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Second of a Two-Part Series

Remember the talk of alternate investments that clogged the airwaves in the first part of the year? (You might remember; it was before talk of credit crunches took its place.) So popular is the foreign push into China that target plays in cities such as Hong Kong and Beijing are disappearing apace, and second-tier cities are rising in incoming investors’ sights. It was, in fact, a recurring theme at Mipim Asia, where we learned that the dynamic is being goosed along by the national government. This insight came from Roy Lee, general manager for DTZ in the Chengdu region. Lee took some time out for GlobeSt.com during the conference to explain how the dynamic is playing out and what it will mean going forward. It should be said–and this figures heavily in the topic at hand–that Lee spent 30 years in the US. He was raised in Los Angeles and worked in San Francisco before moving to China for a four-year stay from 1991 to 1995. He’s now in his second stint there, a stay that started in 2001.

GlobeSt.com: Why the focus on second-tier cities?

Lee: Fund managers are going into second-tier cities largely because the government is attempting to regulate growth in first-tier markets by adding taxes and imposing other financial regulations. So the interest in tier-two cities by professional investors is driven in large part by the cost base. Today you can buy residential for (RMB) $5,000 to $6,000 per sm in T2 cities. And because T2 cities still rely on foreign direct investments for growth, the local governments are not as restricted in enforcing national regulations as in T1 cities. The national government is more likely to let prices in T2 cities go up until there is a level playing field. Until T2 cities rise to the level of tier one, they’re not going to let the T1 cities go up much more.

GlobeSt.com: Are these restrictions being placed on all investors?

Lee: No, just foreign investors.

GlobeSt.com: Obviously, there are lower costs. What are the other benefits?

Lee: Less competition. It’s easier to find a development partner. If you go to Shanghai or Beijing, the developers are so big and so financially strong that unless you are big player like Citibank or Morgan Stanley, you are not likely to find deals. The T1 developers will ask smaller investors what they bring beside money, and there are a lot of smaller investors who want to come to China. In T2 cities, where the developers are smaller and financially weaker, smaller investors with just cash will be attractive to local developers.

So for the successful investor in China today, and this is true in both tier one and tier two, the key is to bring in more than just cash. For instance, China wants retail operators. Domestic developers tend to focus on small-unit residential properties that are easy to sell. But a city can’t survive on just two-bedroom housing. You need shopping a mix of properties to make the city work. If you go to a tier-two city and you are bringing in someone like Wal-Mart, they will give you more attention and they may even break some rules for you. Your value to a tier-two government is more attractive, and if you want to do a project that is, let’s say, 80% retail, you’ll be bringing in skill sets that most domestic developers are weak in. In fact, the local government will often help the developer and the investor to lobby the central government to approve a major deal.

GlobeSt.com: Two speakers at the conference cited local governments. But one implied that tier-one governments are looser and more flexible. Another implied that with less structure getting things done was harder.

Lee: When things are fuzzy it means that there is room for people to make adjustments. On Oct. 31, new regulations came out that all new land development with foreign investors required a JV structure. Only then could they directly develop a piece of land. But the national government does not make clear what percentage the JV is to be split. There are a lot of gray areas, and it is subject to local interpretations. That is where China has advantages. China is not uniform, it is not one country. It is many regions. So the central government leaves room for interpretation.

GlobeSt.com: What is the largest and most compelling advantage to second-tier cities?

Lee: The low-cost base and the willingness of the government to work with you. Because the government is looking for that level playing field, there is a sort of crystal ball. As we saw Beijing and Shanghai develop, you can guess where second-tier cities will grow.

GlobeSt.com: And what are the largest issues?

Lee: So many people come to China thinking relationships are everything. They’re important, but the challenge to investors, more than language or the culture, is the lack of people, like me, who live in both cultures and can bridge the trust factor. Many Chinese who lived only a short time overseas, learning English but lacking real estate experience, end up working for fund managers. So local partners tend to be very difficult to work with, since they don’t have real international experience, and many western fund managers are controlled by senior partners who are not very experienced in China. ( I call these vacationing investors; they come to China only a few times a year.) This creates a very long communication cycle to close a deal, and in a fast-growing market, the price could change significantly in six to nine months, given negotiation time and the government-approval process. Many deals fell through in China because of this. You need a team with international experience, a good knowledge of real estate investing and an understanding of the China market, and that is very hard to find.

The other risk of second-tier cities is how fast they will grow. The smart thing to do is to acquire the land now and develop it slowly if the market is not moving so fast. If you’re planning 6000 units, buildup a limited number, like 500 units at a time, and create some demand.

The other risk is exiting our China investment. Withdrawing your profit is easy if you pay your tax, but unless you liquidate your company , you will have a difficult time taking your principal capital out. Typically, the investor who is in China for the long term will re-invest that capital over and over again, and that will be fine.

GlobeSt.com: One speaker said the second-tier city trend will last for the next 15 years. Do you agree?

Lee: I can see it through the Beijing Olympics in 2008 and the World Expo in Shanghai in 2010. But the exchange rate is bound to change. Also, what if the US does not manage the credit problem well and you go into recession? If US consumers cut purchases, the effect will be export reduction here in China. Factories will cut workers and there will be less spending money in the market. If, in three to five years, China becomes more expensive, combined with the problems in the US, that may have a big effect on China real estate. If I was betting man I would say if you are looking to invest now and exit by 2010 and no later than 2012, you’ll be safe. If you catch this cycle now and do your homework you’ll be safe. Know your limits. If you set your limit and invest wisely, sticking to fundamentals, you’ll be safe. To that degree, it’s no different than investing any other city, in the US or Europe.

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