Chinese capital and German real estate – why we should care

With the pace of Chinese outbound investment accelerating, there is now a clear opportunity for German real estate professionals and companies to gain – even if initially modest - market share of this growing source of international capital, along with the revenues generated from the facilitation and management of invested capital in German real estate assets. As it stands, both funds and mandates are still largely bypassing the local German real estate industry.

On October 6th 2014, new regulations come into effect in China which open the gates for overseas investments of up to USD $1 billion per transaction made by Chinese companies. The new provisions replace, for the most part, a complex and lengthy process of state-sanctioned approval with much simpler registration requirements, as per the Measures for Foreign Investment Management issued by China ́s all-powerful Ministry of Commerce (in short “Measures No. 3”, by MOFCOM).

In July 2014 a further directive and its implementing rules had already eased outbound investment undertaken by individuals, “Circular 37” by the State Administration of Foreign Exchange (SAFE). Both, Measures No. 3 and Circular 37, removed regulatory uncertainty preventing investment, and have greatly simplified procedures. Chinese investors are now in a position to close deals faster, and to compete for a broader set of targets.

These changes are the most recent - if not the biggest - steps within the general “Going Abroad” policy which the Chinese government initiated in 1999. Within that framework, important milestones for institutional investment were a) the 2010 inclusion of real estate as eligible foreign alternative investment and, b), the 2012 increase of the maximum permissible allocation to real estate from 10% to 15%. The overall maximum for foreign investments remains at 15% for the moment.

Official estimates expect Chinese companies to invest over USD $500 billion internationally over the next five years. Germany, ranked by nominal GDP, should be the fourth-largest global recipient of investment capital. Applying the country weight of a benchmark like the MSCI World GDP Weighted Index, a neutral stance on Germany would accordingly generate a market share of around 8% of all Chinese international real estate allocations. There are, of course, plenty of persuasive arguments as to why Germany should actually exceed this 8% share.

The implications for German real estate market participants in this is that there is a fairly new and growing source of capital and revenues becoming available. In addition, since not only economic fundamentals but also capital flows drive valuations, the investment preferences of Chinese investors will become an increasingly relevant factor in performance.

In 2014, more than 60% of global institutional property funds were allocated to office real estate, followed by retail, industrial and mixed-use. Common features characterizing transactions across all key markets include the acknowledged preference

for investing in stable and liquid markets, in established locations, and into income-producing properties. Germany scores highly on all these counts.

The US recovery story vis-a-vis the Euro crisis has not gone unnoticed, either. Preferences may change sooner rather than later, however, because yield compression is in a developed stage, familiarity with a broader range of markets is increasing, and – last, but not least - there is a potential divergence between US and Eurozone monetary policy.

However, the common denominator straddling all these differences, and the one crucial factor underpinning the Chinese outbound strategy, is the need for DIVERSIFICATION.

A good example on the institutional side is insurance group Ping An, which follows a familiar investment principle. Using its domestic bond yields as a risk-free benchmark, the insurance group diversifies into income-producing alternatives with differing yield premiums, for example with its recent London investment in the Lloyds of London building generating an initial 6.1%.

One approach some developers are taking to address one aspect of risk is to target and cater for individual Chinese going abroad. Individual Chinese investors often seek investments that provide residency privileges, foreign passports or other benefits of property ownership where they have business interests or where their children are being educated. Incidentally, Germany is China ́s biggest European trade partner, and the largest group of foreign students in Germany now is the Chinese.

Other Chinese developers and their capital providers are seeking alternative approaches for expansion, as they firmly expect domestic policies to negatively impact their industry in China. They are looking for more predictable returns, and are prepared to lower their return expectations in exchange. Returns of 15 IRR may seem utopian, but must still be viewed in the light of up-till-recent expectations of 30%-50% returns in China. Those days, too, are over.

From a German perspective then, core properties and even project developments in prime locations may not be competitive for the Chinese in respect of pure return considerations. Therefore it is also vital to focus on communicating risk management aspects, as well as the myriad opportunities available in Germany’s secondary locations. Current inward investment volumes are not one-off spikes, but a rapidly-growing base level. Reportedly, for 1H14 Chinese outbound investment (OBI) in real estate reached 16 billion USD globally, up 40% over the same period a year earlier.

Not only are the outbound investment (OBI) allocations increasing, but so are both assets under management (AUM) and actual investment expenditure into real estate. The Chinese economy is projected to keep growing far faster than the Western economies and is projected to reach about 20% of global GDP among the top 30 global economies in 2050. That will entail significant wealth creation.

The Chinese mutual fund industry, pooling retail investors’ money, is expected to reach USD $1 trn (1,000 billion) AUM by 2015. Keeping up with overall economic growth rates would mean around 8% growth p.a. However, a disproportionate amount of the wealth created is going into real estate, not mutual funds.

With the Chinese government now actively promoting more securities investment to the public, one can only speculate as to how this will boost the listed real estate sector and the role played by real estate fund managers. Just 10% of AUM to real estate as an asset class at an 8% country allocation would sweep an additional USD $8 billion to Germany from retail funds and, assuming 5% growth of AUM, fresh money of more than $400 million p.a. thereafter.

As to wealthy Asian individual investors, there is a traditionally high affinity to real estate, with allocations by family offices and ultra-high net worth individuals (UHNWI) of 30% or more not unusual. The assets held by the top 125 Chinese UHNWI are estimated at USD $360 billion.

Meanwhile, at Chinese institutions, in particular pension funds, assets under management have been growing at twice the rate of GDP growth, albeit from a small base. The mainland China overall pension system encompasses a total AUM of more than 9tr RMB. Of that, insurers had about 5/9 at the end of 2012. They are - and will likely remain - the most active market participants in diversifying their assets across asset classes and global locations. Having said that, Chinese institutions are still underweight real estate at 1% of AUM, including their allocation to domestic real estate.

Both Chinese developers and insurers are branching out into the fast-growing asset and investment management industry as they pool funds from smaller players and generate economies of scale. Several onshore Mainland Chinese asset managers now have offshore Hong Kong subsidiaries. With their access to the mainland, Hong Kong asset managers in general are expected to outperform their foreign competitors in fundraising for outbound international investments.

A 2012 plan, introduced by the China Insurance Regulatory Commission (CIRC), included measures to allow Chinese insurers to outsource funds to external asset managers and securities brokerages and, in a manner similar to the changes to the German KAGG a few years back, this can become a catalyst for reconfigurations in the value chain. In Germany, the effect was to open the field for competition and globalization.

Ultimately, these new changes provide German market participants with an opportunity to capture market share in the increasing funds of Chinese capital for German real estate assets, be it as seller, advisor, developer, co-investor, financier, manager or as a local partner in other ways.

It is important to note that, for the German real estate industry, just earning an allocation to German real estate does not necessarily mean that German firms will be involved in the management of assets or the structuring of the relevant investment vehicles. How much investment is routed via New York, London or Luxembourg, for example?

Last but not least, diversification is not just a one-way street. It is good to have different sources of capital. The performance of assets and asset managers can benefit from positive capital inflows. Unlike fundamentals, however, that any one individual can hardly bring too much influence upon, there ARE many ways in which funds can be attracted to invest in a specific market. Germany has many of these attractions.

In consequence, it is up to the German real estate industry to communicate with and meet proactively with these decision makers and their teams. Go east, Germans, then.

Angela Haupt is a Managing Partner at MRAG Projekt GmbH & Co KG in Berlin, Germany, which she co-founded in 2003. Ms. Haupt has about 20 years of international experience in direct and indirect real estate, investment and risk management, manager selection, capital raising, fund and company formation and from a decade working at leading global asset managers. She specializes in linking real estate and capital markets for German operators and international investors. MRAG is a real estate investment and capital markets advisory firm, focused on inbound investment to Europe from the US and Asia.