CorenetGlobal 2015 China Report

CHINA MANUFACTURING & INDUSTRIAL MARKETS1

M A N U FA C T U R I N G & I N D U S T R I A L M A R K E T S

By Beth Mattson-Teig

CHINA

PRIORITYRESEARCH

EXCLUSIVE

RESEARCH


In recent years, China has been working harder to distance itself from its early role as a low cost producer of goods and position itself as an advanced manufacturer and hub for innovation, R&D and higher technology. China is moving up the value chain, and the investment into the industrial sector has to recognize that and to look at where the demand is going in terms of what products are being produced, says Stuart Ross, head of industrial, China at JLL in Shanghai.

To get a clear picture of Chinas industrial and manufacturing marketwhere it is at and where it is headedit is important to fi rst take a closer look at the countrys economy. China has changed over the past decade from a lower world power to one of the largest economies in the world. In fact, the International Monetary Fund recently elevated Chinas rank from the second to now the largest economy in the world valued at $17.6 trillion,

China is in the throes of transformative change as its industrial and manufacturing markets continue to mature. Those changes are having a sweeping effect on corporate location decisions, supply chain management and business strategy.

Companies ADAPT NEW STRATEGIES AS INDUSTRIAL & MANUFACTURING MARKETS MATURE.


edging out the $17.4 trillion U.S. economy. Given that formidable size, it is no wonder that signs of weaker economic growth have sparked concerns about the potential impact of the slowdown.

As reported by the National Bureau of Statistics of China, the annual growth rate in Chinas GDP averaged 9.08 percent from 1989 until 2014, reaching an all-time high of 14.20 percent in the fourth quarter of 1992 and a record low of 3.80 percent in the fourth quarter of 1990. However, Chinas growth has been slowing since 2012. GDP expanded 7.30 percent in the fourth quarter of 2014 over the same quarter of the previous year.

I think some of the concerns related to the slowdown in economic activity and falling growth in GDP rate are perhaps misinterpreted by the public outside of China, says Ross. If Chinas GDP falls to a rate below 7 percent, then the perception outside of China is that the country is falling into recession. However, you cannot grow the China economy, which is as large as it is today, by double digit GDP growth, notes Ross. In fact, JLL expects that GDP growth will likely fall further in the coming years. Our internal economists and research team believe that 5 percent by 2020 is probably going to be a reasonable growth rate given the size of the economy by that time, he says.

Chinas economic growth momentum has slowed down, but in recent months there has been a bit of an uptick, adds Frank Chen, executive director, head of research in China for CBRE. I think the key reason is because the central government has witnessed a slowdown in economic growth since the beginning of 2014, and they are trying to rejuvenate the economic growth by what they call targeted stimulating measures, he says. They do not introduce massive or overall stimulating measures like what happened after the financial crisis in 2009, rather they are just trying to provide more targeted stimulating measures for stimulating industries.

Certainly, corporations are keeping a close eye on the potential impact from slower economic growth. At the same time, the industrial sector is evolving and companies have to adjust their business in a changing market. In some cases, the numbers that are produced, such as the slowdown in PMI or other manufacturing indexes, reflect the slowdown of legacy businesses polluting industries or industries that relied on generating power from coal. Now there is greater re-direction of capital to cleaner industries and value-added industries, notes Ross.

1 China GDP Annual Growth Rate. National Bureau of Statistics of China and Trading Economics. http://www.tradingeconomics.com/china/gdp-growth-annual


2 Hyundai Expands Plans for Additional Chinese Production. In-Soo Nam. The Wall Street Journal. Dec. 30, 2014.

Much of the manufacturing base is moving inland because of higher labor costs and higher land prices along the coastal areas, says Chen. There also has been a shortage of labor supply in recent years in areas such as the Pearl River Delta and the Yangtze River Delta. As a result, some manufacturers are shifting their operation base inland, to West China or to other developing countries such as Cambodia, Thailand or Bangladesh.

Chinas trend of urban regeneration also is fueling a manufacturing shift from first tier to second tier cities, says James Shepherd, MRICS, executive director, head of research, Greater China for Cushman & Wakefield in Shanghai. Even among second tier cities, a similar shift is underway as undesirable industry or very low end manufacturing that relies on unskilled labor at minimal costs moves further out to third and fourth tier cities, he adds. As first tier cities continue to evolve we are seeing migration of low tech industry to surrounding cities and provinces, says Shepherd. The government is supporting this evolution as it raises the game of the first tier cities as they position more towards tertiary industry and meanwhile supports those less well developed cites with secondary investment, bringing valued employment and tax revenues whilst supporting the development of local business hubs and clusters.

There is still a massive stock of low end manufacturing space in second tier cities, much of which is owned by local businesses that are becoming increasingly sophisticated in their production needs, says Shepherd. These old facilities are outdated and becoming inefficient to operate. In highly evolved first and second tier Chinese cities local governments and customers are increasingly challenging such factory owners on subjects such as safety for workers, whether or not building code is being met and pollution, he says. Meanwhile, staff turnover is a continual problem and staff costs in well developed areas are growing quickly. For many such business owners a relocation therefore makes a huge amount of sense and creates an abundance of new real estate opportunities and cost savings, he adds.

Another notable trend in the manufacturing sector is the emergence of industry clusters. There is a lot of clustering going on in China, and companies are more comfortable relocating to an area where like firms are already located, because they know they are going to have, perhaps the utilities support for their particular industry, or the government support or the suppliers or sales market that is accessible to that location, says Ross.

Auto manufacturing, for example, is developing huge hubs in all parts of China. Volkswagen and Toyota are among those auto manufacturers that have set up manufacturing bases in Chengdu. Wuhan is another strong auto center with the likes of Nissan and Peugeot. Hyundai Motor Co., for example, is expanding its operations in China with two new production facilities. The company currently operates three manufacturing facilities near Beijing and is building two additional factories to boost its production. The new Hyundai plant in the Hebei province is expected to start production in 2016, while a second plant in Chongqing will be completed in 2017. In addition, General Motors Co. reportedly plans to invest $12 billion to build more plants in China by 2017, and Volkswagen AG plans to invest $22.1 billion in China by 2018.

Industry clusters is a concept that has been adopted by many local governments, says Chen. For example, a number of Tier II cities, such as Chengdu and Wuhan, have adopted new high-tech economic development zones. Chengdu also has invested heavily to attract high tech manufacturers such as Intel and Foxconn. In addition, technology clusters have developed within some business parks. It is the idea that is adopted by a lot of local governments, but whether they can be as successful as Californias Silicon Valley is a question that has yet to be answered, he adds.

Two key industries driving growth in Chinas industrial real estate market are manufacturing and logistics. Both sectors are experiencing dynamic change. Rising labor and land costs are two of the key factors shifting the manufacturing landscape.

EVOLVING MANUFACTURING MARKET


LOGISTICS: SHORTAGE OF SPACE

3 China50, Fifty Real Estate Markets that Matter. JLL. 2012.4 Preparing for Chinas Middle Class Challenge (Part 1). Gordon Orr. McKinsey & Company.

March 31, 2014.

As low-cost manufacturing moves outside of China to other low-cost countries, logistics is increasingly being steered by the supply chains of value-add and advanced manufacturing industries, such as auto manufacturing and technology.

In addition, the logistics market is feeling more and more pressure to supply Chinas surge of middle income consumers. Double digit sales growth in both traditional retail stores and online e-commerce is fueling more demand for growth in the logistics sector. At the same time, the logistics market continues to battle challenges that include a high cost of transporting goods and limited supply of quality warehouse and distribution facilities.

China has made significant investment in improving its transportation infrastructure, most notably roads, rail and airports. However, one of the stumbling blocks in the logistics sector is that the market is still heavily undersupplied in terms of high quality, efficient facilities, notes Ross. The undersupply is an important topic for both occupiers of space and

investors and developers. The U.S., for example, is home to a population of about 320 million. In comparison, Chinas rapidly growing middle class has already exceeded that and is projected to reach 630 million by 2022, according to a report by McKinsey & Company.

Now compare the supply of warehouse space in the two countries. In the U.S. there might be 160 to 170 million square meters of high quality space in modern logistic facilities. In China, there is less than 50 million square meters in that sector, says Ross. So China has a significantly larger market, yet it has only about one-quarter or one-third of the warehouse and distribution stock. In addition, the cost of transporting goods and the cost of the overall supply chain is much higher in China than compared to the U.S. or other mature markets. So there has got to be ongoing rationalization of the supply chain, otherwise it will be difficult for companies to move from older facilities to newer facilities with higher rents, he adds.

The logistics industry is a vital part of Chinas broader industrial market, and it too is undergoing significant sea change. According to JLLs China50 report, the logistics network is the backbone of economic growth and continued modernization in China.


GROWING CONSUMER DEMAND

Year over year retail sales growth in China averaged 14.56 percent from 2010 until 2014. That growth has slowed in recent months with November data showing year-over-year sales growth of 11.7 percent, according to data from the National Bureau of Statistics of China.

Much of the logistics growth has been concentrated around the Tier I cities to support the large populations that exist in major cities such as Shanghai, Beijing and Nanjing. Companies tend to locate regional distribution centers closer to those Tier I cities and are increasingly consolidating several smaller facilities into one or two major regional distribution centers that offer some efficiencies and economies of scale. Companies are not just moving from one facility to a better quality facility, but consolidating a number of facilities into one larger regional distribution facility, says Ross.

However, that middle class is expanding into smaller cities and provinces more in central and western China, as well as to the north and south. Therefore, the distribution and logistics facilities are also growing in those regions. Yet there is not a great supply of available modern logistics facilities available in these areas. We are undersupplied in most of these provincial capitals, as well as the Tier II, Tier III and even the Tier IV cities that have a growing middle class, says Ross.

Chinas booming e-commerce market also is having a powerful impact on the logistics sector. China is reportedly home to the worlds biggest online population and online shopping has skyrocketed in recent years. Chinas online retail sales, including both consumer shopping and business-to-business sales rose nearly 50 percent in 2014 to reach $2.09 trillion, according to Chinas National Bureau of Statistics. For example, during its annual 24-hour Singles Day online shopping promotion on Nov. 11, 2014, Alibaba said that consumers spent a record $9.3 billion, which was a 60 percent increase over 2013.

Logistics activity has traditionally been concentrated around the Tier I markets and the satellite cities surrounding those Tier I markets for

Another key macro trend in China that is impacting both the manufacturing and logistics sectors is explosive growth in its consumer market. Despite the slowing economy, there is still very good double digit retail sales growth in China.

several reasons. However, the land costs can be significantly lower outside of Tier I markets. That really makes a huge argument when transport companies and the retailers and occupiers themselves are trying to maintain efficiency and cant afford the rents in Tier I cities, says Ross. Over the last five years we have seen very high growth in satellite locations outside of the key centers, he says. For example, warehousing is virtually non-existent in Beijing. So companies have had to move to other satellite cities such as Langfang, which is centrally located between Beijing and Tianjin. Kunshan also is developing as a major logistics hub between Shanghai and Suzhou, according to JLL.

Over the next decade, JLL expects the balance of logistics activity to shift to central and western China. Chengdu is positioned as the largest inland logistics hub and is experiencing strong development activity. Based on an analysis of infrastructure development, business openness, economic size, GDP growth and retailer activity, the cities with strongest growth potential are likely to be: Emerging Primary Hubs Chengdu,

Chongqing, Wuhan and Shenyang Emerging Secondary Hubs Changsha,

Zhengzhou, Hefei and Xian

5 China Retail Sales YoY. National Bureau of Statistics of China and Trading Economics. http://www.tradingeconomics.com/china/retail-sales-annual

6 Chinas e-commerce transactions hit $2 trillion in 2014. The Economic Times. Jan. 21, 2015.

7 China50, Fifty Real Estate Markets that Matter. JLL. 2012.


Certainly, the government still carries powerful influence on location decisions in a variety of ways, such as its urban regeneration efforts, improved infrastructure, development of quality commercial properties and logistics facilities, business support, tax incentives, improved education, land swaps, environmental policy and land use policy amongst many others, says Shepherd. Companies also need to maneuver a number of challenges and obstacles such as staffing, interrupted or insufficient power supply, security of the working environment, goods or intellectual property, as well as the risk of agreed upon special tax treatment not being forthcoming in poorer areas, adds Shepherd. Specific to real estate, some of the added risks could include contaminated sites or fly tipping of contaminated material on site, site clearance, soil compaction, inadequate site infrastructure, land title issues, stratification or unclear ownership structures and poor construction quality.

In the past, there was more emphasis on having the infrastructure support for business operations. However, infrastructure development

ADAPTING TO A CHANGING MARKET

has been huge in recent years with improved access to power and water. Environmental issues now are becoming a very important issue to local governments. So, companies that have any level of potential environmentally polluting output are finding that they are being forced out of Tier I and Tier II cities and into new locations, notes Ross.

One of the challenges that companies face in China when locating new facilities or expanding existing operations is choosing locations that will still be relevant and viable in five, 10 or even 15 years as the economy, its manufacturing and industrial industry and its consumer markets continues to evolve. China now has more than 160 cities that are home to more than 1 million people. So, from an investors perspective, you can pick any 10 cities and do quite well, but it is a very competitive environment and it is hard to look at China and say here are the hot spots you really have to drill down and compare cities within provincial locations to each other to determine what is going to be competitive and a good investment opportunity, says Ross.

The evolution of the economy and growing middle class are influencing manufacturing and logistics location decisions in China. Other important considerations include labor availability, supply chain risks, operating costs and government policies.

Special thanks to the following companies for their research assistance:


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