estate reached $6.75 billion last year, compared to $3.95 billion in 2008 and $4.55 billion in 2007, before the global financial crisis.

CITIC Capital was one of the first movers among private equity firms, making its first investments in 2005. Its first two funds - CITIC Capital China Property Fund and CITIC Capital Vanke China Property Development Fund - were fully exited, while the $400 million CITIC Capital China Real Estate Investment Fund III is also fully invested. The firm reached a first close of $250 million last November on its fourth fund, which is targeting $600 million. It will focus on retail properties.

"While residential market has witnessed more policy risks and competition, there is great potential for retail property investments because there are only a limited number of developers in this area and many cities are requiring better retail infrastructures," says Ching. He adds that there are significant opportunities in Beijing and Shanghai office properties.

Unfulfilled potential

Although private equity has been increasingly important to the local real estate market, it could be argued that the asset class can't fulfill its potential until renminbi-denominated funds grow in prominence. Noah Holdings, the Shanghai-headquartered third-party financial advisory company, is trying to make a breakthrough, seeking to raise a RMB18 billion ($2.85 billion) real estate fund from its network of high net worth individuals (HNWIs). As it stands, though, the leading PE real estate funds in China are all US dollar-denominated, according to AVCJ Research.

"The LP base of renminbi-denominated funds are predominantly HNWIs who are mostly aggregated by either bank or trust companies," says Rachel Renuccci-Tan, CEO of Tan-Eu Capital. "These are short-term investors eager to recover a quick return on their capital, and they would therefore find the 6-7 year fund life of a typical private equity fund too long."

Meanwhile, domestic institutional investors are still not ready for real estate private equity investments. The legal structures are in place to allow insurance companies to invest up to 10% of their assets into property sector, but the insurance regulator has yet to implement the policy. At the same time, major state investors such as the National Council for Social Security Fund (NSSF) have no plans to invest in property to the property market - unsurprising, given the sector is not favored by the central government.

"Ultimately domestic insurance companies will be the major source of long-term capital for the property market, just as in other countries they are a major owner of real estate assets. " says Michael Klibaner, head of research for Jones Lang LaSalle in China. "This is because of a natural fit for asset liability matching."

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• Topics
• Real estate
• Real estate
• Credit/Special Situations
• Greater China
• China
• Real estate
• Distress
• CITIC Capital