Monday, September 26, 2011

The Reasons Behind the Overbuilding of Luxury Retail Malls in China


Some readers may have mistakenly ascribed a political agenda to my postings about Chinese real estate. My views on commercial real estate are nonpartisan and non-ideological.

To those who think that I have been poking fun at “The Communists” or the Chinese government, I point out that the fiascos I've reported have been capitalistic decisions of private owners and investors which happen to have occurred on Chinese soil. (Only one, New South China Mall, had some government involvement, as it was financed by the Agricultural Bank of China, which was State-owned at the time of funding nine years ago.)

I even disagree with the notion that the People’s Republic of China is a communist society. During my trips to the PRC I’ve met many Chinese people, none who have ever expressed the sentiment that he or she wanted to create a classless, utopian society that benefited “The People” rather than themselves. Most just tell me “I want to be rich”. If I ask for an opinion of Chairman Mao, I generally get a strange look which implicitly asks “What century are you living in?

As part of enforced “general education” requirements as an undergraduate at the University of Chicago, I was required to read The Communist Manifesto and The Russian Revolution (strictly in the context of critical inquiry), and neither Karl Marx nor Lenin ever stated that “The People shall have an Omega watch store every four blocks.” or "From each, according to his abilities; to each, a Gucci handbag." Overbuilding is not a Marxist concept, but Marx did explain in Das Kapital that overproduction is part of the natural outcome of a capitalistic society.

Karl Marx has probably caused more human suffering than any other philosopher who ever lived, but his criticism of capitalism was often insightful. He explained that technological advances increase labor productivity, which increases material wealth in the ruling classes while diminishing wages of workers, creating “poverty in the midst of plenty” manifested by overproduction and underconsumption. That may just be what is ailing China at the moment, as Chinese consumer spending as a proportion of GDP has been declining for the last half century in China.

Article in October issue of Shopping Centers Today

Next month’s issue of Shopping Centers Today (the house publication of the International Council of Shopping Centers) quotes me among other analysts in an article entitled “Many shiny new malls in Asia are devoid of tenants and shoppers”. Curt Hazlett reports many new but empty luxury malls in both China and India. There are various reasons cited, chiefly lack of experience and market analysis by the actual developers, who are private entrepreneurs.

This misallocation of resources is now being discouraged by the Chinese government. Recently, the Chinese Banking Regulatory Commission has been trying to proactively engineer a soft landing to a real estate bubble through stricter bank regulations. Reckless Chinese developers now find themselves unable to get Chinese bank loans for ill-conceived projects. The People’s Bank of China reports, for instance, that new lending to property developers declined to 42 billion yuan ($6.56 billion USD) in the second quarter of 2011, down 75% from 168 billion yuan in the first quarter. I have also seen similar policies put in place by the elected governments of Singapore and Hong Kong.

Real estate developers the world over are like heroin addicts, constantly seeking financing, and Chinese developers are no exception. If you give enough money to a developer, he will develop, because that is his raison d’etre. Chinese developers have found two alternate sources of funding after the shutting off of the Chinese banking spigot: private trust companies within China, which funnel investments from wealthy individuals and companies, and REITs created on foreign stock exchanges. The Chinese government is now cracking down on trust company lending, too.

So what is currently causing the continued overbuilding of luxury malls in China? In short, it is foreign investment. The “Chinese economic miracle” has been oversold to naïve foreign investors by self-serving capitalists. If the focus is on wealthy Chinese, most of their shopping is done outside the country, particularly in Hong Kong, in order to escape the VAT, the customs duty tax and the consumption tax, together adding up to as high as 60% on imported goods. That is why all the Hong Kong malls are full.

This last year has shown that it is easier to finance grandiose Chinese commercial real estate development schemes with equity offerings on foreign exchanges than with Chinese lenders. These equity investors (shareholders) have often been suckered because the "Chinese economic miracle" story has been so compelling and the IPO sponsors have been less than forthright. The logic that Chinese GDP growth is causing equivalent growth in consumer demand is contradicted by actual statistics: Per ISI Emerging Markets Inc., who maintains the CEIC China Premium Database, Chinese consumer spending as a proportion of GDP has now hit an all-time low of 34% and predicted to decline for two more years after being about 45% one decade ago and about 50% two decades ago, not quite the "consumption revolution" crowed about on empty New South China Mall's web site.

Walking through empty retail malls in Dongguan, Beijing and Shenyang, I was struck by the high prices on the merchandise offered. The median household income for Class-1 and Class-2 cities is estimated to be about $5700 per year, about 12% of the U.S. median, which is not conducive to a Gucci lifestyle. (The Chinese national average is about $3300 per year.) Wealthy Chinese, however, have the ability to travel and shop outside the country, where they find lower prices on luxury items, whether in Hong Kong, Singapore, Beverly Hills, or Vancouver. (Hong Kong attracts many Chinese shoppers due to the lack of a sales or value-added tax.) That narrows down the universe who have the resources and desire to buy their luxury goods domestically.

Recruiting foreign investors

Foreign investors may have misconceptions about Chinese shoppers based on the Chinese shoppers who travel to their own countries. These shoppers represent the affluent class of China, which is small in proportion to the total population. Mall investment sponsors have been capitalizing on this misconception.

Foreign investors are easier to take advantage of than Chinese investors due to their lack of legal recourse when they are cheated. Law enforcement can be heavy-handed within China. For instance, while I was staying in Shenzhen, the former mayor had just been convicted of corruption and sentenced to death. Executives of a company committing fraud on the Shenzhen or Shanghai stock exchanges are subject to severe criminal penalties, particularly if they cheat the government. Not so if the company is listed on a foreign exchange, such as Hong Kong, Singapore, New York or Toronto.

From GAAP to CRAAP

Just as U.S. securities laws are not extra-territorial, neither are Chinese securities laws. China does not have GAAP (Generally Accepted Accounting Principles), so the rules governing accounting are different; Chinese accounting policy has been nicknamed CRAAP (Chinese Regularly Accepted Accounting Policy) by hedge fund manager Jim Chanos.

The Chinese economic miracle has been a 30-year growth trajectory that has averaged annual GDP growth of 10% per year (according to the government) and created 115 billionaires as of the last Forbes count. Just remember, though, that the building of empty malls and office buildings is part of that GDP growth.

Chinese consumer spending has failed to keep pace, too, as Chinese household income, is less than 10% of U.S. household income. This is what Marx predicted would happen to capitalist societies, that workers would end up being financially unable to buy the very products they were producing. The empty luxury malls are evidence of that.

Wednesday, September 21, 2011

Jinbao Place: Arriving Too Late at the Beijing Luxury Party 金寶匯

Jinbao Street is the ultimate luxury shopping street in Beijing, similar to Rodeo Drive in Beverly Hills. In its two-block stretch there are three 4 or 5-star hotels and Bentley, Ferrari, Maserati and Mercedes dealerships.

A three-year-old, 40,000 square meter (430,000 square foot) luxury mall known as Jinbao Place stands largely vacant on this otherwise busy street. Above the second floor in this seven-stories-above-grade mall, almost all space is vacant. The seventh floor, the restaurant floor, has a roast duck restaurant.

The problem is not the location. Jinbao (translated as “golden treasure”) Street is the best known destination for Beijing’s wealthiest shoppers. The problem is that most luxury retailers are already represented nearby in the Dongcheng district that contains Jinbao Street.
Jinbao Place’s current tenants include Gucci, Omega, Burberry, Canali, Bottega Veneta and Vertu, two restaurants and a coffee stand.

Gucci already has its own stand-alone store 4 blocks west, as does Omega, with its store on the very popular Wangfujing pedestrian shopping street.

Burberry has another store near the Peninsula Hotel just two blocks west as the street name changes from Jinbao to Jinyu Hutong.

Canali has another store at the highly trafficked Oriental Plaza mall (see my blog about the Hui Xian REIT), about six blocks southwest.

This mall was developed and owned by the Fu Hwa International Group, rumored to be a Taiwanese company.

The photos were taken at about 5 pm on a Thursday afternoon.

Cleaning woman, but who is there to clean up after?
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Tuesday, September 20, 2011

A Visit to Perennial China Retail Trust’s Assets in Shenyang, China 鹏瑞利中国零售信托

Recapping my June post on Perennial China Retail Trust (PCRT), PCRT was a recent Chinese real estate IPO on the Singapore exchange which advertised itself as the only “pure play on Chinese retail” available to Singaporean investors. It advertised “a total valuation of approximately S$1.1 billion as of December 31, 2010” based on an "independent valuation" of its five principal assets, which are two malls and an office complex situated together in Shenyang and malls in Foshan and Chengdu, but the valuation report was based on the false premise that all five properties had been completed and fully leased, when only one building, the Red Star Macalline Furniture Mall, had been completed and opened, and the malls in Foshan and Chengdu had not only not been started, but the land had not yet been acquired by PCRT at that time. In other words, the Foshan and Chengdu malls did not exist, yet they had been included in the current market valuation of this trust, as published on page 434 of the Prospectus.

In other words, the valuer had not been independent and had instead abetted the misrepresentations of the IPO sponsor. It should also be noted that the CEO/IPO sponsor receives substantial annual compensation (0.38% of appraised value) based on the independent valuation rather than the market capitalization of the outstanding shares, which is now less than half the amount of the "independent valuation" report. This is another built-in conflict of interest within PCRT.

I also questioned why the Singapore Exchange would allow PCRT to represent undeveloped properties as being fully developed and leased in their representations to the public of total asset valuation and why there were no controls on the misbehavior of supposedly “independent valuers” who are in reality the paid advocates of IPO sponsors.

PCRT initially attempted to go public in February by offering approximately 1.1 billion shares at S$1 per share but received an inadequate response. The offering was re-priced at S70 cents per share in June and was fully subscribed at that time. Since then, the market-traded share price has declined to S40 cents per share as of October 5, 2011. With 1,121,695,000 shares outstanding, this represents a loss to investors of more than S$336 million in market capitalization.

The visit to Shenyang

The location of the Shenyang properties is highly visible and accessible via the First Ring Road, and the Longemont Mall also has its own bus depot and subway rail station. This is a first-rate location.

I was disappointed to find the renamed Red Star Macalline Global Home Furniture Life Mall closed for the day at the time of my arrival at 7:15 pm. I naively assumed that it would be open late like most Chinese malls, but its official closing time is 6:30 pm; the error was mine. The closing time is the same at the other Red Star Macalline store in Shenyang.

The Longemont Shopping Mall had its opening on July 1st and is a beautiful sight to behold. The only things lacking are tenants and shoppers and western-style toilets. (Chinese "squat" toilets are simply porcelain holes in the floor. For a purposely western-style mall, this is an incongruity that I just cannot take sitting down.)

Ground floor of mall, 7:15 pm on a Friday evening

First floor of atrium

Third floor

To be fair, basement levels B1 and B2 have a hubbub of activity drawn by a major 20,000 square meter (215,000 square foot) supermarket with linkages to the city’s bus and rapid transit systems. Floors 1 through 7 were a different matter entirely, as seen in the other photos. My visit was timed between 7:15 and 8:30 pm on a Friday evening.
Basement supermarket

Many multi-level Asian malls also have their top floor or floors devoted exclusively to restaurants, and this can be one of the busiest sections of a mall in the evening. Not so here. Longemont’s 7th floor is also devoted to restaurants, plus an ice skating rink, but it appears that only half of the restaurant space has been rented out.
Seventh floor restaurant level

While I was dining on shredded dog meat in chili sauce on the 7th floor, I asked an employee why the Red Star Furniture mall was closed so early, and he was surprised to hear that it was already closed for the day, claiming that it was supposed to be open until 9 pm just like the Longemont Mall. “Not many people go there,” he also said. Nevertheless, the signs at Red Star Mall clearly indicate a 6:30 pm closing time.

Miscount of tenants at Longemont Shopping Mall

Although the PCRT web site advertises Longemont Mall as having 800 tenants, the number of open stores appears to be less than 200.

Is Longemont Shopping Mall "skating on thin ice"?

Two 56-story office towers are still under construction and show progress compared to previous photos from June. Leasing activity is not known yet.


Options on other sites next to future High Speed Chinese Rail Stations are also mentioned in the Prospectus. The July 23rd high speed train crash in Zhejiang that killed 40 and injured almost 200 revealed shoddy standards and official corruption which warranted the the arrest of the former railway minister Liu Zhijun. As a consequence, railway construction is now being delayed, with only one-third of projects still ongoing construction, while many railway construction workers complain about not being paid (more than 2000 alone at the China Railway Engineering Corporation.) What is the consequence for PCRT assets located at future high speed rail locations?

Remember, too, that all 5 properties are situated on ground leases. The Shenyang lease expires in year 2059, while the Foshan and Chengdu leases expire ten years earlier. What will happen then? The Chinese ground lease system only started in 1980, so none have expired yet, and there is no case history to learn from about when valuable malls sit on expiring ground leases.

Investors in PCRT (N9LU on the Singapore exchange) are probably quite disappointed now; those who bought at the offering price of 70 cents have seen a 43% decrease in value since June. $336 million of investor value has been lost since the first day of public trading. For those who relied on the independent valuation report, I don't know what legal recourse they have in Singapore.

One bit of encouraging news is that CEO Pua Seck Guan has finally started buying shares at recent market prices. Why didn't he buy before now?

Disclosures: None. I have no short or long position in this stock.
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