April 29th//PT China

The Partners Trust China Report–First Quarter 2016

Sean Mei, Founding Partner of Partners Trust China, recently presented at the Leverage Global Partners Navigate 2016 conference and has prepared comprehensive research on the Chinese market.

An abbreviated version of his findings is below. For the full details, please download the Partners Trust Quarterly Report.

China has been in the new more and more in the past six months. While Chinese investment continues in the U.S., circumstances have definitely changed. As someone who is based in Shanghai and meets with investors and analysts on a regular basis, I have a unique window into the mind of the Chinese investor.

General Economic Feeling in China
‘Volatility’ and ‘Uncertainty’ are the two best words to describe the general sentiment in China about its economy and the near future. While China’s revised forecast for 2016 sets the lowest economic growth target (at between 6.5% to 7%) in the past 26 years during the recent, the hard landing that many economists had predicted has still not happened. Policies are changing very fast.

Changes were announced and are being implemented regarding foreign currency control, government spending – reduction in domestic spending, drastic lowering of foreign reserves to protect the value of the RMB, an increase in overseas spending for state-owned enterprises under the One Belt One Road strategy.

The general sense is that it remains wise wherever and whenever possible to hedge bets and invest in overseas markets. Outward Direct Investment (ODI) has reached never before seen levels over the past six months.

China Outward Direct investment (ODI) 2016 forecast
Fueled by uncertainty about China’s domestic market, a devaluing RMB and the draw of a more stable US and overseas market, in this first quarter alone, China’s ODI is exceeding $54 billion, following historic high of $118 billion in all of 2015. Who is doing this buying? The majority are still state own enterprises but private conglomerates are joining the action. Many of these firms are trying to either buy before the RMB may further devalue or for similar reasons, companies with high levels of foreign debt have been racing to pay off their debts in the last 6 months. So much money has flowed out of China in a short amount of time, that the government in January further tightened regulations restricting individuals’ capability and ease of moving funds out of China thereby directly affecting the real estate market in the US and California.

New Laws and Policies affecting Investment and Liquidity
The restrictions on foreign currency exchange further restrict the annual limit of US$ 50,000 that each individual has to exchange funds. The practice of being able to collect larger amounts by mobilizing relatives and friends and use their quotas has for the time being all but been eliminated. So has the capability to withdraw cash overseas on ATM’s by Chinese citizens, which was a loophole in the system. However, these restrictions are expected to be short-lived. While in the short-term, Chinese leaders are trying to provide stability by re-assuring investors and industries whose financial performance are tied to a stable relationship between the RMB and the USD, by managing the outflow of RMB, at the same time China remains on its path to turn the RMB into a freely tradable international currency. Managing these two seemingly contradictory policies is China’s true balancing act, which ultimately has far-reaching implications on US real estate.

Ultimately, the long-term goal of internationalizing the RMB will lead to loosening of the policies and restrictions on currency exchange. In fact the lowering of the economic growth target is a positive sign that central government planners can accept more modest and therefore more sustainable growth targets that in the past decade was too dependent on large scale state-owned enterprises and not enough fueled by consumer spending.  The momentum towards a freely traded RMB/CNY is virtually unstoppable and more a matter of timing. When that happens, a potential floodgate of ODI by individuals becomes highly probable.

The USA and in particular the West Coast remain the historical frontrunners as one of the first destinations for such investors.

Who are the Chinese Investors?
To take full advantage of the ODI from China, it is critical to realize who these investors are. Broadly speaking there are two main categories of investors, individual and institutional. A further distinction is as follows:
1) Institutional Investors
a) State-owned enterprises – large deal sizes, most often initiated by demands from within the organization, focus on trophy properties/ acquisitions that fall in line with political or economic strategies, tend to overvalue the acquisition targets. Difficult to get involved in, only through lengthy (and potentially costly) engagement to earn trust and be included within inner circle.
b) Private enterprises including large enterprises which are most often publicly traded companies, listed in China, HK or the US. Acquisitions are generally like most acquisitions by large US companies. High premium on performing detailed financial due diligence. Swiftness of deals tends to be a function of how much power is concentrated with original founders/ executive teams. Small and medium enterprises tend to be just entering the ODI game and are often headed by small number of owners/ decision makers. Unlike the large State-owned and Private large enterprises, may have difficulty to legally move funds out for investment purposes. This segment needs the most help and are motivated to seek expertise.
2) Individual Investors
a) Chinese with foreign citizenship may already have experience in investing overseas. They tend to come from China’s three largest cities, Beijing, Shanghai and Guangzhou. They are savvy and do a lot of their own due diligence. They will seek out brokers and consultant when they feel they need it. They seek opportunities but because they also tend to have excellent language skills many opportunities compete for their attention. This group already has means to get money out of China and have access to overseas financing.
b) Chinese Nationals who have not acquired citizenship yet and may not be not interested in that. Repeat investors in this group invest overseas because of wealth diversification or preparation for future education of their kids or eventual retirement but their business and immediate future is solidly based in China. They tend to make trips overseas for investment purposes and follow the advice and investment trends of their closest relatives or business associates that have overseas citizenship or PR.  They tend to rely on Chinese language promotional information and Chinese language channels for their own due diligence.

First-time international investors, who often live in second and third tier cities know that investing overseas is something they must do.  They will rely on Chinese language channels and domestic brokers and consultants to help them. They also tend to have the hardest time to get funds out currently and are the least familiar with financing possibilities. This however is a vast group with great potential. This group comprises many of the tours that travel overseas to look at different investment opportunities.They need experts who not only speak Chinese but are familiar with their culture, which is not as cosmopolitan and worldly as the above categories that tend to come from China’s three largest cities.


What does all this mean then for US real estate companies and professionals?

In the short term, estimated next 6 to 12 months, China’s domestic policy changes in real estate property tax structure and personal income tax combined with the foreign currency limitations for individuals are designed to motivate Chinese investors to first look at domestic 2nd and 3rd tier city markets and invest in the surplus of real estate there. China’s investors, whether institutional or individual have a continuing desire to invest overseas but are held back in short term by foreign currency limitations.

When China’s currency becomes freely tradable, expect the floodgates to open. US real estate companies should prepare for what is anticipated to become a massive opportunity, especially in California, which remains a top destination for Chinese investors.

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