Academic journal article Journal of Real Estate Portfolio Management

Tiptoe Past the Dragon: Replicating and Hedging Chinese Direct Real Estate

Academic journal article Journal of Real Estate Portfolio Management

Tiptoe Past the Dragon: Replicating and Hedging Chinese Direct Real Estate

Article excerpt

Executive Summary. Despite the large volume of foreign direct investments in Chinese commercial real estate markets, there has been little academic research done to analyze and characterize the risk structure of Chinese commercial properties. This paper examines the risk characteristics of direct property investments in Chinese first-tier cities. It applies macro variable models to analyze the risk structure of office properties in Beijing, Shanghai, and Guangzhou. It then tests a selection of instruments that could be used by investors to hedge the risk of investing in these three markets. It concludes with recommendations that could help investors deal with the risk of direct investments in China's property markets.

"Discard ingenuity, exterminate profit, and there will be no more thieves and bandits." Lao-tzu in Tao Te Ching (Chapter 19)

Few sights are as striking as first-tier Chinese cities when it comes to witnessing the actual effects of economic growth and urbanization in China. Megacities mirror the drastic changes undergone by the Chinese economy since 1979 when Deng Xiaoping decided to put an end to the Maoist era and initiated a new 'Open Door Policy.' Following the entry of China in the World Trade Organization in December 2001, the pace of economic growth has continued unabated, resulting in more intense urbanization and construction projects on a scale unknown before. The tenets of China's miracle growth are well known (Brandt and Rawski, 2008), whereas their repercussions on commercial real estate are still somewhat of an urban myth. Over the past 10 years, Chinese real estate markets have joined the global universe of investable assets as exemplified by vibrant skylines and the construction of startling commercial properties in Chinese megacities. It is now difficult to ignore a market ranked as the third largest globally by invested stock (DTZ, 2012). In recent months, several international financial powerhouses reputed for their business acumen and a track record of savvy investments (e.g., Soros, KKR) have decided to enter the Chinese direct commercial real estate markets, hoping for many happy, albeit possibly somewhat late, returns.1

International investors who are often mesmerized by the historical growth and potential size of the Chinese economy, as well as the reassurance by Chinese authorities that their commercial property markets are sound, might not have a clear understanding of the nature of the risks they face in China. Notwithstanding the focus on operational and legal risks whose need was emphasized by some highly publicized cases of international investors being caught in the complex system of Chinese guanxi, international investors venturing into the Chinese direct property markets are faced with many macro risks that have to be addressed.2 Surprisingly, despite the large volume of foreign investments in the Chinese commercial real estate markets, there has been little academic research done to analyze and characterize the risk structure of Chinese direct commercial properties. As a matter of fact, while research on securitized real estate markets in Greater China is quite frequent (e.g., Liow and Newell, 2012), studies pertaining to the Chinese direct real estate markets are scarce, due in large part to the difficulty in accessing relevant data. For instance, Tse, Chiang, and Raftery (1999) analyze the risk of office properties in Shanghai, Guangzhou, and Shenzen based on the Security Market Line. Academics have considered the issue of inflation hedging and direct real estate in the Chinese context (Chu and Sing, 2004; Lecomte, 2012) but have not applied to China the type of analysis that has been used to scrutinize commercial properties in Western markets (e.g., Kling and McCue, 1987; Geltner, 1989; Ling and Naranjo, 1997; Liang and Mcintosh, 1998).

Using a database never applied before in the academic literature, this paper fills in the gap by studying the risk characteristics of direct office property investments in three first-tier Chinese cities: Beijing, Shanghai, and Guangzhou. …

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