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SHANGHAI — China has the location, but good retail space is still hard to find.

Brands from around the world are hungry to enter the world’s most populous country and establish stores as the Chinese consumer economy continues to mature. Retail development, however, is fragmented and not always up to meeting the needs of Western brands or investors.

“Starting last year, and continuing at least through next year, an adequate supply of good retail space is just not ready,” said James Chen, director of United Corporate China Apparel Ltd. “Space is very hard to get. It’s a matter of simple mathematics and timing because they can’t just kick people out. A lot of international brands are postponing their launch here until they can get a good location.”

Chen, whose company is the exclusive China distributor for St. John, Nike Golf and Nike 360, traced the shortage to an influx of brands since January 2005, when the Chinese government started allowing foreign apparel brands to fully own their local operations.

“Rents doubled or at least went up 80 to 90 percent between 2003 and 2005,” he said.

China’s retail sales grew 13 percent in the first half of 2005, according to realtors Cushman & Wakefield. The attendant growth in demand for retail space has outpaced supply, at least in the primary cities of Beijing and Shanghai, even as the country undergoes a construction boom.

From massive metropolis to provincial hamlet, cranes cram the horizon and energetically erect the high-rise developments that are driving the country’s double-digit growth rates. Retail space represents a fairly small portion of new development, compared with residential and office space, but is nonetheless expanding exponentially. According to Jones Lang LaSalle, a Chicago-based real estate investment firm, China as of late 2005 had 400 shopping malls nationwide and 200 more under construction, and some in the industry estimate that more like 300 retail projects are being developed at any given time.

In retail, however, particularly at the high end, size and location are not everything. Every Chinese mall, whether locally or internationally owned, hopes to fill the ground floor with prestigious, well-known brands as tenants, but most are hampered by substandard management, services and infrastructure. Rents and competition for space are driven by reputation, professionalism, brand mix and traffic quality, factors that vary between regions, cities and even neighborhoods, and can change dramatically over a short period of time.

This story first appeared in the March 21, 2006 issue of WWD. Subscribe Today.

“Most property investment now is in office space, not retail,” explained Cathy Hau, deputy general manager of Times Square Shanghai, a Hong Kong property that was of the earliest developments on the prestigious Huaihai Road. “Here we have 30 floors of offices, 26 floors of apartments and only seven of retail because the rate of return is the lowest.”

Retail requires the highest overhead because “we need maintenance and to revamp the merchandising mixture every two years, and constant renovation. For example, five years ago, marble was in; now, everything has to be transparent and airy.”

Paul French, director of AccessAsia, said none of China’s luxury retail developments is profitable and even the most prime locations offer steeply discounted rents to attract prestigious tenants. Profits from the office spaces above the malls subsidize the retail sections.

The activity along West Nanjing Road, home to in-demand retail properties like Plaza 66 and CITIC Square, support this theory. Plaza 66 is constructing a second office tower and several of its neighbors with similar premium street access along Nanjing road, such as the Kerry Center, have eschewed retail areas altogether.

Yet new projects proliferate. Beijing, where demand is high but options limited to a few properties like China World, boasts a spate of new developments. Last year inaugurated Golden Resources, which boasts six million square feet containing 1,000 shops and 230 escalators. Luxury retailers are battling for space in the Four Seasons and The Place, both of which will debut in the capital this September. Zhongguancun, the area around Beijing’s Olympic Village, will also see a number of new retail properties leading up to the 2008 Summer Games.

In Shanghai, each district’s government is pushing its own retail centers. Huangpu District is focusing on the Bund, a historic landmark but with mostly low-income traffic, where several new spaces, most notably a Dolce & Gabbana flagship at Number 6, will open this year.

The Jing’an District will continue to develop West Nanjing Road, while the Luwan area will similarly focus on Huaihai Road. In Xuhui District, the crowded Xujiahui neighborhood, long a popular mass shopping district, is starting to attract more upmarket enthusiasm, as well as tenants. The area’s Grand Gateway, or Ganghui in Chinese, which opened in 2000 as a no-brand, low-end mishmash, has successfully transitioned into a popular mid-range, white-collar destination.

Hong Kong and Southeast Asian developers were the groundbreakers in most of China’s earliest malls and remain major players, but international investors are increasingly a part of the new developments. Most famously, Morgan Stanley last July acquired a 92 percent share in Shanghai Square, an office building and previously unsuccessful six-story mall on Central Huaihai Road, for $108.8 million. The company just announced plans to invest $3 billion in Shanghai property this year. America’s Taubman Group is developing four high-end retail properties.

Singapore’s CapitaLand has 38 retail projects under development, all mass market and mostly in second- and third-tier cities, said French. Of these, 21 will be operational this year and will immediately have yields of 8 to 9 percent. According to French, the best developments have more of a mass, mainstream appeal, and even fairly high-range products need an engaging consumer environment.

“For example, Plaza 66 is terrible, it’s all luxury on the ground, none are paying much in rent, with no food court, nothing to get people in…it’s too off-putting,” he said.

Most of the developers are from Hong Kong or Singapore, and the “Hong Kongers all want to copy Pacific Place, and the Singaporeans places on Orchard Road. They want a grand project with luxury brands, but those attract no traffic,” he continued. “They think malls have to be like Ginza or Pacific Place. No one wants to deal with the great unwashed and they are encouraged in this mind-set by the government. Foreigners come and don’t realize that neon does not equal wealth.”

The first-floor clustering of premium brands allows them street-level advertising and exposure, but, according to Chen, “logically the brands should be at the top, because they don’t need the traffic.” However, bad experiences in China make the brands distrustful of mall management.

“For example, with St. John’s store in Xintiandi, we accepted a more removed location based on promises that it would be exclusive and focused, but then our neighbors turned out inexpensive,” Chen said. “So the safe way is to focus on just getting the best location.”

As a model, Plaza 66 compares unfavorably to Grand Gateway, which is owned by the same group, French said.

“Grand Gateway’s basement has sporting goods stores, a KFC,” he said. “The ground floor has high-traffic stores like Giordano, it has a regular department store and a food court, serving not just Western food, but noodles and cheap Japanese food. At the top, they have a big Karaoke bar and a multiplex. The floors are arranged by theme, it’s like street level. Chinese street shopping is grouped by men’s, women’s, children’s wear or home goods, so people can comparison shop, which is what the Chinese like to do.”

Traditional street shopping remains far more predominant in China than the mall model and even in developed urban markets many brands prefer the direct consumer access that a freestanding location allows.

For example, Zara just launched a freestanding flagship on West Nanjing Road, and it is already enjoying brisker traffic and sales than its competitors situated within CITIC Square and Plaza 66, which it directly faces. Lacoste maintains 130 outlets of varying size around China, of which a third are freestanding, including a flagship also on West Nanjing Road.

“Our freestanding stores are not the most profitable in terms of sales by the square meter,” said Sandra Hu, Lacoste’s China chief executive officer. “But they provide more exposure and are good for the image.”

Hu added that freestanding stores are more predominant in secondary cities, emerging markets where the retail environments are far less evolved than in the urban hubs of Beijing, Shanghai, and, to a lesser extent, Guangzhou and Shenzhen. Within the second tier, the levels of development and business infrastructure vary vastly.

“In Chongqing, there are a lot of malls going in, some six to 10 now, but it’s not a good consumer environment, it’s very government-driven and they can’t sell anything because they’re all peasants without any money,” said French. “Wealth is rippling, not jumping, inland from the coastal cities. In all the cities in the Yangtze River Basin, companies have trouble finding enough retail space.”

He cited Zhengzhou, a small city in the Yangtze region, as a place that recently completed its first mall, which quickly ran out of spaces.

According to Chen, who has been distributing in China for seven years, it takes a new mall between three and four years to tweak its tenant mix and public appeal into a coherent success. The current pace of construction, he admitted, threatens to turn today’s shortage into tomorrow’s oversupply.

“In China, there is always the risk of a bubble because the pace of supply and demand is unbalanced,” he said. “Things change fast, about every two years. Now everyone is building, but it also depends on the management.”

Given the prevailing idiosyncrasies of management, infrastructure, tenant mix and regional differentiation, the future of China’s retail real estate market will likely juxtapose high demand with an oversupply of properties that fail to meet the desired criteria.

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