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June 23, 2016

Inside China's shopping spree: A look at a growing Silicon Valley real estate portfolio

Silicon Valley Business Journal

Nathan Donato-Weinstein

A stellar international brand has made Silicon Valley commercial real estate attractive to Chinese investors seeking condo projects, office buildings and corporate campus sites. 'It's everything,' says one industry expert.

A few years ago, Chinese commercial real estate investment in the U.S. was contained to America's glittering "gateways" - New York, San Francisco, Los Angeles. Now it's washing over Silicon Valley's suburban cities, too.

In just the last year, developers, investors and corporations from China have closed or announced massive deals worth billions of dollars: From buying Yahoo's excess Santa Clara real estate to embarking on downtown San Jose's largest-ever condo towers and scooping up a massive Sunnyvale townhome project.

"The interest and level of activity is surrounding owner/user groups, development requirements, leasing space for themselves - it's everything," said Eric Bluestein, an executive vice president with Kidder Mathews' China Services Group.

A recent report from the Asia Society and Rosen Consulting Group highlights the tremendous growth nationally: "From a modest base in 2010, China was the source in aggregate of at least $350 billion in U.S. real estate holdings and investments by the end of 2015," the report states. The total includes direct purchases, mortgage-backed securities and debt financing.

Chinese investment into existing, income-producing U.S. commercial real estate surged to $585 million in 2010, the Asia Society report found, and then exploded. In 2015, Chinese investors did $8.5 billion in acquisitions, bringing the five-year total to $17.1 billion.

The reasons for the boom vary, but Bluestein says it's driven by a need to diversify outside of China amid uncertainty in the Chinese economy and a slowdown in that country's once-red-hot real estate market. (Indeed, stories abound of empty apartment buildings and stalled projects across China outside the prosperous coastal cities.) At the same time, the Chinese government in 2013 loosened restrictions on capital outflows, allowing external investment to flourish.

Roger Power, who heads up KPMG's Bay Area real estate practice, said the region attracted Chinese investors for the same reason it's drawn domestic pension funds, REITs and private equity: Solid economic fundamentals. But the trend has evolved more recently. "There was an initial attraction to the gateway city, the trophy, high-rise property," said Power, who regularly travels to China to meet with investor groups. "As those cap rates continued to decline, they have looked at some of the neighboring communities outside San Francisco and heading south."

The appetite for stronger yields is now pushing Chinese investors away from in-place assets into the development game, where returns - and risk - can be higher, he said.

The Bay Area is also a place many Chinese investors are comfortable with. "To me, this is really the West Coast portal to China," said Alan P. Mark, president of condo consultant The Mark Company. Silicon Valley and San Francisco - even Stanford - are sterling brands in China, he noted. And while projects such as Guangzhou R&F Properties' 643-unit Silvery Towers in downtown San Jose seem big to locals, they're tiny by Chinese standards.

Betting on cross-border investment
Some players are catering to an expected boom in Chinese companies locating here and needing space. InnoSpring, a U.S.-China technology startup incubator in Santa Clara, just paid about $4 million for a 4,200-square-foot building at 3401 El Camino Real in Palo Alto.

"Closing on a prime Palo Alto location is an exciting milestone for InnoSpring," said Xiao Wang, general manager of InnoSpring Silicon Valley. "We plan to build out the facility in the coming months in a manner befitting our larger mission of fostering cross-border entrepreneurship and innovation."

Genzon, a huge Shenzhen-based developer, paid $90 million for a 260,000-square-foot office complex in Burlingame last fall it plans to transform into a "global innovation center" that will help overseas companies - mostly from China - open U.S. operations. It's also planning to build an 800,000-square-foot campus next door called Burlingame Point that will feature a similar business model. Genzon and its partner, H&Q Asia Pacific, paid $48 million for the 18-acre development site last year.

"It's moving forward, and at an aggressive pace," said Burlingame Planning Director Kevin Gardiner. "The project means business."

The ambition is also underscored by LeEco's $250 million acquisition of Yahoo's nearly 50-acre development site near Levi's Stadium. The maker of smartphones and a future electric car only has a few dozen people in San Jose, but it says it plans to build a 3 million-square-foot campus for more than 12,000 workers as soon as it can.

There are challenges, however. Mark, who consults for Chinese condo developers, said the biggest hurdle for the new players has been California's land-use regulations, which are unfamiliar to developers used to transforming vast areas in the blink of an eye in China.

"It's how difficult the entitlement process is and just the whole approval process," he said. "But that was very true for developers who come from far away from California - groups from New York who've never done anything out here and don't understand how difficult it is."

Trouble ahead?
The big question now is what happens next. There are increasing signs that the U.S. commercial property sector is headed for a downturn; in Silicon Valley, the office vacancy rate ticked up in the first quarter of 2016. For recent Chinese investors, it would be their first down cycle. And it's worth noting that none of the Chinese-funded development projects have yet seen a successful completion.

"They've only been here in the up market, but someday it will turn down," said Sean Randolph, senior director at the Bay Area Council Economic Institute, at a panel last month sponsored by China SF. "How do they ride out the inevitable down market that will come?"

Alan Pomerantz, senior counsel with Pillsbury Winthrop Shaw Pittman LLP, says things could go very badly. He thinks some Chinese investors won't be prepared when things go south because banks, attorneys, developers and real estate operators work differently in the U.S. than in China. Chinese banks, for instance, are used to acting more like partners with their borrowers, but the relationship can be more adversarial between lenders and borrowers in the U.S. That will mean less wiggle room to work out a deal - or more time - if an asset fails to perform and a borrower can't service debt.

"Unlike in China, where banks and borrowers work together, here they can't - and they're obligated to be aggressive," he said.

Pomerantz notes that some Chinese-backed deals have been done with highly optimistic expectations. If the goal is simply to park money outside of China, the assets' performance might not matter. For other deals, it could get painful.

"I think a lot of these development projects pencil out to sales and numbers that are very nice, but if the market doesn't sustain those numbers - that's it," he said.

Amid all the activity - and uncertainty - some have raised comparisons to the Japanese investment boom in the 1980s. Japanese investors bought trophy assets, including office towers, hotels and resorts (most famously Pebble Beach), for sky-high prices until it all went bust when Japan's economy collapsed and U.S. real estate values fell.

Arthur Margon, a partner at Rosen Consulting Group, said he doesn't foresee a replay, noting that Chinese buyers aren't bidding higher than other investors and that buying American real estate still makes sense relative to Treasurys. He also doesn't foresee a possible Chinese pullback having a big impact on the broader market, unlike the wreckage that the Japanese bust left behind.

"I believe it's a much broader range of potential investors coming into the U.S.," he said, adding: "The Japanese pulled out when things went bad. We don't expect that with the Chinese."

Zhengyu Huang, chairman and founder of ImmCapital, agreed. "Almost all Chinese investors I've encountered, high-net worth individuals or institutions, see the U.S. as a long-term destination," he said. "It's the one country that has the liquidity, opportunity and the size to accommodate Chinese interests. I think it will be a quick learning process. The Chinese make mistakes, but they learn super quick and they come back stronger."

For the full story, go to Silicon Valley Business Journal.

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