The days of “build it, and they will come,” are starting to fade. Today, oversupply is a common concern in several Tier II, III, and IV cities. Below is a breakdown of the top five contributors to this risk.

1. GDP growth as a top objective

For the past couple of decades, the best way of demonstrating achievement within the government was by growing GDP at double-digit rates. The favoured way was to create new development zones or business districts, utilising real estate (and infrastructure) development as a tool to spur GDP growth. Pudong in Shanghai is the quintessential example and a model that many cities in China have looked to emulate. However, smaller cities are showing difficulty generating the level of demand that can sustain large, new business districts.

2. Form over function

Iconic projects make a city instantly recognisable, giving local governments strong incentives to build landmarks in their cities, and there is often strong involvement in the exterior design of the buildings. This has led to buildings which are aesthetically pleasing but otherwise inefficient and inconvenient for occupants, creating difficulties in leasing out space and leaving projects with very high vacancies years after opening. Fortunately, feedback from the architecture community indicates this practice is in decline.

3. Bundling of commercial land with residential

Local governments generate the bulk of their tax revenue by selling land – and their rising debts have increased their need to sell more land. The most in-demand land is residential land given the fast return it has traditionally offered developers. However, it is only a one-time generator of revenue for local governments, causing them to want to sell more commercial land to generate on-going tax from business activity. To entice developers to build commercial land, it is bundled with residential land for mixed-use projects. However, this can result in commercial projects appearing in areas where they are un-economical or unfitting for an emerging area. Furthermore, without sufficient community input, positioning and design may be mismatched with the market.

4. Mismatched lending incentives

Because mismatched lending incentives exist in the system, real estate projects that should not be financed receive funding and, in many cases, add unwanted supply to cities.

5. Absent property tax

Instead of trying to obtain revenues from real estate development, local governments should continue to move in the direction of tapping into a large potential tax base that already exists – China’s hundreds of millions of homeowners. By having a steady revenue stream, local governments will have less of a need to sell land and have it developed.
Not all cities will experience oversupply in the long run. Tier 1.5 cities will fare relatively well, while smaller cities face more challenges with depth of demand as it will take longer to materialise. Also, new CBD areas are much more affected than traditional CBD areas. If China continues to grow its service sector as planned, it will undoubtedly need more office towers. However, by the time many of these towers get used, their quality and specifications will be outdated. Therefore, it would be better for local planners to take a measured and conservative approach to the pace of CBD development that matches local demand.

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