Foreign funds have returned to the Shanghai real estate market in a big way, running up an unprecedented 12 billion yuan (HK$15 billion) in deals in the first five months of this year.
Most transactions were in the office sector, which saw its capitalisation rate - or rate of return based on the expected income that the offices will generate - driven to an historical low of 4-4.5 per cent; grade-A office prices have risen more than three times from an average price of 25,000 per square metres a decade ago. The prospect of rising rents and shortage of supply has driven the sector's cap rate down and will continue to keep it low.
New supply in tier-1 cities has lagged historical supply levels. According to DTZ, in Beijing, for example, the limited new supply of 283,957 square metres last year was equivalent to just 4 per cent of its existing stock.
Shanghai's new-supply-to- existing-stock ratio was 11 per cent. The implication of this is that in these major cities the supply shortage is set against strong demand from business expansion, resulting in exceptionally low availability of office space in these cities, thus boosting price growth.
Since 2004, office prices have risen 220 per cent in Shanghai, and 250 per cent in Beijing. There are also major gains in office prices in Shenzhen and Guangzhou. The sharp price rises in tier-1 cities have prompted investors to begin eyeing investment opportunities in tier-2 cities, where office prices are much cheaper.
Total investment in offices in second-tier cities rose 88.5 per cent quarter-on-quarter to US$29 billion in the fourth quarter last year, with deals accounting for 78.8 per cent of total investment volume.
In recent years foreign funds have been able to find increasing opportunities to exit their office properties in tier-2 cities like Suzhou, Nanjing, and Dalian, raising transaction levels and bringing them good returns.
Beijing is encouraging domestic consumption to drive gross domestic product growth. Both foreign and domestic investment looks set to continue to rise, especially that in prime commercial properties.
Some tier-2 cities are catching-up with their bigger rivals and are building or expanding their central business districts.
But most of the office markets in tier-2 cities suffer from over-supply and low demand and have very few leased en-bloc office stock available for sale. Picking a winner among tier-2 cities is therefore a challenge for investors. The yardsticks lie in the city's economic influence in the region, the future scale of its grade-A office market, and the presence of a diversified capital base.
Cities in which prospective office space will not reach 2 million square metres will find it difficult to compete with larger rivals. Suzhou, Chengdu, and Shenyang are our top picks. Each has an attractive macro-economic story, and their office prices are below land replacement costs. Suzhou's GDP grew 30 per cent last year, much faster than its long-term average growth.
Foreign developers like Sun Hung Kai Properties, Wheelock and CapitaLand have entered Suzhou, which has the added attraction of being in the prime Yangtze River Delta location.
Nearly all the major second-tier cities in the delta region are in the process of building new commercial office CBDs as they try to boost the contributions of their service sectors to overall economic growth.
Chengdu saw sustained tenant demand in recent years as the city benefitted from demand from companies eager to tap into growth in central and western China. Demand for grade-A offices is very strong and net absorption increased threefold year-on-year in the first quarter of this year.
The office market in Shenyang, meanwhile, is catching the attention of both occupiers and investors. In its flagship survey "Global Occupancy Costs - Offices", DTZ Research ranks the cost of business space across 126 business districts in 49 countries across the globe, and found that Shenyang rose to 78th place this year from 111th place last year.
The jump in ranking reflected an upbeat market with limited office supply, and vibrant leasing activities by companies attracted by the city's positive outlook.
Buying tier-2 offices now is equivalent to buying into a city's future and betting that its growing service and financial industry will propel its grade-A office sector.
Jim Yip is the Managing Director, Investment and Advisory Services, China, DTZ