China’s retail development and investment opportunities are progressively spreading to large second- and third-tier cities – all with populations above 1 million – which puts added importance on building the right contacts and partnerships in China’s real estate market.

“Understanding a local market – its incomes and consumer preferences – is becoming the single most important challenge for developing and investing in China, and that is really only done with local partners,” said Rong Ren, chief executive officer of Harvest Capital Partners, a Hong Kong-based real estate investment, development and management firm that launched two successful retail investment funds in 2010. “You need to come to China with a longer-term vision and strategy. It’s not for speculators looking for quick deals,” said ULI member, Ren. 

China remains one of the hottest economies emerging from the global recession, making it an increasingly favorable environment for property investment. China’s GDP is forecast to grow at a torrid 8%-10% pace during the next few years, and China is expected to surpass the United States in total commercial real estate development during the decade of 2009 to 2019, according to Pramerica Real Estate Investors, part of Prudential Financial Inc.

Retail is already playing a significant part in this growth. Across Asia, retail property deals jumped 38% in the first half of 2010 compared to the same period of 2009, and in China’s largest cities, retail sales surged on a year-over-year basis, rising 19% in Shanghai through May and up 16% in Beijing in the second quarter, CB Richard Ellis reported. Total retail sales in China are predicted to double in coming years, from $2.09 trillion (US$) in 2010 to $4.21 trillion in 2014, according to Business Monitor International’s third quarter China Retail Report.

“In the current climate, China’s retail market has greater potential as an investment vehicle than almost any other retail market in the world,” KPMG and property service firm Knight Frank concluded in an investment trends report earlier this year.

The main drivers of China’s retail potential are the country’s continuing urbanization and rising consumer culture. Although Chinese per-capita spending remains below U.S. levels, annual consumer consumption in China is forecast to grow six-fold during the next three decades, according to Goldman Sachs economists. Meanwhile, the proportion of China’s population living in urban cities has jumped from 19% in 1980 to an estimated 45% today. This is resulting in a dramatic shift in geographic distribution, with 200 cities in China now boasting populations of at least 1 million.

China has four giant first-tier metropolises – Beijing, Shanghai, Guangzhou and Shenzhen, along with Hong Kong off the mainland. The national government also ranks two-dozen other cities as “second-tier,” generally provincial capitals with populations near or above 10 million — places like Chengdu, Hangzhou, Suzhou and Zhengzhou. At an International Council of Shopping Centers conference in Beijing in November, many of those cities were viewed as under-retailed and ripe for development.

“Foreign investors are entering such cities to explore potential investment opportunities, as it’s much easier for them to find suitable investment inventories in those cities, and the continuous improvement in retail sales and consumer spending is also convincing them of the market’s potential upside,” Danny Ma, director of CB Richard Ellis’ China Research, said in an interview.

Developers and investment firms such as Turkey’s Star Mall Group, Singapore’s Keppel Land and Hong Kong investors Hang Lung Properties and Harvest Capital Partners have been actively pursuing projects in China’s so-called smaller cities. Harvest raised $600 million (US$) this year, primarily from North American pension funds and individual investors, to develop and manage family-oriented shopping centers. These centers typically involve 100,000 square meters (1,076,391 sq ft) in a 4- or 5-story building, anchored by a Wal-Mart or Sam’s Club and including electronics outlets, brand-name stores like Nike and Zara, a movie theater and sometimes a skating rink.

The concept is designed to appeal to children, and with China’s one-child-per-family policy, each child typically brings two or more adults. “Our type of shopping mall, the family destination mall, is a popular trend,” Harvest’s Rong Ren said in an interview.

Still, retail development and investment in China come with plenty of challenges. These include: long delays in the regulatory approval process; occasional government regulations to limit foreign investment; onerous requirements such as developing super-blocks instead of single sites; and lots of domestic competition – domestic purchasers accounted for more than three-fourths of Asian real estate deals in the first half of 2010, according to CB Richard Ellis.

In a nutshell, it’s difficult for foreigners to get a foothold in China, which is why Harvest’s Ren and others recommend establishing investment partnerships there to manage the risks. “If you have no contacts in China, it will be difficult for you to get the approvals,” said George von Liphart, managing director of Peninsula Real Estate Capital Advisors in San Francisco and a veteran China deal broker who is chairman of ULI’s Global Exchange Council. “It is still very much a question of who you know and how you cultivate that.”

Overall, retail development and investment in China promise the tradeoff of low initial yields – usually 4.5% to 6.5% – in exchange for greater longer-term asset appreciation. Harvest Capital Partners is trying to buck that trend, with its new retail investment funds targeting 15% and 20% net returns over 5 and 6 years, respectively.

“Overseas investors must have a business presence in China before they can make any actual acquisitions, while the Chinese government is posing stringent control over the approval of investment funds in China,” said CB Richard Ellis’ Ma. “Therefore, the most viable option for foreign investors would be to source an equity deal via an offshore structure, such as looking for an equity investment in Chinese developers that are listed (on the Hong Kong Stock Exchange) and have some investable-grade retail assets.”