Opportunity Beyond The Advantaged Few

This article was originally published on Pere, The China Report 2015.

The dominance within the Chinese logistics space by international investment platforms and certain large e-retailers does not diminish the prospects of the sector for those willing to take a bottom-up perspective, explains Chris Lerner, partner and head of Asia for placement advisory firm Eaton Partners

Over the past few years, concerns about oversupply in the Chinese real estate market have not been hard to find, despite China’s economic resilience following the global financial crisis. The easing of credit and influx of liquidity helped China sustain a remarkable bounce back between 2009 and 2011, sparking questions of economic decoupling for the first time.

Investment in the property and infrastructure sectors continued to be among the most significant contributors to the republic’s ever expanding GDP. However, in 2011, concerns about over inflated asset prices led the Chinese government to begin implementing curbs. As a result, last year saw the culmination of a slowdown in the property sector and real estate investment drop to a five year low.

One segment, however, has emerged as a bright spot: logistics.

Amazon-sized demand

The massive IPO of Alibaba Group last year propelled the subject of logistics to the forefront of discussions on real estate in China. While the fundamentals driving this real estate sub-sector are pervasive, Alibaba itself seems to epitomize the market potential. In 2013, Alibaba’s sales surpassed that of Amazon and eBay combined.

In that same year, the e-commerce giant delivered approximately 5 billion packages; more than UPS delivered globally. Then, on November 11 of last year, the Taobao unit of Alibaba generated a record $9.3 billion in sales in one day, over 4.5 times the amount of sales on Cyber Monday in the US.

This boom in China’s e-commerce sector is indicative of an overall market trend that is expected to continue. According to projections from iResearch, online retail sales in 2017 are expected to double from 2013 levels, making China the world’s largest e-commerce market. Yet, e-commerce, where penetration remains lower than in the UK and US, is only one facet of retail and the highly intermediated wholesale distribution network driving the flow of goods within China.

Companies like Alibaba and other retailers are representative of China’s greater shift from investment and export-driven businesses to ones based on consumption. As this shift becomes more pronounced and Chinese consumers increase their demand for timely shipping, the supporting logistics infrastructure will have to expand and existing facilities will have to be modernized.

“China has one of the largest e-commerce markets in the world by both volume and value yet it possesses the most underdeveloped logistics fulfillment infrastructure of all the leading e-commerce markets globally,” says Martin Tacon, a Founding Partner of Hong Kong-based property fund manager Sniper Capital, which invests in real estate private equity in China.

Privates leading the way

While China’s government has recognized the need to modernize its logistics facilities as indicated in the last five-year plan from the Ministry of Industry and Technology; the real change is being driven by the private sector.

Private equity investors and others have already begun to take interest in the logistics sector and we’ve seen a wave of deals in the past 12 months. In May, the Dutch pension fund manager APG Asset Management, struck a deal to buy about 20 percent of Chinese warehouse developer, Shanghai e-Shang Warehousing Services, for up to $650 million. Four months later, Singapore-listed developer Global Logistic Properties announced a deal to invest $324 million for a 15.3 percent stake in China’s largest state-owned warehouse logistics provider, CMST Development Co. Private investment manager RRJ Capital and Singapore state investor Temasek Holdings agreed to invest $250 million in one of China’s largest warehouse developers, Shanghai Yupei Group. That deal came about two years after The Carlyle Group and The Townsend Group invested $200 million in Yupei Group.

Larger deals are also beginning to emerge. The Blackstone Group recently formed a joint venture with Vanke, China’s largest property developer by revenue to fund opportunities in the logistics real estate sector.

Despite the flurry of recent activity, logistics space per capita in China is still less than 10 percent of that in the US.  Acancies in the sector continue to decrease, and net absorption levels have been consistently sustained over time.

As a result, current yields, not to mention development cycles, look particularly attractive when compared across  commercial, retail and residential sectors in China. With GLP’s 2014 annual report announcing it expects the market size by value in China’s logistics property to be in excess of $2.5 trillion by 2029, it is no wonder China sits atop the Ti Emerging Market Logistics Index. The Urban Land Institute and PwC have ranked China warehouses the most promising property type for 2015 in Asia.

Inadequate and concentrated supply

Even with the recent investment by the private sector, China’s logistics facilities and warehouses are woefully inadequate to meet the underlying needs and growth of the economy. According to a recent report by CBRE Global Research and Consulting, modern logistics facilities only account for about 2 percent of the total stock in China. That stock has worked for decades as warehouses were once supported by low cost manpower, and originally built for industrial storage and  xporters, not the new wave of e-commerce companies, express delivery, cold chain logistics, and modern supply chain  services. As a result, China has the highest logistics cost to GDP globally as reported by Morgan Stanley Research.

To make up for this problem, some large retailers and e-commerce companies have decided to build and operate their own logistics facilities ala Amazon. That strategy can work for the very largest companies, but the majority of retailers in China face a number of barriers including upfront capital requirements, expertise and operation management, all which come with added risks and costs. Most of these companies will look to lease warehouse space and logistical facilities from  thirdparty companies that can operate more efficiently and have vast networks of distribution centers.

Moreover, as Vincent Cheung, President of BPS Global, one of the leading privately held logistics and supply chain management consultancies, observes: “last mile delivery costs often represent up to 10 percent to 15 percent of an average online purchase. With free shipping already the market standard in China, the efficiencies to be gained by working via modern warehouse facilities are economically significant.”

Even though new supply is undoubtedly coming online, approximately one-third of new investment is targeted in the city’s bonded areas, according to global real estate firm  Colliers International. The highly regarded specialist developers and private equity-backed logistics players such as GLP,  oodman, Proligis and Yupei need to work closely with municipal governments to secure properly zoned land and have been focused on addressing major hubs in the value chain where there is a strategic need and ability to put large amounts of capital to work.

But such concentration does not begin to solve for issues facing the intricate network of roadways and railways spread throughout the country, where the dearth of logistical warehousing facilities can be easily seen. The fragmentation at this end of the market seems to underscore a whole other opportunity set.

Unlike most cities in the US, “Chinese residential communities are uniquely vertical in nature, providing very high levels of residential densities in almost all major Chinese cities,” adds Tacon of Sniper Capital. “Combining this with the high levels of internet and e-commerce penetration yield rapidly growing demand for last mile logistics and high volume, small package delivery infrastructure.”

Delivering on the promise

Big ideas and large market opportunities attract attention, especially in China. Given its inherent tie to the long term, secular growth of the economy, and the strategic importance of modern logistics to bring needed productivity  improvements to the country, the investment opportunity in logistics is no exception. The role of good private market investors is to identify and cultivate specific opportunities to buy into that growth at a reasonable, if not advantaged, price, and then find ways to add value to augment performance.

This is a fundamentally bottoms up proposition. Therefore, our view is outside of the advantaged few with unique access and those with existing operational scale, winners in this segment will stick with a focused, hands on strategy, and  capitalize on customized solutions and off-market opportunities around Tier 1 cities where the demand is greatest, and rental rates and assets prices hold.