When the SARS epidemic surfaced in China in 2003, the impact on domestic real estate was severe but fairly short-lived, with rents and prices rebounding quickly once the outbreak had peaked. The fallout from COVID-19, however, promises to be more profound, as shrinking global demand for Chinese products turns the screw on firms that have only recently restarted operations.
The impending slump in Chinese gross domestic product (GDP) data is likely to be severe. Oxford Economics predicts that GDP will grow just 1 percent this year, the weakest rate in decades. The result, according to Carrie Liu, managing director of asset management at China Life Capital, is that “there will be huge office supply for China’s first- and major second-tier cities over the next three years.”
That said, the impact on occupational markets will probably not be seen until the second quarter. According to James Macdonald, head of China research at Savills: “Combined with little take-up or even space being handed back, the net effect will be that vacancy rates in major office markets may trend up slightly [1–2 percentage points], but not by much. Grade B offices, however, are likely to be more exposed to SMEs and will likely see more of an adjustment.”
Savills’s provisional data for the first quarter shows office vacancies rising just 50 basis points to 13.2 percent in Beijing, 1.1 percentage points to 26.2 percent in Shenzhen, and 1.8 percentage points to 32.9 percent in Chongqing, with rents falling by 1 to 2 percent in most markets. With office vacancy rates already at higher-than-normal levels, the outlook does not seem promising, but major cities in China have a track record of growing into supply gluts created by over-enthusiastic development, and long-term demand for office space is considered to remain reasonably strong
Retailers Feel the Heat
The retail sector, meanwhile, has taken more of a hit, with consumers either banned altogether from leaving their homes during the (now lifted) quarantine or financially constrained after several months out of work. However, as Macdonald says: “We are not expecting to see substantial change in mall vacancy, as international retailers will be desperate for China to make up for the shortfall in other markets. Domestic retail chains will likely keep key locations open, hoping to capitalize on the consumer rebound as the country starts to normalize. The smaller independents are likely to be the ones that suffer the most.”
And according to Liu: “The impact has been greater on suburban or community malls in terms of financial performance, rather than larger regional malls. We expect regional central malls to lose around 15 percent of NOI [net operating income] this year, but for community malls it could be 20 to 30 percent due to temporary closures, tenant failure, and slower re-leasing. This is because community malls tend to have more education- and service-related tenants, all of which have remained closed and also more smaller businesses with weaker cash flow.”
The travails of community or suburban malls are likely to lead to a change of thinking, she says. “Previously, it was argued that community malls would be more resilient because they have a broader range of tenants and more nondiscretionary shopping. However, this may not have been the case.”
China retail real estate has been more resilient to the impact of online shopping than many markets, partly because malls play a more important community role than in the West and partly because newer malls have been designed with omni-channel retail in mind. However, according to Hei Ming Cheng, chairman of investment manager KaiLong, “the COVID-19 situation has accelerated China’s move towards online retail, so this will put more pressure on retail assets. After SARS, people realized the vulnerability of hospitality assets, so they became valued off higher yields. This is likely to happen for retail assets after COVID-19.”
Liu adds: “Tenants with a stronger brand and a strong online presence have been more resilient, so in future I expect landlords will be more careful about leasing and to prefer brand stability. There will be consolidation—stronger tenants will grow market share and so will stronger malls. I don’t think retail will be valued differently, but the difference between stronger and weaker malls will become more apparent.
“We have seen that malls with an outdoor element have had more traffic than those with only indoor space, so we may see more indoor/outdoor malls developed in future.”
Due to the outbreak, the whole of China had a crash course in remote working, which was not always successful. According to Alfred Wu, assistant president and general manager of Greater China Asset Management Department, Fosun Hive: “Even if your firm is OK with working from home, the problem is that your suppliers may be incapable of working remotely. We cannot collaborate if only one side can work remotely.”
However, Cheng notes a more positive reaction among KaiLong staff to remote working: “People have had to get used to Zoom, online meetings, and webinars, and I think this may bring some changes to the way we work in future. Once you get used to online meetings, they are very efficient.”
China’s flexible workspace industry, meanwhile, was suffering already from overcapacity even before the current crisis. As predicted, the sudden downturn in business sentiment has now only added to the pain. Macdonald says: “Coworking spaces where tenants can leave on short notice will likely see vacancy rates surge and we may see some closures and early lease terminations. Nevertheless, in the long term, as employers and employees play around with new ways of working, flexible space may make a resurgence.”
At the same time, however, China Life’s Liu sees more flexibility demanded in future, particularly from multinational companies. “Foreign firms will move towards more flexible working practices and also to more decentralized offices and multiple locations. Developers will have to offer more flexible leasing terms to attract and retain tenants, and this will be the case for some time.”
Unsurprisingly, the crisis is likely to promote future demand for wellness and healthy buildings, an area where China had previously lagged behind the United States and Europe. As the shortcomings of current design practices have become apparent, there is now a groundswell of support for a range of building automation processes, such as sensor-operated doors, no-touch faucets in bathrooms, automated temperature testing, and facial recognition cameras to remove the need to swipe in and out.
Another way the pandemic may change the status quo is by accelerating the diversification of the global manufacturing base away from China, meaning that demand for manufacturing facilities has likely already peaked. As Liu says: “My personal view is that global supply chains will refocus, with some manufacturing returning to companies’ home markets and some redistributed to other markets.” This will add to a trend already begun by the U.S./China trade war.
Apple, for example, has already begun trials to manufacture its AirPod headphones in Vietnam. That said, however, relocating supply chains is a complicated task that cannot be completed overnight. Apple chose to offshore AirPod manufacturing because it involved a product with relatively fewer components that was easier for lower-skilled workforces to assemble. Repeating the exercise for more complex goods is a more challenging proposition that will evolve only gradually.
Nonetheless, the move by multinational manufacturers to diversify supply chains will pose challenges for China that go beyond simple losses in productivity, says Liu. In the long term, Beijing’s goal is to replace jobs lost in its manufacturing industries with others that require more sophisticated skillsets, an ambition that China’s workforce may not yet be ready to take on. “Can lower-skilled workers be up-skilled to work in China’s growing high-tech manufacturing space? It will be difficult in the shorter term. These [low-skilled] workers have been important in growing domestic consumption in lower-tier cities.”
Homebuyers Still Active
Of all the asset classes, the Chinese residential sector is perhaps the only one likely to see a relatively quick resurgence, due mainly to substantial pent-up demand. Many developers have turned to online marketing to get sales moving again, and early indications suggest that sales are picking up. Also, most Chinese cities have longstanding measures in place designed to cool the residential market, such as restrictions on applying for mortgages and buying second homes. By relaxing these as needed, authorities have a set of tools to fine-tune the demand side of the housing equation that they are well versed in using.
Liu says: “There is still huge demand for residential property, not least because Chinese people lack alternative investment products. Some cities have now begun to relax residential market cooling measures and where this happens, we will see more money come in.”
Still, in the current environment nothing is set in stone. Predictions only a few weeks old can quickly be made to look ridiculous as the landscape rapidly evolves. On February 3, for example, Oxford Economics cut its prediction for China’s 2020 GDP growth to 5.4 percent; by March 3 this had been downgraded to 2.3 percent, a forecast it then changed to just 1 percent by March 19. In a world of such uncertainty, recovery will probably be a long-term process. As KaiLong’s Cheng says: “It could take a decade for the world to find equilibrium again.”