Central government efforts to cool off the property sector have created a vacuum that is sucking in large chunks of investment funds from abroad.

Some of these overseas funds are linked to the biggest names in international finance. They include Morgan Stanley, Lehman Brothers and Rockefeller of the US and ING from the Netherlands. Singapore-based CapitalLand, one of Southeast Asia's largest publicly listed companies and the Government of Singapore Investment Corp (GIC) have also jumped on to the bandwagon.

To be sure, foreign investors have long recognized the potential of China's property market. But their previous overtures were largely ignored by the big domestic players when bank loans were easily available and borrowing costs were low.

Not anymore. The government-initiated credit crunch has forced many cash-strapped domestic property developers to welcome the injection of fresh capital from overseas funds. Suddenly, the door to the promised wealth of China's property market has been flung open and the rush of foreign investors has begun.

Morgan Stanley, one of the first international financial firms to enter the China property market, is also one of the most active in forging partnerships with local players. In the past several months, the Morgan Stanley Real Estate Fund has entered into co-operation agreements or established joint ventures with various mainland developers, including Goldfield Industries, Shanghai Fudi, Yongye and Sunco Group.

The fund's newly established joint venture with Goldfield has acquired from China Construction Bank 2.85 billion yuan (US$343.3 million) of non-performing assets consisting of 154 unfinished real estate development projects in South and East China. Under the joint venture arrangement, Morgan Stanley Real Estate Fund will be responsible for "resolving the capital problem" and Goldfield is to take care of the development to complete the projects, according to an official of the joint venture.

Tim Grady, executive director of the Morgan Stanley fund for the Asia-Pacific region, says that the joint venture with Goldfield will initially focus on the rehabilitation of non-performing real estate assets acquired from commercial banks. "We believe that the rapidly maturing property market in China is creating plenty of opportunities for foreign investors," Grady says.

He is not alone in his enthusiasm for China properties. ING, one of Europe's largest financial institutions, has gone into partnership with Beijing Capital Land to establish an investment fund targeting mainland properties. Major shareholders of the fund include large real estate developers and financial institutions from Europe, the United States, Hong Kong, Taiwan and Southeast Asia.

Separately, GIC, a global investment company established by the Singapore Government to manage the nation's foreign exchange reserves, became the single largest shareholder of Beijing Capital Land after acquiring a 9.8 per cent stake in the mainland property firm.

CapitalLand, another Singapore company, established the CapitalLand China Residential Fund in October for investing in mid- to high-end residential properties in Beijing and Shanghai.

So far, the fund has invested a total of about US$12.7 million in two residential projects in Shanghai and one in Beijing. The Shanghai projects are Oasis Riviera in Changning District and Huacao Town in Minhang District. The one in Beijing is La Foret in Chaoyang District.

Lin Mingyan, chief executive officer of CapitalLand China Holding, says that there is plan for the fund to substantially raise more capital to take advantage of the many investment opportunities. "Initially, the fund had targeted to raise a total of US$100 million," Lin says. But now, "we are aiming to double that amount," he says.

Foreign funds have adopted a number of different approaches to investing in China properties, industry sources say. Some foreign funds have invested in the development of projects, getting involved in all stages from the transfer of land to designing, construction and marketing. Others concentrated on the acquisition of completed residential or office blocks which were either resold for profits or kept for rental income.

There are those, like Morgan Stanley and Goldman Sachs, another US investment firm, which are trying to make profits out of the restructuring of non-performing property assets they acquired from domestic banks and other financial institutions.

Reasons for enthusiasm

Excessive investment in the property sector has raised widespread concern about the creation of a market bubble, which, when burst, could not only hurt the economy but also cause great losses to the public. Figures show that the combined investment in the property sector in 2003 accounted for 18.3 per cent of the nation's fixed asset formation totaling 1.01 trillion yuan (US$122 billion).

More worrisome is that an estimated 70 per cent of all investments in property development have been financed by bank borrowings. Such a highly leveraged market is of course very sensitive to price fluctuations. Even a slight correction in prices could shake confidence far enough to trigger a crash. Such market vulnerability has been further intensified by the widely expected increase in global bank interest rates which could help push up domestic rates.

Since mid-2003, the government has taken firm administrative measures to curb the flow of credit to the property and other sectors, including steel, cement and aluminum, which were deemed to be overheating.

The People's Bank of China, the central bank, announced last year a tightening of the housing loan policy in June, which called for an increase in interest rates on loans for the purchase of houses, luxury apartments and office premises. In addition, the new policy has banned mortgage loans on pre-completion apartments.

Meanwhile, commercial banks are permitted to lend only to real estate developers with good credit history, and the loan amount for each project is limited to 70 per cent of the total cost, compared to 90 per cent in the past.

Central bank officials have said the policy was designed to control the increasing number of bad loans. In effect, the policy is shrinking the source of capital to many property developers.

"The stricter measures have forced the real estate companies to look for alternate funding sources to finance their new projects," said Ji Rujin, vice-director of Real Estate Research Institute affiliated to Tsinghua University.

China's property sector began to take off in 1998. Since then, it has been growing at an average rate of 22 per cent a year. The boom of investment in 2003 lifted growth to a record 32.5 per cent.

Big money is being poured into the property sector because the returns on property investment have remained high in the major cities in the past several years. Latest statistics from Beijing Land Bureau show that the revenue to investment ratio of high- and medium-grade housing has reached as high as 30 per cent to 40 per cent in Beijing, compared with around 5 per cent in the Europe and the US.

This record of high returns has not been ignored by foreign investors who seem to show much less concern about the potential risks than China's economic planners. According to research conducted by Morgan Stanley, in the coming two to three years, around US$30 million to US$2 billion funds from abroad will flow into Shanghai's property market.

Difficulties met by foreigners

Even if foreign investors are prepared to overlook the potential market risks, they must face a host of regulatory uncertainties that could fundamentally affect their investment strategy in future. At present, China is drafting a law to regulate investment funds. The legislative process will take quite some time to complete, industry sources predict.

Meanwhile, both domestic and foreign investors can only feel their way within the vague boundary of the existing regulations that may have an indirect implication to their business activities. Foreign investors, in particular, must try to cope with this uncertain regulatory environment which is markedly different from those in their home countries.

Michael Lee, executive director of Regal Lloyds International Real Estate Consultant Co Ltd, pointed out that property funds industry have been developed in the overseas market for decades and the relatively stable and mature operation models have been established.

When entering China, how to adjust and optimize their models to adapt to the local market with its unique characteristics has become a crucial problem to overseas fund operators.

"Some of them (the overseas funds) often complain about the poor transparency of policies, substandard market mechanism, too many financial limitations as well as confusing administrative procedure in China," Lee says. But "I believe the only way for them to expand in China is to develop new products suitable to the local market," he says.

Nie Meisheng, chairman of the Real Estate Industrial Chamber affiliated to the All-China Federation of Industry & Commerce, agrees that China's fund management market lacks uniform standards. This shortcoming has created serious problems, such as poor interests protection and convenient withdrawal mechanisms, that are potential pitfalls to foreign investors.

"The foreign funds also face other challenges concerning relationship with domestic partners, adapting to an unique local culture, and coping with bureaucratic intervention," said Nie.

Promising prospect

Despite the challenges, the prospects of the property fund segment is promising, insiders say.

A recent survey of real estate developers by China Central Television showed that 57.5 per cent of the respondents said they were experiencing financial difficulty, while 80 per cent said they preferred the establishment of real estate development funds to help them get over the present capital crises.

"The Chinese Government is taking efforts to establish a real estate securitization market," Luo says. "The co-operation between China Huarong Assets Management Corporation and Morgan Stanley on the disposal of real estate non-performing assets may be seen as the first attempt," said Luo.

The mushrooming of the domestic and foreign funds investing in China's property market may prompt the government to speed up its law-making process, which can help to attract more investors from home and abroad.

A sound legislative framework and the full liberalization of China's financial market are essential to ensure fair competition that is conductive to the development of new investment products suitable for the domestic market industry sources say.

(China Daily July 15, 2004)