International Appraiser: Objective valuation advice on international real estate: Shanghai's Lujiazui financial district and "Skyscraper Index Theory"

From left to right: Shanghai World Financial Center, Jin Mao Tower, and the intended 2073-foot Shanghai Tower under construction

The last three years has inspired debate about whether China is going through a real estate bubble. Prior to my first visit, I had read beforehand of 64 million vacant Chinese apartments and 50% office vacancy rates in Beijing and Shanghai. When I arrived in China, I did not see this, except for some vacant luxury retail malls in second-tier locations. Perhaps some of these vacancy estimates were inaccurate or even hyped to make China look foolish. Claims of 64 million vacant apartments seemed preposterous when urban Chinese people told me they couldn’t find an affordable one, but to bubble theorists I have found the following chart from Wendell Cox of NewGeography.com. (My undergraduate degree was in Geography.) If there is a surplus, it is in the construction of luxury housing, which has been built more rapidly than affordable housing.

In the most recent Jones Lang LaSalle global office space count, the picture became clearer about all that formerly vacant office space in Beijing and Shanghai – it has been leased. By JLL's measures, Shanghai and Beijing ranked first and third respectively in the global absorption of office space during 2011.

Focus on Shanghai

I recently visited the two tallest skyscrapers in Shanghai, side by side, the World Financial Center and the Jin Mao Tower, both exceeding 1300 feet in height. Both have Hyatt Hotels atop office towers each with over 75 floors of office space. The building directories both indicate almost no vacant floors.

Despite such apparent success, there has been a recent re-introduction of a “skyscraper index” theory that portends a coming recession that naturally occurs after a flurry of new “world’s tallest buildings”, a theory that has been recently re-introduced by Barclays Capital’s equity research team in Hong Kong. This theory is not meant to imply causation, but instead reasons that having so many “world’s tallest buildings” built at once is but one symptom of a significant misallocation of capital that creates asset bubbles and resultant crashes. The recently published Barclays paper points out that of the world’s skyscrapers under construction, 53% are situated in China, which will be expanding its stock of skyscrapers by 87% by year 2017.

The crane-dominated Lujiazui skyline. The trapezoidal hole at the top of the Shanghai World Financial Center is designed to reduce building sway from high winds at this 1600-foot altitude. The hole was originally designed as a circle by the Japanese developers, which was perceived unfavorably by older Chinese generations as symbolic of the "Rising Sun" emblem on the Japanese flag -- an offensive reminder of the Japanese occupation during the last century.

Origins of the "skyscraper index theory"

The “skyscraper index” theory appears to date back to a 1999 paper by Andrew Lawrence, research director for Dresdner Kleinwort Wasserstein, perhaps in response to the southeast Asian financial meltdown concurrent with the opening of the world’s new tallest buildings of the time – the Petronas Towers in Kuala Lumpur. The southeast Asian region was collapsing in debt much like the current Eurozone crisis.

Some empirical evidence consistent with the skyscraper index theory

Since the beginning of the 20th Century, there seem to be some interesting correlations.

The famous Panic of 1907 coincided with the construction of two new world’s tallest buildings in New York. The 612-foot Singer Building was completed in 1908 while the old Metropolitan Life Tower (not the one blocking Park Avenue) was completed in 1909 at a height of 700 feet. The one year Panic of 1907 led to an approximate 30% decline in business activity and the severe monetary contraction was the impetus for the creation of the Federal Reserve System.

The 791-foot Woolworth Building in New York was completed in 1913 during the two-year recession of 1913-1914 which saw an estimated 26% decline in business activity as well as a decline in personal incomes. The Woolworth Building was just one of many New York skyscrapers completed at that time.

It was not until 17 years later that three new world’s tallest buildings were completed in rapid succession – the 928-foot Bank of Manhattan Trust Building (40 Wall Street) in 1930, followed by the 1050-foot Chrysler Building later that year, followed by the 1250-foot Empire State Building completed in 1931, all while the nation was sinking into the Great Depression.

It was not until more than 40 years later that the records were shattered by the 1368-foot World Trade Center in New York, opening in 1973, and then the 1450-foot Sears Tower in Chicago, which opened in 1974 amidst the worst U.S. recession since the Great Depression. Interestingly enough, you will find no offices built between the years of 1974 and 1980 in almost any American CBD.

The world height record was not exceeded until 1998, with the opening of the 1483-foot Petronas Towers in Kuala Lumpur at a time when southeast Asia was in financial crisis.

One interesting exception to the skyscraper index theory is the opening of the 1671-foot Taipei 101 building in 2003. Economic disaster did not strike.

Last of all, there is the 2717-foot Burj Khalifa that opened in Dubai in 2010 at a time when Dubai was about to default on its sovereign debt and was rescued at the last moment by its UAE neighbors. Perhaps this is the most obvious example of misallocation of capital as this building still stands largely vacant.

What are the implications for Shanghai?

In 2007, the Shanghai World Financial Center was completed at a height of 1614 feet, exceeding the 1381-foot Jin Mao Tower next to it. More auspicious, however, is the adjacent construction of the Shanghai Tower, which will top out at 2073 feet, making it the world’s second tallest building.

It is interesting to observe that the adjacent Shanghai World Financial Center and Jin Mao towers are both fully occupied. Bubble naysayers can easily say, “Look. All that space got built and leased.” The Shanghai Tower could be a game-changer, though, according to the “skyscraper index” theory, as the bubble just got larger.

Thanks to reader Ms. Ng in Chicago for pointing out that the pavement near these skyscrapers, which were built on landfill, is actually buckling. This appears to be some ugly concrete patchwork.

Not to be outdone by Shanghai, the Greenland Financial Center under construction in the Chinese city of Wuhan is considering a redesign that will have it top out at 2087 feet. When towers are built to assuage civic egos or developer’s egos rather than meet financial measures, watch out – a bubble is in the making.

My own “L.A. freeway model” of real estate bubbles

Those of us who have had to commute to distant jobs in southern California spend a lot of time in freeway traffic and often find patterns to get to our destinations quicker. Here is one pattern I learned early on:

When traffic is moving smoothly on eight-lane freeways, one can drive fastest in the “fast lane”, the lane farthest left in societies where traffic moves on the right side of the road. However, when the volume of traffic reaches a certain saturation point, the fast lane is beset with the most sudden decelerations, causing cars behind to hit their brakes even harder, and the fast lane suddenly becomes the slowest lane. It is during these types of traffic conditions that I make the quickest progress by driving in the far right lane where traffic is entering or exiting.

Liken a fast-moving freeway lane to a fast-moving economy, and the point I make is this: the fastest growing economies experience the hardest landings, or “the most sudden decelerations”. I have witnessed it many times before – Texas in the 1980s, southern California in the early 1990s, and recent examples in Las Vegas, Phoenix and Florida. That is why I say, “Watch out, Shanghai.”

For other information or views on an impending Chinese real estate crash, check out www.Chinesecrash.com.