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Ivanhoé's big bet on China's middle class

Pedestrians walk past commercial buildings in the Pudong area of Shanghai, China, on Wednesday, Jan. 30, 2013. China's economic growth accelerated for the first time in two years as government efforts to revive demand drove a rebound in industrial output, retail sales and the housing market.

Tomohiro Ohsumi/Bloomberg

Huang Jia Ying stands in front of an Italian coffee shop in Shanghai with an iPhone 6 in one hand and a $10 Godiva ice cream cone in the other.

She has short cropped hair, wears a loose sweater and clutches a black Michael Kors purse as she takes a break from Saturday afternoon shopping. She's placed three overflowing bags from American Eagle Outfitters on the ledge of a concrete fountain, next to a hip, young father resting beside a hot pink stroller.

"I come to hang around, to buy clothes, have dinner," says Ms. Huang, who works in customer service for a Fortune 500 company.

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Obviously not poor – she has relatives in Vancouver, but chooses to stay in China – Ms. Huang is not a millionaire, either. She explains that this retail complex – called the Life Hub @ Daning – has more affordable brands than the luxury malls in central Shanghai. And she's not about to go shopping at Prada, either, noting that English lessons for her daughter are beginning to strain her finances.

"I only shop at sales," she says, gesturing to her bags. "American Eagle is 35-per-cent off right now."

Ms. Huang is one of China's new urban, middle-class consumers. And she is at the centre of a big bet on Chinese real estate being made by one of Canada's largest overseas real estate investors: Ivanhoé Cambridge, the real estate arm of the powerful Caisse de dépôt et placement du Québec. Ivanhoé Cambridge – which has $48-billion in property assets around the world – teamed up with a Dutch pension manager earlier this year and injected $920-million (U.S.) into Chongbang Group, which developed the Life Hub @ Daning project, along with several others.

When some global investors think of Chinese real estate, they visualize the excesses of Beijing's infrastructure-building binge in the wake of the global recession: Eerily deserted ghost cities of endless, towering apartment blocks; enormous, empty malls of darkened shops; corrupt local government officials in provincial cities presiding over massive property-related debt that could represent a systemic shock to China's economy.

But when Ivanhoé Cambridge thinks of China's real estate market, it is thinking of top-tier cities such as Shanghai, not remote corners of the Chinese hinterland; and it is thinking of well-off – but not absurdly wealthy – consumers such as Ms. Huang, who form the backbone of the burgeoning Chinese middle class. China, in turn, is powering a broader, longer-term shift of the world's middle-class wealth from Europe and North America to faster-growing parts of Asia, where huge populations are gaining disposable income.

With roughly $1.2-billion invested in China, Ivanhoé Cambridge is betting talk of a China slowdown is overrated, and that Beijing will be able to orchestrate a transition from an export-oriented manufacturing economy to sustainable growth based on domestic consumption and a middle class.

A focus on emerging markets

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Rita-Rose Gagné, Ivanhoé Cambridge's executive vice-president in charge of growth markets, is a busy woman: She's on the road nearly 50 per cent of the time. In early November, she arrived in Shanghai for the Montreal mayor's trade mission to China, and was leaving later that week for New York to speak at a conference before returning to Montreal for a weekend with her family. Ms. Gagné was then off to Brazil, where she chairs Ancar Ivanhoe, a joint venture with Brazil's Carvalho family that is now a top-five player in Brazil's shopping centre sector. Ivanhoé Cambridge has about $2-billion (Canadian) worth of assets in Brazil, the firm's largest emerging market. But growth markets still only account for about 9.2 per cent of Ivanhoé Cambridge's total investments. That figure is going to go up, Ms. Gagné says.

"It's about to double at least," Ms. Gagné says, noting that the growth markets team has expanded rapidly in the past year and a half to 22 people, with 10 on the ground in China. "Our role is to position Ivanhoé Cambridge for the next phase of growth."

That growth is the emerging middle class in places such as China and Brazil. Unlike emerging-market equities investors, though, which can tap into country-wide economic growth through companies selling consumer goods, real estate investors – and particularly more cautious pension funds like Ivanhoé Cambridge – have to be much more specific. That doesn't mean Ivanhoé Cambridge will never invest in second-tier cities, Ms. Gagné says, pointing out that these cities can have populations above 10 million. It just means that for now, they can't invest in less predictable places on the assumption that booming growth will spread there in 10 years time. For Ms. Gagné, for now, that means investing in places such as Shanghai.

"We're pretty focused on the big cities," she says, as a mini-bus zooms her and top executives from Chongbang Group to one of their development sites outside of Shanghai. "It costs you to invest in first-tier cities. But we're a pension fund. We need to look at the risk-return ratio."

But even within greater Shanghai – with a population of about 23 million – there is a need to be site-specific. In the city of Kunshan, which is roughly 20 minutes by high-speed train from a major Shanghai train station, real estate is roughly $2,500 per square metre – and that's where Ivanhoé Cambridge and Chongbang Group are building a massive, mixed-use residential, commercial and retail project called the Life Hub @ Kunshan. That allows Ivanhoé Cambridge to tap into the right macro-level trends: middle-class growth, as young Chinese continue to move from the countryside into cities. In central Shanghai, though, where some real estate has New York prices, per-square-metre costs skyrocket to $10,400 – and it becomes a luxury play.

"One mistake investors have made in China is focusing on luxury," Ms. Gagné says, as she gets out of the bus at the Kunshan project. "This is the higher bracket of the middle class. It's not low-end, mass market. This is a much more sustainable model for China. We're focusing on young, professional families. It's a very good fit."

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To do that, Ms. Gagné says, you need a good partner.

"If you look at who has made money in China and who hasn't, it usually comes down to their partners."

'Bonjour! Welcome to Kunshan!'

Fannie Leung, Chongbang Group's cheery marketing head, walks across a wide road in Kunshan – which is effectively a distant suburb of Shanghai – and up to one of the deer statues scattered across the grass. She chooses a bright blue deer with pink antlers and legs. A young woman's face is painted on the deer's white chest, while cartoons of lipstick, makeup brushes and compacts decorate its flank. Ms. Leung smiles as she gives the deer's flank a slap, prompting it to deliver an ode to their Québécois partners.

"Bonjour! Welcome to Kunshan!" the deer says.

Ms. Leung leads the group past the deer – a temporary condo marketing trick that is dwarfed by larger, permanent deer statues nearby – and through the ongoing construction of office space to a grassy spot in front of the huge 30-storey apartment blocks that make up the residential bulk of the project. Henry Cheng, Chongbang's ebullient chief executive officer, gazes up at the building and begins his sales pitch for their particular brand of real estate.

Mr. Cheng, who is from Hong Kong, has been based in Shanghai for 22 years. With his previous company Shui On Group, he was responsible for one of Shanghai's most well-known development projects: Xintiandi, an area of bars, shops and cafés built of revitalized Shanghainese shikumen lane-way houses channelling Shanghai's romantic 1920s vibe.

He divides the past 20-odd years of real estate experience into two broad phases. From 1992 to 2000 was the era of quantity, he says, the early years of China's opening when China bloomed with thousands of apartment blocks and Shanghai swampland sprouted China's highest skyscrapers. The second era, from 2000 to about 2010, was what he calls the era of quality, when projects like Xintiandi opened up and competition got fiercer between developers fighting for prime land as prices began to skyrocket.

"Now we are entering the third phase – the survival of the fittest," Mr. Cheng says. "Quantity no longer counts. Even quality isn't enough. Now you have to be different."

For Chongbang's executives, different means more than creating mixed-use real estate projects that blend office, retail and high-quality residential apartment units that come fitted with appliances – unlike some other cost-cutting developers, Mr. Cheng said, pointing to a large development across the street in Kunshan that sold empty apartments that require hundreds of residents to begin installing toilets and kitchens as they all move in at the same time. It also means creating physical spaces for events and scheduling hundreds of activities, concerts and shows each year, he says.

At the Daning Life Hub in Shanghai, there were various children's activities going on – a Halloween show scheduled for the night, several rehearsals for amateur theatre productions and a pop-up stand selling ukuleles. Many of the people were shopping there all afternoon, letting their children run free as they enjoyed the day.

"All the surveys show that retail in China is a leisure activity. People want to spend a few hours," says George Agethen, senior vice-president for Asia-Pacific in Ivanhoé Cambridge's Hong Kong office.

Chongbang's Life Hub projects are located mainly in satellites or suburban neighbourhoods of Shanghai. There is one in Kunshan, a suburb connected by high-speed rail that is popular with young professionals who can work in the foreign businesses there; one in Anting, which is located near a lot of the Shanghai region's auto factories; and there is the Daning Life Hub, as well as one in Shanghai's Jinqiao neighbourhood, both of which are on the city's subway system.

Mr. Agethen notes that growth in China occurs in pockets, and that although the national economy has dipped to 7-per-cent gross GDP growth, satellite cities around Shanghai are still growing between 8 and 9 per cent. Ivanhoé Cambridge and Chongbang have used these areas as staging grounds to focus in on a highly particular segment of China's broader middle-class growth story: Young, newly-urban professionals who might be coming into real disposable income for the first time, and might care about things – such as greener cities, urban transportation connections, higher-quality shopping and leisure options – that were distant concerns before.

By some estimates, the European and North American share of the global middle class will shrink from roughly 50 per cent today to about 22 per cent in 2030, while Asia will grow to account for 64 per cent – and about 40 per cent of middle-class consumption. By 2030, the Asian Development Bank estimates that China alone will account for 20 per cent of the world's middle class.

"It's the aspirational middle class," Mr. Agethen says. "It's what we're after, all over Asia. It's what everyone's after."

The risk from real estate

Back at the Daning development in northern Shanghai, not too far from the retail complex's Starbucks, Xu Yun is trying to sell luxury condos from an elaborate booth with a small-scale model and a clown making balloon animals. Ms. Xu works for China Jin Mao Group Co. Ltd., a large commercial developer that built Shanghai's iconic Jin Mao tower in the financial district, an 88-storey building located at 88 Century Ave. (The number eight is considered lucky in China.)

Jin Mao is just getting into residential. But even though its new development – 10 buildings between 15 and 22 storeys – is on what some consider the city's outskirts, a luxury three-bedroom apartment still costs about $2.7-million (or $16,700 per square metre).

"There's only two buildings left," Ms. Xu says. "We sold a lot of apartments here when we did the first round of promotions. Every time we do a round of promotion, we sell out quickly."

Admittedly, this is the type of luxury property that Ivanhoé Cambridge has tended to avoid. But it still gives a sense of China's hot housing market.

Over the past decade, real estate investment and construction have been a key driver of China's furious growth, and accounted for 15 per cent of China's GDP in 2014 – up from just 4 per cent in 1997, according to the International Monetary Fund.

Residential housing, in particular, makes up 15 per cent of fixed-asset investments in China and 15 per cent of total urban employment, and also accounts for 20 per cent of Chinese bank loans. House prices did slip in 2014 – as well as in 2006 and 2010 – but there was no significant impact on retail spending during these downturns, according to London-based research firm Capital Economics. Price slumps may affect wealthy buyers with multiple properties, but slight moves don't make any difference to owner-occupiers, and actually help make apartments more affordable for first-time buyers. House prices are now rising again, but in historical context they have actually fallen relative to rising incomes by as much as 40 per cent over the past 15 years because of strong household income growth.

Given the huge boost new housing and infrastructure give to the overall Chinese economy, some analysts are only really concerned about housing starts and construction, given that they have powered so much of the Chinese economy. On that note, there are some concerns: In 2014, there was a contraction in new housing starts and falling investment, and worries that residential prices were beginning to fall.

In a macro sense, there is risk to the broader Chinese economy and financial system from real estate. Massive overbuilding in remote areas, encouraged by local officials more concerned about keeping up local GDP growth than long-term sustainability, may leave some overleveraged developers vulnerable if housing demand slips, or falling prices erode their collateral. The Chinese banks that lent that money would also be at risk, and there are concerns that China's broader slowdown could raise the number of non-performing loans to 4 per cent from 1.5 per cent, according to Barclay's analyst Victor Wang.

"There's a lot of volatility in these markets," Ms. Gagné says. "So that's why you want a long-term partner, to be able to go over these cycles, to weather these swings."

However, unlike in 2012, when the Chinese government implemented new policy measures to cool what Beijing saw as an overheated, dangerous property market, the declines in 2014 were not a result of new policies, but the market adjusting to various factors, such as obvious oversupply. Moreover, this oversupply – as well as some of the worries – tends to be somewhat restricted to more remote Tier-3 and Tier-4 cities, which saw some of the most rapid expansions of real estate during the boom years. Tier-1 cities, such as Shanghai and Beijing, where real estate has soared in recent years and is now at a premium, account for just 10 per cent of China's total floor space, according to the IMF; whereas Tier-2 cities, such as provincial capitals, account for about 50 per cent and smaller Tier-4 cities account for about 40 per cent.

But since the end of last year, the People's Bank of China has cut interest rates six times. Policy makers in Beijing also introduced new policies aimed at boosting the housing sector: They reduced the minimum down payments necessary on second homes and extended capital gains tax exemptions to sellers who had owned their home for at least two years – something that previously only applied to sellers who owned homes for five years or more.

Strategic partners

Ms. Gagné notes that China's markets can seem opaque, but that strategic partners with local knowledge come armed with specific statistics and figures to sort through the mess. That makes the market seem transparent, she says, and Ivanhoé Cambridge now has a number of investments in the country in real estate, including a mall that opened in 2011 with another partner, and also in logistics, an industry Ms. Gagné feels is ripe for transformation.

In China, Ivanhoé Cambridge expects returns well above 10 per cent over the next 10 years. And Ms. Gagné now travels to Shanghai all the time.

"If you don't do the travel, you would think China was just ghost towns and empty buildings – though there are those," she said. Laughing, she adds: "I arrived in Shanghai at one point, and it felt like arriving home. And I thought, what's wrong with this picture?"

In Anting, Mr. Cheng walks through their modern mall with Ms. Gagné. The mall features a library, a bowling alley and a clubhouse on the roof for members who live in the nearby apartments. The mall was designed to be open and ventilated so that it requires no heating or air conditioning. On a rainy Sunday in early November, it is cool inside and visitors stroll past Haagen-Dazs and Samsung stores in their jackets, but the mall is packed and a group of children are sliding down an art installation on the ground floor – near a display for an electric car.

Mr. Cheng says apartments attached to the mall have doubled in price recently, and that there is a long waiting list. Standing outside, Mr. Cheng looks across the street to a competitor's mall, which seems as empty as his is bustling.

"I'm proposing to buy that mall," Mr. Cheng says, as an assistant shelters him with an umbrella. "If you have the necessary capital, and the gut for it, you can go very far."

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