Q: In what condition is office space leased?
A: Although it varies slightly from building to building, generally office space is leased in raw condition. This means that only the ceiling grid (T-bar, ceiling tiles and lighting), HVAC (heating, ventilation and air conditioning) and emergency systems (smoke detectors and sprinklers) are installed (based on open layout). All other work in the space is the responsibility of the tenant. Occasionally, if second generation office space is leased, the leasehold improvements from the previous tenant can be reused but generally these will have been removed.

Q: Who pays for the leasehold improvements?
A: Although it is usually possible to negotiate some rental abatement (free rent) to offset the cost, leasehold improvements are almost always paid for by the tenant.

Q: Are there restrictions on how leasehold improvements are constructed?
A: All leasehold improvements must be approved by the landlord and the relevant local authorities (including district re service bureau, tendering bureau and quality bureau) before construction begins. The tenant is responsible for providing formal construction plans to the landlord for this purpose. Landlords usually require that tenants use their designated contractors for any work affecting the buildings HVAC, electrical or emergency systems. Some landlords charge a construction supervision fee at a rate of RMB8-15/sq m (gross) of the tenant?s total leasehold improvement cost.

Q: How much time is needed to complete leasehold improvements?
A: The length of time required for the design and construction of leasehold improvements varies according to the size and complexity of the project. For a typical project, allow six weeks for design and approval of drawings and eight weeks for construction, (not including tenant?s planning and tendering work).

Q: Who manages the design and construction process?
A: Typically, tenants hire one company to handle the design and construction of the leasehold improvements. Until recently, independent project management was not readily available in Shanghai. The role of a project manager is to ensure that all aspects of the leasehold improvement project run smoothly and that the tenant receives good value for money.

Project management includes technical reviews of building systems, aggressive negotiation of construction costs and onsite construction supervision. We recommend project management to all of our clients especially for large projects.

Other facts about leasehold improvement projects:
Labor is not unionized.- Currently there are no major shortages of building materials although importing items can cause delays.- Generally, HVAC systems are either Variable Air Volume (VAV) or Fan Coil Unit (FCU).- Electrical power enters the building at 380 volts, 3-phase, 50 hertz then transformed for use by the tenants to 220 volts, 2-phase, 50 hertz.- Tenants are generally provided with 60 watts of power per square meter leased with additional power available on request.

Statistics show that at the end of July 2002, China’s unsold housing space totaled 120 million square metres, up to half of which remained unsold for over one year, resulting in over RMB257 billion in non-performing capital. This leads all other industries in terms of bad assets.

The scale of real estate construction in many cities appears to be being cut. Real estate development in Beijing has, all along, been testing the limits, surpassing Shanghai’s housing real estate boom in almost all aspects. Cranes towering over dusty construction sites dot the skyline of the capital city and many large office and residential towers are shooting up. The result: many high-end apartments remain unsold. Beijing’s total investment in the real estate industry in the first half of this year rose 42% to hit US$2.66 billion.

According to data released by the Guangdong Provincial Department of Construction, the province’s investments in real estate development rose sharply in the first half of this year, but the pace of growth in housing sales slowed down. Between January and June, housing sales increased by 13%, down 18% from that of the same period last year, although total area of land development and the area already under construction jumped 128% and 38% respectively. The scenario was similar in Shenzhen, where more than 70% of the real estate developers are eyeing the top 5 to 15% of the consumers, despite the fact that their purchasing power is nonetheless limited. The average housing price last year stood at RMB6,921 per square metre in Shenzhen and this rose further this year away from the mainstay consumer group, the average wage-earner who earns about RMB3,000 a month. Beijing faces the same problem. If the cycle for real estate development is calculated at four to six years, then 2002 should have been the year for Beijing to reach the ceiling in real estate supply. If sales continue to lag behind, the market will have to make adjustments to housing prices.

Wuhan’s housing market also reached historic heights recently. On top of several records set last year, investment in real estate development grew 27% to reach RMB9.5 billion. As much as 85% of the investments went to housing construction and the amount of floor space in housing under construction, newly started housing projects, and completed housing projects soared to new limits.. The total area covered by completed housing shot up 34% to hit 5.1 million square metres. Meanwhile, housing prices in Wuhan rose by more than 10%. Suzhou has also been affected by the overall increase in housing prices, which have risen to around RMB500 per square metre in the new region or even RMB1,000 in some of the hottest areas.

In 2001, China’s housing prices increased 2.2% from the year before and in the first half of 2002 grew a further 3.6%, staying within a reasonable range. According to surveys of 35 mainland cities, only five of the cities reported that the average prices per square metre were at or above RMB3,500. The ratio of housing prices to average disposable incomes stood at five to 14 times, in contrast to 6 times to 12 in the developed countries.

The Central Bank released a report recently on the implementation of the country’s monetary policies in the second quarter of this year. The report points to possible adjustments in the real estate industry following several years of rapid growth, a forecast that should arouse people’s attention. As to the contribution to the nation’s GDP growth, that of the real estate industry has been obviously far too high. According to estimates, real estate investments contributed directly to 1.3% of China’s GDP growth in 2001and indirectly between 0.6 and 1.2%. In total, the real estate industry contributed to between 1.9 and 2.5% of the country’s GDP growth last year. This is a clear indication that China’s GDP growth has been too dependent on the real estate industry.

The most important factor behind the real estate boom has been the country’s reforms in the real estate system and particularly the housing system that started in 1998. One can see an obvious watershed from the statistics over the years.

The Chinese economy started its rapid growth in the early 1990s and peaked in 1993 to 1994. This was followed by the central government’s drive to tackle the overheated economy, which led to downturns in both investments and the scale of housing construction. After hitting the bottom in 1996 and 1997, starting from 1998, the real estate industry began to experience an almost straight-line increase, which peaked before the end of the year; with total housing investments and new housing projects exceeding those of 1994. The Chinese economy continued to grow in 1999 and 2000, and the area covered by newly started real estate projects topped 200 million square metres in 2000. On top of that, 2001′s investments in real estate projects expanded by another 30%.

The rapid development, therefore, started in the wake of the 1998 reforms in the country’s real estate system. The real estate industry has so far been the driving force behind the development of the overall economy, and the reform has contributed dramatically to this. If the latest real estate fever is no bubble and all the demand seen so far is real, then the question is what will happen in the future? If the high-end market continues its expansion, a real estate bubble would be very likely, as there is no way of predicting where the market will turn.

China experienced a very dangerous real estate bubble ten years ago, which triggered two-digit inflation rates and led to mounting loans, that the banks could not recover, from speculative investments in the real estate industry. Such worries are again starting to haunt China.

A recent media story, which power companies denied, claimed that almost 65 million power meters in urban China had registered zero consumption over a six month period, which raised a theory that there are enough empty apartments in China to house 200 million people.

However, the true figures will probably never be known, because there is little transparency in such statistical information, which has led to calls for accurate information to be published.

Without this information, policy-makers face an uphill battle, because the actual size of China’s unused apartment stock is crucial to measuring the extent and seriousness of the nation’s property-market bubble.

It is also highly likely that such data would also reveal a quantity bubble as well as a price bubble.

Price bubbles, which generally last a long time, occur primarily because of government regulation, like height limits that almost eradicate the possibility of increasing supply in accordance with demand, such as occurred in Tokyo in the past, and are occurring in London right now.

China also is experiencing an urban price bubble nationwide, but high prices in major cities cannot be rationally explained.

Rising rents can be explained easily, because it can be linked to inflation expectation, with landlords fearing the cost of repairing user wear and tear will be higher in the future.

However, China’s property bubble is exceptional, in that there is an unprecedented amount of living space available, the large number of empty apartments, which equates to the nation’s quantity bubble.

Quantity bubbles are less common than price bubbles, and usually don’t last as long, as rising supply normally forces prices down, but the influx of money in China seems to be keeping the prices higher, even though supply is still rising.

Price bubbles cause economic damage in three ways: a banking crisis; a weakening economy for several years; and adverse effect on other supply industries.

A quantity bubble ends when the building cycle changes, new supply causing prices to crash, as happened in the United States in the late 1980s, and in turn causing a banking crisis.

Quantity bubbles occurred in Southeast Asia during the 1990s, causing a market crash, and finally the Asian Financial Crisis.

In Taiwan’s quantity bubble of the late 1980s, analysts used electricity meter data to establish the number of empty flats, and concluded that 15% were empty, and today, analysts are trying the same tactic in China, compounded by the lack of reliable availability of such data.

The data that is available concludes that China does not have a housing shortage, and it’s per capita living space of one person per 28-30 square meters is higher than in Europe or Japan, and using Japan’s standard, China has enough living space for every man, woman and child in the country.

Of far greater importance, however, are the housing figures showing a huge amount of empty flats being held for speculation, and no other reason.

The total normal vacancy rate in a normal economy is determined by a world standard calculation, and is normally about 3%, compared with an estimated 25-30% vacancy rate in China.

This is speculative inventory; property is being stockpiled just as copper and other commodities are stockpiled in expectation of price rises, and are probably worth about 15% of China’s GDP.

China needs a reasoned property strategy, to avoid the problems that America is experiencing from its property bubbles; failure in America caused a crash that has lasted, and will continue to last, for many years.

Famous short seller and predictor of the Enron demise, Jim Chanos, founder of Hedge Fund, Kynikos Associates Ltd., dominated China news headlines recently sparking concern of a China bubble. In a widely publicized talk at a conference in London, he said there are about 30 billion square feet of space in construction in China’s commercial property sector and called China, “Dubai 1000 times over.”

Chanos is not the only pessimist about China’s real estate sector. Zhang Xin, CEO of SOHO China, a residential and commercial property developer caused some nail biting in the market recently when she criticized government stimulus for creating the framework for a real estate bubble. “Real estate prices should only go up because people want to actually use the space, but at the moment we see more and more empty buildings across the whole country in every real estate segment,” she said. “The rising prices are a direct result of so much money coming from the banks and the Chinese banks should be very worried.”

China’s real estate sector set several new records in 2009. Nearly 940 million sqm of properties sold, and the average price hit 4,695 yuan ($687) per sqm, China’s National Bureau of Statistics (NBS) revealed in January. Consequently, Beijing is curbing lending for new developments and reducing incentives such as discounts on loans. In January, Chinese banks were ordered to increase their reserves in an effort to prevent a surge in credit following a flood of lending last year to support stimulus projects.

The banking industry’s top regulator, Liu Mingkang, said in January that Chinese banks are expected to scale back lending to about 7.5 trillion yuan ($1.1 trillion) this year after handing out 9.5 trillion yuan ($1.4 trillion) in 2009. Concern of a bubble has also spread to other realms of the real estate market such as industrial and commercial. China’s biggest bank, ICBC, said in a statement in early February that it will “strictly control” lending to real estate and industrial projects deemed too dirty or energy-intensive and those outside government development.

Certainly Chinese banks are in a much healthier position than U.S. banks were prior to the mortgage crisis. For one thing, with Federal Reserves in the range of $2.4 trillion, they have plenty of cash. Chinese home buyers are also much less leveraged than U.S. home buyers, in most cases putting down payments of more than 30%. Nevertheless the government is concerned about reckless lending and hoarding of vacant land or properties by developers. While there is also an attempt to provide more affordable housing for the masses, Beijing wants to discourage speculation in the residential market.

Policy versus reality
How will tightening of credit in the residential market affect the commercial and industrial sectors? “The commercial and industrial sectors have different fundamentals,” says Stephen de Kyper, Managing Principal of CresaPartners, a commercial and industrial property consultancy. “Residential property is more speculative. Lenders and developers look at commercial and industrial properties with a longer view.” One caveat about the recent policy talk is that there is often a large gap between policy directives and actual implementation.

“While the law may not make much distinction between different elements of the property sector, the intent is to cool down the residential market,” says Michael Cole, Managing Director of Right Site Asia, a web portal aimed at bridging investors, developers, industrial zones and consultants in the property sector. “On the basis of this, I would expect the new measures to be implemented more leniently for commercial projects, and especially for industrial projects.”

Echoing DeKyper’s emphasis on the differences between residential and commercial, Wei Wang, Assistant Director at Mapletree Investments Pte., a Singaporean commercial and industrial property developer noted that “The residential sector overheated due to the pressure of demand on limited resources, whereas the other sectors cooled down due to the financial crisis.” Wang does qualify that “if there is an impact on the commercial and industry property sectors, I’d say it will be more difficult for investors to raise funds.”

Raising funds will be especially difficult for foreign developers. “Western developers are facing difficulties to raise funds for China due to the crises in their own countries,” says Arnaud Sebban, Commercial Director for GSE China, a design and engineering and construction firm which builds large scale industrial properties. “Money is coming primarily from China and Singapore” “There are still a number of foreign REITs and other funds, especially Asian investors, who have significant appetite for commercial projects in China,” says Cole of Right Site Asia.

Another consideration is that much of the financing for real estate developments comes from cash rich state owned enterprises (SOE’s), looking for revenue growth and opportunities to make bigger profit margins. These SOE’s are paying premium prices for land and property, often outbidding private developers.

An example is State-owned Shanghai New Huang Pu Real Estate and Shanghai New World which won a joint bid for a prime parcel of land for commercial development in Shanghai for just under US$500 million. The 13,709 square-meter site, near the Nanjing Lu shopping district has a potential gross floor area (GFA) of 65,743 square-meters.
These SOE’s are less accountable to shareholders and don’t necessarily rely on banks for funding. They also have strong “guanxi” with local governments and can more easily acquire land and licensing for their projects.

Market recovery
Certain industry segments, such as retail, will face no trouble finding funding. Jones Lang Lasalle (JLL) sees retail, driven by Chinese domestic consumption, creating increasing demand for commercial and industrial space all over China, but especially in second and third cities and Western China. JLL, along with the other brokers also see a turnaround in the commercial property sector. According to Greg Hyland, Head of Investment at JLL in Shanghai, “In Pudong, overall market vacancy is at 11.1%, down from over 20% a year ago. Yes a lot of developments are underway, but 40% of supply is sold to preleased and owner occupiers.”

Contrary to Chanos’ warnings, many developers, brokers and consultants in China seem optimistic that what we are experiencing is not a real estate bubble. China’s Economy expanded significantly in January and all indicators are it’s going to be a good year. With a focus on IT and software related property projects, DeKyper, of CresaPartners is experiencing strong interest from his clients in upgrading and expanding on their commercial and industrial space in Shanghai.

In their recently publicized 2010 market outlook, Jones Lang Lasalle, bullish on most areas of China’s property market, sees domestic consumption as the primary growth driver. “Lending will be tighter than what it was last, but it will be accommodative,” says Hyland at JLL. Along with JLL and others, Sebban at GSE has his eye on the tier one cities and western China, “Most logistic developers are targeting Tier 1 cities but we see interest and opportunities in cities like Chengdu, Chongqing, Wuhan.”

Eric Ng, Head of Direct Investment (China) at IMCPAA, a port facilities and commercial property investor and developer out of Hong Kong and Singapore is similarly focused on second and third tier cities, with projects underway in Chengdu, Southern China and Qingdao. “In some segments there might be a bubble, but overall, no,” says Ng. “Even with high vacancy rates in cities such as Shanghai, things will be different in two or three years. Also on an individual level, real purchasing power of Chinese is much higher than commonly believed.”

Whether or not there is money to be made in commercial property development remains to be seen, but it seems unlikely that the money pipeline for the right real estate projects will stop. Even with restricted bank lending and government control, the trend we are likely to see in China is ongoing development.

The Beijing News, the capital’s main daily newspaper, cited loan officers of the Bank of China on Wednesday as saying that the lender has already abolished its 30% discount on government-set mortgage rates.

The best rate that the bank now offers is a 15% discount, and even that requires a strong credit record, the officers said.

Developers are also being squeezed by the banks following a series of warnings from the authorities for lenders to tighten up their risk management and avoid excessive exposure to the real estate market.

China Business News, a Shanghai-based daily, cited industry sources today as saying that several lenders have either completely stopped extending loans to developers or have cut back on their supply of credit.

“The banking regulator hasn’t asked banks to stop lending to the property sector but it has been warning about risk recently,” said Lu Zhengwei, chief economist of the Industrial Bank in Shanghai.

Lu noted that market sales volumes have dropped sharply and that “(banks) need to make further observations.”

There is mounting evidence that the market is responding sharply to Beijing’s gradualist moves to tighten up the housing market, with the official China Securities Journal reporting Tuesday that the volume of sales in the secondary market plunged nearly 70% last month over December, and those in the primary market dropped over 45%.

Data from the National Bureau of Statistics showed that Chinese banks lent CNY1.13 trillion to property developers last year, up 48.5%.

The massive surge in bank lending, particularly to the property sector, is raising widespread concerns about the health of the Chinese banking system.

Fitch Ratings on Tuesday downgraded the ratings of China Merchants Bank and China CITIC Bank, two leading second-tier Chinese commercial banks, warning of rising on- and off-balance sheet credit risks following the 2009 loan boom.

Chinese property prices rose 7.8% y/y in December, government data show, though the national average masks significant regional price gains.

The government began rolling back measures to support the property market at the end of last year, including re-extending the exemption period for the national property sales tax in December to five years from the previous two.