China Residential Real Estate: A Critical Return & Risk Analysis

Stephen Chung

Managing Director

Zeppelin Real Estate Analysis Limited

February 2007

　(Based on Data from the China Real Estate Index System CREIS)

Newcomers to the China real estate markets would be awed by the scale and immensity of the development activities taking place. To put the overall picture in more down-to-earth terms, China is today building the ‘equivalent’ of a) 14,000,000 residential apartment units each of 1,000 ft2 in floor area, b) 1,400 office towers each of 500,000 ft2 in construction, and c) 1,120 retail malls each of 2,000,000 ft2 in size. And these just relate to the commodity or private market sectors.  

Many investors initially would also tend to treat China as one single uniform market especially given its background in planned economy. Nonetheless, after having opened up its borders and economy some 28 years ago, this notion, even if it had been true at some point in time, does not stand too well to scrutiny. While real estate markets do share certain common traits, different cities would also harbor different characteristics given their varying stages of economic growth.  

Here we are going to look at these 10 major markets in China and their residential real estate market performances and we have included brief descriptions of these cities at the end of this analysis for convenience: Beijing, Shanghai, Guangzhou, Shenzhen, Tianjin, Wuhan, Chongqing, Nanjing, Hangzhou, and Chengdu. And here is a summarized market performance index chart on these 10 cities: 

From the chart, one can observe, quite obviously, that Shanghai, which was the leading market for a few years since 2002, has been overtaken by Shenzhen in 2006, which overall performance and price level has jumped some 40% or more since early this year. Beijing having been in the shadows of Shanghai for quite a while has also seen increased prices and transactions albeit at a slower pace than Shenzhen. Of the Big Four, namely Beijing, Shanghai, Guangzhou, and Shenzhen, Guangzhou has somewhat been a laggard although it has also seen increases in market activities.  

Of the remaining markets, mostly prominent 2^nd tier cities, Tianjin appears to have followed the footsteps of Beijing in seeing more market activities and price increases. The others in this category have mixed results with some edging up a bit and some straggling and struggling along. We have also looked at some rounded average prices per square meter (Yuan / m2) for each of these markets based on transacted properties in August 2006 [a technical note: these average unit prices could contain skews in that a market where there are more luxury transactions would have a higher unit price during the period while another with more ordinary grade transactions would see a lower unit price in the same period]:  

While micro factors such as unit prices, required total investment sums, property location, terms of financing, building quality, target tenant group, management arrangement, and the like could be important when contemplating which market and / or project to invest, making reference to macro aspects such as potential return and risk is also vital. 

We have performed simple macro analyses on the return and risk characteristics of these 10 residential real estate markets and are glad to share them with readers. Essentially, we have measured the overall return, based on the indexes and expressed as a percentages, for the past 12 months or so leading up to September 2006 for each of the markets and at the same time, we also calculated the volatility of the markets during such period using their respective indexes. Hence, we would end up with a set of return and volatility (reflecting risk) figures for each market thus enabling comparison among them. Here are the relevant charts: 

The above 2 charts are actually the same though we think they would be easier to comprehend if the city names are presented separately. Two observations almost immediately stand out: 1) Shenzhen leads the pack in terms of return offering 55% while the next one in line, Beijing, does not even come close giving only 23% or so; and 2) the motto of the higher the risk, the higher the return (and vice versa) apparently holds some truth in this case, as indicated by the correlation factor R2 which is 0.66 between return and volatility (risk). Please note these trends only represent what had occurred in the past 12 months and as such may or may not continue to hold true. Also, the return measure has not taken into account items such as transaction costs, taxes, rental income yields, and the like and is just a simple measure of buying for $X last year and selling for $Y today (if Y is larger than X, a profit is made, if not, a loss is incurred).  

These and similar charts can also help investors select markets. Using the foregoing charts as examples, while Shenzhen offers the highest return of them all, not all investors would have the stomach or desire to take on also the highest risk which Shenzhen offers. Stating the obvious, investment implies seeking and selecting investment opportunities which offer the highest possible return for a certain given level of risk. As such, while a high risk tolerant investor may go for Shenzhen, a less risk tolerant investor would want the other markets. For instance, and referring to the chart with the city names, while both Chengdu and Wuhan harbor the same level of risk (x-axis), Wuhan offers a higher return (y-axis). That is to say, an investor with that level of risk tolerance should focus more on Wuhan than Chengdu. The same principle applies when considering and comparing the other markets.  

Will the trends be different if the observation periods are longer say 5 years instead of 1? You bet! We have done similar analytical studies on the markets going back all the way to 2000 or prior and the results were not the same. For instance, you may find Shanghai ruling the pack instead of Shenzhen. Not only that, while there are certain synchronizations between most of the China real estate markets studied, they may not be highly or perfectly correlated, implying leads and lags in between. Shrewd investors may find such patterns to be an opportunity.  

Notes: The article and/or content contained herein are for general reference only and are not meant to substitute for proper professional advice and/or due diligence. The author(s) and Zeppelin, including its staff, associates, consultants, executives and the like do not accept any responsibility or liability for losses, damages, claims and the like arising out of the use or reference to the content contained herein.                                

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