Too many central business districts, not enough business

Q&A: CBRE's Frank Chen

Too many central business districts, not enough business

The vacancy rate in commercial property in Beijing's central business district is low, below 5%. But outside of China's first-tier cities, commercial vacancy rates have skyrocketed on oversupply

Chinese commercial real estate developers don't take kindly to the government stepping in on their business.

That's why developers were taken aback in mid-February when local officials in Suzhou issued a limit on the amount of floor space they could sell before projects were finished. Commercial developers often sell property long before completion but, given the great oversupply of commercial property in Suzhou, the local government is afraid developers could grab the cash and run if the market goes south.

So far, the commercial property control is unique to Suzhou. But oversupply in China's second-tier markets is widespread. Ambitious local governments looking to take a regional – even international – lead in business or finance have welcomed commercial developers en masse, hoping projects will boost employment and tax revenues. But demand for the new floor space has fallen short and vacancy rates in many cities are rising sharply.

The average vacancy rate in second-tier cities in China is about 21%, double the healthy rate, says Frank Chen, executive director for China at CBRE, a global commercial real estate services firm. In the southwestern city of Chengdu, vacancy rates have hit 44%. Chen spoke with China Economic Review about the pressure commercial real estate developers are facing in 2014 and the kind of smart urban planning that's needed to improve the market.

When I scan the news, there seem to be a lot of stories about developers struggling in commercial real estate. What’s the story behind their difficulties?

For the sector as whole, it’s kind of a two-tier market. The commercial property market in tier-one cities, generally, is still healthy. But for tier-two cities, we do find ourselves at increasing risk of oversupply. For example, Chengdu is at risk of oversupply in the office sector. And Shenyang is at risk in the retail sector. In tier-one cities, the property market is still quite healthy. In tier-one cities, on average, the vacancy rate is roughly about 8%. In tier-two cities, the current vacancy rate is 21%.

What is generally considered a healthy vacancy rate for the commercial property sector?

Anything below 10% is quite healthy, because you need some space available for new expansion and for new tenants to move in and change locations. Below 5%, it would be quite tight. For example, the market in Beijing is quite tight. The market has been below 5% for a long time. Beijing is quite unique in that perspective.

Besides these current vacancy pressures, second-tier cities also face pressure from new properties in the pipeline. Looking at the future supply, the situation for these developers is quite daunting.

For example, Chengdu’s vacancy rate for offices is 44%, but they still have over 1.5 million square meters scheduled for completion in 2014. Of course, the actual amount that is completed will be less than 1.5 million. We can expect the high vacancy rate is not going to decrease any time soon.

In a city like Chengdu, with so many property projects in the pipeline and a vacancy rate of 44%, what will we see happening in this market in the medium term?

We have seen the rents declining for the last few quarters. We think the office rents in Chengdu will be under pressure, especially for those developments in the so-called “new CBD [central business district].” That is where most of the supply will come online. This is the sub-market that has the highest vacancy rate at the moment. Some kinds of premium assets in prime locations we think will do certainly better in the market.

What accounts for this change in the market? Are there certain factors that you could point to which has led to this current situation?

Definitely these kinds of trends started especially after the financial crisis. These changes occurred because of the RMB4 trillion stimulation measure, and the sudden loosening of the credit environment. A lot of local, national and international developers believed that second-tier cities had more upside potential. At the time, they thought growth in first-tier cities have slowed down. But actually, from an economic point of view, for most of the tier-one cities, GDP growth has slowed down to 7-8%. Their growth rates, most of the time, are lagging behind the national average. The commercial property sector growth is way above the GDP growth in the second-tier cities.

The other thing is, most of China's major cities are trying to develop new CBDs, sometimes two new CBDs, and even three new CBDs. So, with all these new CBDs, they are trying to build a new town. They are willing to provide more than enough land for commercial developments. The reason is because, from the local government’s perspective, if you sell residential land property, you can only receive the revenue once. But if you can develop successful commercial properties, this kind of property development will help from an employment and tax-revenue perspective. In theory, if they are run successfully, they can attract more business to settle down in their cities. Then they can generate more strong tax revenues from these developments.

So, local governments have been quite welcoming of these developments then?

The root of the current situation is a lack of well-designed city planning.

What about beyond the second tier? What does the commercial real estate look like in the tier-three and tier-four markets?

Office development in lower tier cites is still very low. Office demand for these lower tier cities is very low. Not a lot of large companies would like to set up their headquarters in lower tier cities. If the local company gets to a certain status, they want to move to a bigger city, either for their brand image, or for exposure. So the office demand in lower tier cities is very limited. So far, we don’t see a significant scale of office property development there. For retail, they don’t have a lot of modern shopping malls. Most of these low tier cities might rely on the department store and street front model.

How has the government reacted to all these problems in the second-tier market? In 2013, the government gave a lighter touch to residential real estate controls. Historically, how has the government reacted to oversupply in the commercial real estate market? And how do you think it will react this year?

So far, compared to residential market, the commercial property market is unregulated. Most of the policy measures introduced so far were targeting the residential sector. If you look at real estate investments, almost 70-80% is targeting the residential sector, which affects the daily lives of the common people. For commercial property, it’s more of a business decision, even if there is some oversupply risk. So it doesn’t have an impact on people’s daily lives. From this standpoint, we can understand why the central government doesn’t seem to have a tight hand on the commercial property market. We have seen the latest measure targeting the commercial property market in Suzhou.

Do you think there could be a heavier policy hand in other cities in the commercial sector, following Suzhou?

We hope that the local governments could be more sensible for their investors for the overall development of the commercial property sector. But so far, we haven’t seen any similar measures in any other cities. We also hope local governments can be more sensible in terms of the city planning.

When you’re talking about more responsible city planning, what does that entail?

Take office development, for example. In office development, you need to have some idea on what kind of businesses you can attract. There are a whole lot of cities in China that want to be the financial center for its region or the country or even the world. But in the United States, they have two global financial centers, one is New York, to a lesser extent you can argue Chicago.

In China, Shanghai is the obvious candidate to be developed into the global financial center. But given our economy size and stage of development, how can it be possible that we can have two or three global financial hubs. We hope that the local governments can be more realistic in their demands. This will guide their city planning. But of course we understand that they might face dilemmas, as well. So many local governments rely on land revenue. It’s the chicken and the egg problem. It’s related to local government debts. All these issues are sort of intertwined. But purely from a property perspective, we believe they need to be more sensible on commercial land supply.