Shanghai has too much room to work in

In recent years, the developers of Shanghai's top-notch office blocks faced agreeable problems: how to find the next good plot of land and how high to build on it. The demand for A-grade office space was insatiable as the target tenants -- multinationals -- were typically increasing headcount by around 10% a year, prompting a construction boom. Even in a buoyant market, that much building was going to increase vacancy rates and push down rents. The problem for the developers now is that all the new towers are opening their doors during the worst climate the Chinese economy has faced since liberalisation.

Rents in Shanghai's office market peaked during the second quarter of 2008 with 3 million square metres of A-grade office stock in the central business districts, according to Jones Lang LaSalle. Since then, nearly 50,000 sqm have come online, and there is plenty more on the way.

Vacancies, as of the end of the first quarter of 2009, are 14.2%, up 9.1% since the peak. Pudong, which contains the city's financial centre, Lujiazui, has 23.6% of its premium space empty. And rents across Shanghai are down by nearly a quarter. "Since September 2008 we have seen that demand has been falling away at an unprecedented rate," said Steven McCord, senior manager of research in Jones Lang LaSalle's Shanghai office.

For some developers, the trick is to try to postpone the completion of buildings that are under construction so that they are finished when demand has picked up. "We expect a lot of delays to emerge in the next six to 12 months," said McCord. "But still, very few buildings have officially changed their completion dates, which is strange because you can see construction visibly slowing down on a number of projects."

No signs of distress

Investors are already crawling around for bargains. "We have had a lot of investors come to us recently asking about distressed assets, and they are surprised that there aren't any," said Hingyin Lee, director of research at Colliers Shanghai.

While the situation isn't bad enough that distressed assets have appeared on the market, now could be a good time for investors looking to get exposure to Shanghai's office property space. In 2006 and 2007, landlords were keen to keep hold of their properties because they wanted to keep enjoying, what looked at the time, to be an ever-increasing rental income.

"Landlords right now are seeing a reduction in leasing demand, a decrease in rentals, a rise in vacancies and much new supply to be completed in the market down the line," said Shaun Brodie, associate director for research at property firm DTZ in Shanghai. "Put all these factors together and you will see some landlords looking to offload their assets." But he points out that the deals haven't started to flow yet, partly because there is still a gap between the price expectations of the landlords and investors.

This is perhaps a perfect opportunity to buy office space, noted Brodie. "Ten or 20 years down the line, when Shanghai has increased in importance in the Asia-Pacific region, people might look back on now as a golden age for buying commercial property, since the long-term trend is going to be upwards."

Even if demand doesn't pick up in the short term, the government could potentially help prop up the market by putting state-owned enterprises into the new buildings. But in the medium term demand will gradually pick up as foreign companies start to expand again in Shanghai. And the market will evolve, as Chinese companies will become more likely to set up shop in a top-tier building.

The central government has reaffirmed its support for Shanghai. Early last month, it set a target for the city to become an international financial hub by 2020, which reignited the old chestnut about whether Shanghai or Hong Kong will emerge supreme as China's prime destination for the financial industry. If there is an ounce of truth in the government's schedule, offices in Shanghai will remain a good bet for investors willing to ride out the current oversupply problems.

This story was first published in the May issue of FinanceAsia magazine.