China Real Estate Investment: How a City is Tiered Bears Little Meaning

Stephen Chung

Managing Director

Zeppelin Real Estate Analysis Limited

February 2009

In recent years, we have heard quite a bit of market opinion which say the 1^st tier cities in China, namely Beijing, Shanghai, Guangzhou, and Shenzhen, have become too expensive, and thus one should now consider the 2^nd tier (or even 3^rd tier) cities which are emerging and offering better pricings, thus implying better prospective investment returns.

No doubt the 1^st tier cities are comparatively expensive with residential prices hovering 10K or more Yuan per square meter of floor area, and no question that some 2^nd tier cities offer excellent potentials.

Yet, as with stocks investment where a typical investor would likely have some blue chips in his or her portfolio despite the blue chips tend to cost more per lot, not to mention some investors only go for blue chips, it is almost nonsense to suggest that the 1^st tier cities in China be dumped for the 2^nd tier ones simply because the former cost more to acquire, or for that matter, the latter look cheap.  

An overvalued small stock is still overvalued, and an undervalued blue chip is still undervalued. One does not go for an overvalued small stock because it costs $1 to buy while shunning the undervalued blue chip that commands $10. Likewise, one goes for a real estate market which is by and large undervalued, be it 1^st or 2^nd tier, and avoids one which is overvalued, again be it 1^st or 2^nd tier.

The market appears to have been confused by and at the same time fused two different percepts together: city ranking and investment market ranking. While cities can be categorized as 1^st, 2^nd, 3^rd, or even 4^th tier based on their stages of development, city scale and population, cultural or political significance, and the like, such tier rankings bear little meaning from a real estate investment angle.

However, readers may ask, aren’t the 2^nd tier cities offering higher returns, especially when real estate developers appear to flock to them? To address this question, we shall look at some numbers and charts, but first a word on relying overly on the investment actions and decisions of real estate developers; it is dangerous to do so.

Why? Because real estate developers have one thing which most real estate investors do not have, and this is ‘value creation’ via the change of land use, redevelopment, the alteration of building scale, the application of better design and functionality, and so on. What is more is that given all things being equal, real estate development economics do not always need to rely on real estate price increases. Such asset price increases are naturally nice to have and will boost a developer’s IRR, but are not as crucial to a developer as it is to a real estate investor who buys and sells only existing (built) properties. In short, a developer may at times enter a market even if he or she expects prices there to remain more or less the same.

Now to the numbers: We have picked 10 cities-markets for comparison, including the four 1^st tier cities of Beijing, Shanghai, Guangzhou, and Shenzhen, and six 2^nd tier cities of Tianjin, Dalian, Chengdu, Nanjing, Hangzhou, and Wuhan. We also focused on the luxury residential sector and its rental and price performances from 2003 to 2008. Data sources include various city government websites and real estate agencies such as CBRE. For ease of comprehension, we have only shown the graphic data and calculations in broad terms of 1^st tier and 2^nd tier cities.

A)    Method = we shall look at the rental and price aspects of the luxury residential real estate sector for each of the 10 cities mentioned above in terms of 1) their volatilities during the period, calculated by dividing the standard deviation by the average; and 2) their overall percentage gain or loss during the period.

B)    Rental and Price Volatilities during the period = generally, the higher the volatility measure, the higher the risk is, and assuming all factors being equal and purely from a risk-adverse standpoint, an investor may wish to consider cities which dots are geared toward the “lower left corner” i.e. cities with lower rental and price volatilities (or say fluctuations). Two of the 1^st tier cities do exhibit lower than most volatilities while one hovers with the ‘average or typical’ crowd. The fourth 1^st tier city contains the highest price volatility though the highest rental volatility award goes to a 2^nd tier city. Overall, almost all of the cities shown herein tend to have lower rental volatilities and higher price volatilities. In short, prices appear to fluctuate more than rents implying interchanging rental yield compression and expansion.

C)    Rental and Price Percentages Gained or Lost during the period = generally, the higher the percentages, the better the return is, thus implying an investor may wish to consider markets which dots are geared toward the “upper right corner”. Interestingly, while all 10 cities exhibit gains of varying degrees in terms of asset price performance, some of the cities actually offer reduced rentals during the period. This jives with the observation in (B) that some cities offer compressed rental yields i.e. their luxury residential real estate have gone up in prices without a proportionate increase in rents. Of the four 1^st tier cities, three tend to offer lower rental and price increases than most (but not all) other cities, yet the best performing city in both rental and price increases is a 1^st tier one.

2^nd tier supporters (or hardliners) can still argue the above numbers reflect only the past, but not the future which may actually show 2^nd tier cities to be offering definitively higher returns, even on an adjusted basis. As your humble author is no astrologist or fung shui master, let time be the judge then.

 Just that to date, the 1^st tier cities as a group still offer some punch in both risk and return parameters.

Notes: The article and/or content contained herein are for general reference only and are not meant to substitute for proper professional advice and/or due diligence. The author(s) and Zeppelin, including its staff, associates, consultants, executives and the like do not accept any responsibility or liability for losses, damages, claims and the like arising out of the use or reference to the content contained herein.

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