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SIMON JOINS MORGAN STANLEY, WAL-MART IN CHINA VENTURE

By Curt Hazlett

When Wal-Mart opened its first store in bustling Shanghai on July 27, thousands of shoppers waited for hours to grab their share of the food items and goods jamming the 200,000-square-foot center. It was a sign not just of Wal-Mart’s drawing power, but also of the massive consumer appetites that wait to be fed in China.

Wal-Mart’s success that day underscored an announcement made just two days earlier by Simon Property Group that it would enter the Chinese market — the first U.S.-based shopping center REIT to do so — in a joint venture to build Wal-Mart-anchored malls.

“This is really big-picture stuff,” said David Harris, an analyst at Lehman Bros. “Clearly, people are excited about the business prospects in China. It’s a country of vast population and rising economic power and untapped potential.”

And it’s a country of some risks, too, including those arising from political and legal differences. But Simon is entering China with powerful partners: Morgan Stanley Real Estate Funds, a unit of the big American investment bank, and SZITIC Commercial Property Co., the retail property division of Shenzhen International Trust & Investment Co., a state-owned investment firm.

Together they will build as many as a dozen malls with Wal-Mart anchors (perhaps more later) in the prosperous Yangtze River delta, which includes Shanghai.

The three-way agreement ties back to Wal-Mart’s aggressive growth plans in China. Locked in a pitched battle there against the French Carrefour and German Metro hypermarket chains, the Arkansas retailer wants to double its Chinese stores to 90 by the end of next year.

Simon CFO Stephen Sterrett describes the deal cautiously. “Thus far we have committed only to one project,” Sterrett told analysts the day after the announcement, though Simon and Morgan Stanley have the right of first refusal for at least a dozen centers SZITIC is expected to propose. He called the venture a way for Simon “to enter and learn about the Chinese retail marketplace on a profitable but prudent basis.”

Caution aside, it is clear that the agreement, which has been nearly a year in the making, is a watershed event for Simon and the industry.

“It’s important because it’s the first tangible investment in China by a large U.S. retail REIT, so I think it’s groundbreaking,” said Leslie T. Chao, president of Chelsea Property Group, which Simon acquired last year and now operates as a division.

“It’s an illustration of the importance that China is taking on not only as a production superpower, but also in the developing consumer side of the mainland Chinese market,” said Chao, who has been doing business in Asia since 1999 and took part in the SZITIC deal. “It’s the first investment of many, and I’m sure Simon will not be the only company to go there.”

The first project will be a 500,000-square-foot mall in Hangzhou, a city of about 6 million people some two hours southwest of Shanghai. The developers expect to start construction in October and finish in early 2007.

The agreement with SZITIC calls for Simon and Morgan Stanley to be the “preferred partners” for as many as 12 centers. The American companies will each own 32.5 percent of the venture, with SZITIC owning the rest.

“This is a toe in the water,” said Louis Taylor, an analyst at Deutsche Bank Securities. “The opportunity for so many businesses in China has been incredibly enticing, and there’s no reason it shouldn’t be on the shopping center side. Simon has found a partner it’s comfortable with, an opportunity it’s comfortable with, and it’s going to put some money to work and get some more experience.” Indeed, Chao notes that more projects are possible. “They would like us to look at as many as we’re comfortable with, so we’re expecting a lot more opportunities,” he said. “Right now we’ve got to walk before we can run, so we’re starting out with six and then another six.”

The centers will rise four or five stories and range from 430,000 square feet to 750,000 square feet. Chao says Wal-Mart will occupy a third to a half of the gross leasable area; in some centers a Warner Bros. International Theaters cinema will occupy the top of the building. “The bulk of the tenants at this point will be mostly Chinese domestic retailers,” Chao said, “but we hope that over time, we’ll be able to bring in more of the branded international names.”

Chao says the centers “will be heavily influenced by the way we see design. They will benefit from Simon’s experience in laying out retail, and we’re going to adapt it to what we think are the local needs.”

The Yangtze River delta, where the Simon deal will be focused, is among the wealthiest areas of the country. “In China almost all growth is concentrated on the east coast, south of the Yangtze River,” said Scott Harris, ICSC’s vice president of business development in Asia, Latin America, the Middle East and Africa.

At the heart of the region is Shanghai. “Shanghai clearly is China’s lead city commercially, and maybe Asia’s as well,” said Scott Harris. “It’s a very hip place.”

“Shanghai is the New York of China,” Chao said. “The initial properties we’re being offered are in the Shanghai region, and a couple in two neighboring provinces.” Furthermore, “the locations in the provinces are rapidly developing and are relatively affluent and under-retailed.”

To Lehman’s David Harris, Simon’s move to China makes sense. “Simon is obviously of a size where it has to cast a wide net in terms of what is going to drive its growth, and clearly it has got to a size where it’s difficult to see that,” he said. “As you get bigger, there’s more difficulty in seeing how to make further acquisitions, or to develop more that will make a material impact on the bottom line. So we think that looking overseas is a legitimate area.”

But building centers in China will not be free of risk, David Harris says. In China “the rule of law is weakly established. There are issues such as local corruption. The tax code is not, I’m sure, set in stone, and that’s all aside from the operational challenges.”

But ICSC’s Scott Harris says the market risk for Wal-Mart-anchored centers is not as great as it is for developers of luxury properties. “There are plenty of middle-class-and-below consumers,” he said. “What’s more risky are those folks, mostly indigenous developers, who are developing high-end stuff. For a project pitched to the middle class, the risk is much, much less.”

Even if the venture should run into trouble, “it’s an extremely modest amount of money in the context of Simon,” said Taylor. “If it doesn’t work, it’s not like they’re going to lose a lot.” Sterrett put the total cost of each project at between $45 million and $70 million, with an equity investment by Simon of between $8 million and $10 million per project.

To Scott Harris, the participation of Morgan Stanley’s Real Estate Funds unit is a sign that Western investment in China is coming of age. “The involvement of Morgan Stanley and serious, thorough investors will accelerate the professionalization of the Chinese shopping center industry,” he said. Though locally financed developments may lack thorough analysis, he says, “Morgan Stanley is not going to get involved in a project unless they go over it with a fine-tooth comb.”

In fact, Simon is the second U.S. REIT Morgan Stanley has teamed with this year in the region. In April Taubman Centers announced that it would explore Asian opportunities with Morgan Stanley. Taubman hired Morgan Parker, the former head of the Real Estate Fund’s retail management and operations business in Asia, to run its new Taubman Asia division.

“I’m not expecting anybody but Taubman to have something near-term [in China],” said Taylor, “but 10 years from now all the companies will have some investment over there.”

David Harris sees a twist in the fact that Simon’s entry is being driven by Wal-Mart’s desire to tap the China market. “The irony is that Wal-Mart is sourcing most of its goods from China,” he said, “so it’s only right that the Chinese themselves should have access to the goods they’re producing.”

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