Shanghai surprise

Just as China is slowing down, Shanghai is speeding up. But can the city survive its next unprecedented supply boom?

The hazy view from the 26th floor of the Plaza 66 skyscraper puts Shanghai’s exponential growth into context.

The vista takes in a panoply of towers, from the wedding cake peak of the Stalinist Shanghai exhibition centre across the street, to the forest of concrete and glass polygons beyond it.

It is easy to believe JLL’s managing director for east China, Anthony Couse, when he says the city’s office stock has roughly doubled over the past five years. But his next statement stretches credibility.

“It is going to double again in the next five,” he says. “I doubt any city on earth has ever done that.”

Like the rest of China, Shanghai is a city of dizzying superlatives and numbers so large they are hard to comprehend. In the time between the UK introducing the first Crossrail Bill in 1991 and starting construction in 2010, Shanghai built the world’s longest metro network from scratch. And when that process first started, the whole of Pudong was just mudflats.

But even in a city where incredible stories are scribbled on every wall, the tale of Shanghai’s office market stands out.

So with China now experiencing a slowdown, can this city cope with a another doubling of its office supply by the end of the decade?

A tale of high demand

While most cities in China will measure rents on a per square metre per month basis, in Shanghai they are quoted in square metres per day.

This is a legacy from when occupiers used to lease hotel rooms when they could not find enough office space.

And despite the boom in development, commercial space remains a real problem.

Although the city’s skyline suggests a vast office market, most of the towers that form it are either blocks of flats or comprise office space that is a long way from grade A.

“The story in Shanghai is one of demand,” says Couse. “Shanghai’s total grade-A office space is still only 70m sq ft. And yet it has a population of 23m. Compare that with London and New York [and those cities’ populations] and it is minuscule.”

Domestic occupiers have driven the market since the 2008 financial crisis, boosted by the RMB4tn (£430bn) government stimulus that triggered expansion even as the multinationals that had previously dominated the office market were retrenching.

“Shanghai is on a journey, going from 80% international to 80% domestic, so there is massive untapped demand,” Couse says.

“It’s not that domestic occupiers are not here, they are just not in grade A.”

The government’s shift to a consumer-led economy is expected to drive take-up, as all effort is now directed at expanding the service sector.

James Allan, national director and head of tenant representation for JLL in Shanghai, says: “The tertiary sector outperformed other sectors if you look at the latest GDP numbers. And that push towards the tertiary sector will push office demand.”

Free trade zone opens

A key part of the government’s attempt to stimulate the service sector in Shanghai has been to introduce a free trade zone that opened officially in 2013, initially covering 11 square miles in the Pudong area, the home of the iconic skyscrapers that face the historic Bund across the Huangpu River.

The launch of the free trade zone was a statement of intent from the local and national government about the planned road to financial reform.

At present the big banks are relatively modest occupiers of Shanghai office space, with US and European institutions typically preferring to base themselves in financially liberalised Hong Kong rather than on the mainland.

Goldman Sachs, for example, occupies just 30,000 sq ft in Shanghai, a fraction of its footprint in other major financial centres.

But the government is now firmly on the path to financial reform and the Shanghai free trade zone is expanding, raising the prospect of increasing demand from financial occupiers.

“A year ago the free trade zone was just a little area. Today it is a big area and before you know it, it will be all of Shanghai,” says Couse. “That will be when the big tenants such as Goldman Sachs actually have something to do in Shanghai.”

That is why JLL is forecasting that, despite the unprecedented wave of office development planned mainly in areas outside the city centre, vacancy rates will rise only marginally, from 7.8% today to roughly 10% by 2020, and rents will continue to rise modestly over the next two years.

“We have a strong belief that net take-up will balance with new supply, which means that demand will double,” adds Allan.

Developers gear up

Developers have responded to the prospect of a rapidly expanding financial services sector with relish.

Fosun Property, part of the largest privately owned company in China (company profile, p74), is under way with a gargantuan mixed-use scheme on Shanghai’s Bund designed to tap into the forecast surge in financial occupier demand.

The 4.4m sq ft Bund
Finance Center is an office-led mixed-use scheme that Fosun believes will create a banking cluster on the opposite side of the river from the prominent Lujiazui financial district, home to the city’s tallest skyscrapers.

The scheme reflects how Fosun is “adapting its domestic business” to tap into the pockets of demand in China’s patchy real estate market, according to the company’s executive president Alex Gong.

“For Fosun Property, our domestic strategy includes Hive City [public-private partnerships designed to create mixed-use clusters, of which the Bund scheme is an example] and to focus on tier-two and tier-one cities like Shanghai,” Gong says.

While the occupational markets might be in rapid expansion mode in Shanghai, the same cannot be said of the investment market.

Spending on commercial property in the city dropped by more than 35% last year, from RMB65bn in 2013 to RMB 42bn in 2014, according to JLL.

The city’s investment market remains immature and can fluctuate significantly on local factors such as fund expiries. But despite this there has been a clear knock to sentiment caused by the economic slowdown – and in a market that lacks transparency, shifts in investor mood are often amplified. With the government spending much of the past two years downplaying expectations for growth, investors took time to readjust.

“Imagine being so used to double-digit growth that it is the only environment you have ever operated in, and suddenly you have a new government saying, ‘we are in contraction mode’,” says Couse. “What transpires is businesses do nothing, which in the real estate world translates to low volume, which affects sentiment and pricing.”

Key deals boost investment

But just as sentiment can trigger a sudden drop in activity, so it can just as suddenly return.

A couple of key transactions in the final quarter of last year – including the RMB3.1bn purchase of Suntown Plaza by Gopher Asset Management, and a few trophy assets being lined up for sale in Q1 this year, and suddenly sentiment is on the up.

“This year will be a bumper year again,” says Couse. “We are already seeing major transactions in Q1 and because it is so sentiment-led, we see a flock mentality.”

As with leasing demand, investment activity is likely to be led by domestic players, according to JLL.

Chinese insurance companies, which were permitted to start investing in real estate in 2009, have huge sums at their disposal but thus far they have been more active overseas than at home. This is because the government has restricted them to buying buildings with yields of no less than 6% domestically.

With prime Shanghai office yields well below this they have not yet had a huge impact on the market.

But as with the gradual reform of the banking sector, analysts are expecting a gradual relaxation of the rules governing insurance companies. And should that be the case, there will likely be a significant surge in demand.

“My view on Shanghai from an office standpoint is that it is an investor’s dream. Because there is no land, there is a massive emergence of domestic consumption, which is like oil under the ground just flowing into the marketplace. And,” adds Couse, “you have a government that is hell bent on making Shanghai a world city.”

jack.sidders@estatesgazette.com