Attendees at a networking event at the 2013 ULI Asia Pacific Summit in Shanghai.

As China’s real estate market experiences a slowdown, investors are retreating to Tier 1 cities, according to the Urban Land Institute’s Mainland China Cities Survey 2014. The annual survey, which evaluates the real estate investment and development prospects across 36 of the largest cities in mainland China, recorded an average 8.5 percent decline in ratings for each city, indicating a more pessimistic outlook overall for prospects compared with last year. However, investors remained confident of the prospects for the Tier 1 cities of Shanghai, Shenzen, Beijing, and Guangzhou, which were the four highest-ranked cities for investment and all in the top five rankings for development.

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China_cities_1The report highlights that at the time the survey was undertaken, mainland China’s real estate sector was entering the initial phase of a sharp downturn. Property sales during the first four months of 2014 dropped by 9.9 percent from the same period in 2013, largely caused by the restrictive lending and home-purchase policies introduced by China’s central government to reduce speculative real estate investment. In addition, many investors became increasingly concerned about the oversupply of new stock in a large number of Tier 2 and 3 cities, and although excess residential property supply will be absorbed by many economically active cities over the coming years, it may take much longer for commercial property, especially shopping centers, to be occupied.

Furthermore, China’s wider economy was experiencing a slowdown, with gross domestic product (GDP) growth down to 7.4 percent—the slowest growth rate since 2002, with the exception of the first quarter of 2009 at the start of the Great Recession.

However, participants in this year’s survey were confident of the prospects for China’s Tier 1 cities, which all improved or maintained similar ratings to last year’s report. The report argues that these cities are political and economic hubs with relatively transparent and open environments that attract strong demand for real estate and can sustain reasonable increases in house prices. Tier 1 cities also offer sizable new areas for development outside of the city center, either anchored by major new transportation infrastructure or supported by business-friendly central government policies. As a result, these cities are better positioned than Tier 2 and 3 cities to handle an economic or property market slowdown.

“As the Chinese real estate market slows down, investors remain confident on the outlook for mainland China’s Tier 1 cities,” said Ken Rhee, ULI’s chief representative in mainland China and coauthor of the report. “The survey shows that people are comfortable operating in the major cities including Shanghai and Beijing, which have strong underlying market fundamentals, but are increasingly cautious about the prospects for many Tier 2 and 3 cities, especially those with oversupply issues such as Chengdu, Tianjin, and Shenyang.”

The top five rated cities for investment prospects in this year’s report are as follows:

china_cities_21. Shanghai. Shanghai has retained its top ranking for both investment and development prospects and continues to benefit from having the deepest pool of investment-grade assets across all the major asset types. Its relative transparency and access to both local and international talent make it attractive to overseas investors, and many of the foreign funds that entered the market a decade ago have reinvested in the city after successful first investments. The recently announced Shanghai Free Trade Zone (FTZ), in the Pudong District, will further help international investment.

The established business hubs of Lujiazui as well as districts along Huahuai Road and Nanjing Road continue to benefit from investment and development, and the city’s growing reputation as one of the world’s premier financial centers will be further reinforced with the completion of the 632-meter (2,073 ft) Shanghai Tower in 2015. The city’s decentralized locations offer a substantial volume of new development opportunities supported by significant infrastructure investment and favorable government policies. The most significant development project in Shanghai’s suburbs is the Hongqiao Transportation Hub (HTH), which by 2020 will have 4 million square meters (43 million sq ft) of commercial space supported by the Hongqiao International Airport, two subway lines, and a high-speed railway station with direct links to many of the major cities across China.

2. Shenzhen. Shenzhen’s strong performance this year is largely due to the central government’s establishment of the the Qianhai Shenzhen–Hong Kong Modern Service Industry Cooperation Zone, which provides companies registered there with preferential conditions. The special economic zone will focus on the development of finance, science, technology, and other professional service industries. A large number of mainland Chinese financial institutions have already registered new businesses in the area. This will boost Shenzhen’s already strong financial services sector, which is home to the country’s largest number of private equity companies and mainland China’s second-most-important stock exchange.

Shenzhen’s real estate market has been historically dominated by local players, and there has been a limited pool of investment-grade assets to attract international capital. Development of the Qianhai area may help the local real estate industry mature, and early signs of this include Silverstein Properties’ acquisition of a waterfront site in the heart of Qianhai, in partnership with a local investor. The city is also set to benefit from a relatively limited supply of land available for development as well as its close integration with Hong Kong, Guangzhou, and nearby cities in Guangdong.

3. Beijing. Beijing has continued to surprise many investors who worried about the large oversupply of office buildings released after the 2008 Summer Olympics. However, strong demand for Grade A office buildings from local companies means that the new supply has been fully absorbed and Beijing now has the highest average office rents in mainland China. The expansion of the CBD, which will release more than 1 million square meters (10.7 million sq ft) of property over the next few years, is not perceived as a real threat given the strong demand for office buildings from local companies.

The city is expected to benefit from a large volume of development projects near the new second international airport, which will be located in the Daxing District and will be connected to Beijing South Railway Station by a new 37-kilometer (30 mi) high-speed rail line. The airport will have eight runways and become the world’s busiest airport, handling 130 million passengers per year when completed.

Beijing continues to rank near the bottom in terms of livability, which is seen as hurting the market, especially in the luxury residential market, with wealthy Chinese and expats preferring to live in Shanghai. As a result, luxury residential units in Beijing command around 70 percent of the price that can be achieved in Shanghai.

4. Guangzhou. Guangzhou’s high ranking for investment results from the maturing of the Pearl River New Town and the improving infrastructure of the city following the 2012 Asian Games. Some survey respondents argued that the city government continues to develop new areas, such as the Guangzhou International Financial Town (GIFT), without providing sufficient time for recently completed areas to mature.

However, like the other Tier 1 cities, Guangzhou is running out of developable land in the city core and developers need to look toward urban renewal projects to find opportunities. In addition, while the additional office supply in GIFT is expected to keep office rents from rising, high-end residential units have clearly benefited from the maturation of the Pearl River New Town, which includes a large public open space at its center and a host of world-class cultural facilities, including a Zara Hadid–designed opera house. Residential units that traded at about RMB 20,000 per square meter several years ago are now trading at more than RMB 50,000 per square meter.

5. Nanjing. Nanjing has often been overlooked by institutional investors, in favor of Suzhou. However, the opening of the high-speed railway connecting the city to Shanghai and Beijing has made it very accessible and highlighted new opportunities to investors. Nanjing also benefits from strong, stable, and balanced patterns of supply and demand.

Nanjing’s emergence as a key business center has been aided by the development of the Hexi central business district, located in the Jianye District. When completed, the Hexi CBD will have a total of 6 million square meters (64.5 million sq ft) of space and will house a cluster of modern services industries, exhibitions, culture, and sports, as well as trading in Jiangsu Province. Delivery of the project is being accelerated as the Youth Olympic Games are being held in the Jianye District of Nanjing this year.

Tier 2 cities with strong high-tech industry such as Nanjing, Wuhan, Suzhou, and Xi’an fared well, ranking among the top ten in investment or development prospects. There were notable declines in this year’s rankings for Hangzhou, Chengdu, and Chongqing. Hangzhou’s investment ranking dropped to tenth from fifth, though its development ranking moved up to 11th from 13th. Chengdu’s ranking dropped to 13th from eighth for investment prospects and to 15th from seventh for development prospects due to an oversupply of commercial properties in its downtown and in the Tianfu New Area. Chongqing continued its decline in rankings, dropping to 16th from 12th for investment prospects and to 17th from 14th for development.

In terms of sectors, industrial and distribution continue to be the most popular among respondents, with 56 percent indicating they plan to increase exposure to this sector, in response to the rapidly growing e-commerce in mainland China and the severely limited stock of high-grade logistics warehouses. Despite concerns about weakening residential sales and an oversupply of office buildings and retail properties, the respondents in general plan to increase exposure in the midmarket residential, retail, and office sectors.

The report also ranks mainland China’s cities based on their livability. Shanghai, Hangzhou, and Xiamen came out on top in the livability rankings, followed closely by Shenzhen, Suzhou, and Chengdu. Shenzhen’s ranking shot up to fourth from 11th, possibly reflecting the good job market and improving living conditions there. In contrast, Beijing continued to be ranked near the bottom, at 32nd, one place lower than last year, largely due to the continuing air pollution problems there.

Livability seemed to have had some impact on respondents’ rankings of the cities for investment and development prospects. For example, Beijing’s luxury residential market was seen as less favorable than Shanghai’s as China’s upper-middle class, overseas Chinese, and foreigners clearly prefer to live in Shanghai over Beijing, in spite of the capital city’s good job and education opportunities.