China’s less than luxurious luxury retail business

This is an article I'm in the process of finalising for a Harvard University publication. The topic of China, its spending patterns, its property business and fasination with luxury are all much discussed these days.

Even as the global economic crisis takes hold, China remains on track to become the largest luxury market in the world within the next decade. Nowhere else are people joining the luxury consumption class as rapidly. Nowhere else are the world’s leading brands opening more stores. So it comes as a paradoxical irony that China really doesn’t have any international quality luxury shopping venues today. To understand why, is to understand the intricate and intimate relationship of developers, banks and government in China.

In the absence of logical ‘drivers’ of development, the very forces that should act as ‘regulators’ or facilitators of responsible development, function as the opposite: ‘stimulators’ of imprudent development. So reckless that it has scarred the very fabric of many Chinese cities for a generation to come. Within a few short years, developers lacking requisite experience, capital or management capabilities have been able to graduate, without merit, from simple residential projects to the most complex mixed-use commercial projects conceivable. These short-term, profit minded developers have borrowed money with ease to undertake enormous shopping center projects. Projects which lack proper planning and design consideration, have no anchors or pre-leasing, and no thought given to on-going property management. The result: ill-conceived and poorly executed projects which have little chance of success, ever.

The huge potential of the Chinese luxury goods market
Currently the third largest luxury market in the world, China is growing faster than both the US and Japan. Since the onset of the global economic crisis the rate of China’s relative growth to these other global giants of luxury has only widened. Various sources and analysis estimate that by 2014 China will have ascended to the leading position, accounting for over 20 percent of the global luxury market.

The fact that China will be the biggest luxury consumer in five years is thrilling, but what’s more, is the velocity at which this metamorphosis has occurred. The Chinese love affair with luxury seems to have even out-paced the meteoric rise of China’s general economy since the early 1990s. Just six or seven years ago there were few signs of China’s latent consumption capacity. Luxury stores were rare and those open were little more than showrooms for curious aspirational passers-by. It was also only a small percentage of Chinese that were travelling to consume luxury goods in those days.

To understand consumption capacity, a distinction should be made between luxury consumption in China and Chinese luxury consumption. The former being a shallower, albeit growing, pool of luxury retail sales occurring in stores within China. The latter being the global aggregate of luxury goods consumption by Chinese nationals. The future of China’s domestic luxury consumption lies in the incremental migration back, of the vast quantum of luxury expenditure made outside China.

Hong Kong is a luxury shopping mecca. Its resident population of approximately 7 million is among the most prolific and sophisticated luxury consumers in the world. Hong Kong is also the most visited destination in the world for Chinese tourists. This has proved to be an astonishing boon for luxury retailers in Hong Kong, who over the last few years have seen Chinese mainlanders account for the majority of their sales.

As a destination for Chinese tourists, Hong Kong is followed by Macau and Singapore, other countries in South-East Asia, then Europe, and finally the US. The propensity for Chinese to consume luxury whilst travelling has compelled luxury stores everywhere to hire mandarin speaking staff and adjust their marketing interface to better accommodate the needs of Chinese customers.

The Chinese economy has enjoyed near double digit annual growth for the last decade. In the midst of the global economic crisis, China’s growth still looks set to outshine the world’s large developed economies. Notwithstanding, China will need to re-engineer itself for the post-crisis global landscape. In doing so, it will perpetuate a culture of persistent wealth creation as China has throughout its economic coming-of-age. This relentless emergence of new wealth pockets as China’s economy flexes, widens and deepens is the driver of continued Chinese luxury consumption. The current economic conditions will only serve to alter the pace of China’s luxury ascendency but not its inevitability.

The lingering question is where will the Chinese luxury feast play out? Today there is a huge gap between global Chinese luxury consumption and China-based luxury sales. There are many persisting reasons for this gap to remain, most notably the imposition of a luxury tax in China that makes purchasing domestically illogically expensive for well-researched and increasingly well-travelled Chinese customers. The only thing more powerful than Chinese brand-consciousness is their value-consciousness.

International travel not only provides Chinese with access to more compelling prices for luxury goods, it also exposes them to better shopping environments and service standards. Shopping is an experience, especially luxury brand shopping. The best sensory experiences excel in providing four key ingredients: an extensive product range, enticing store environments, deft customer service and competitive pricing. These levers of productive retail are rarely evident in China. So it is not surprising that Chinese are already the world’s most prolific tourist shoppers.

The paradox of luxury retail space in China
In China’s economic transformation a luxury customer has been borne. In parallel, we have witnessed the dawn of Chinese urbanization. The birth of cities is perhaps the most profound social change to take place in China’s modern history. The escalation of urbanity has forever impacted the way Chinese perceive themselves. A new set of ideals and aspirations has materialized for a generation seeking a contemporary mode of living, working and shopping. These expectations are high for China’s new luxury class.

Against the backdrop of exploding consumption and urbanization, shopping centers have developed at an unprecedented cadence. Yet despite rampant development and surging demand for luxury goods, matched by strong desire of luxury brands to open more stores, China hasn’t produced a proportionate quota of quality shopping venues.

Developers in China have built over 100 new shopping centers (of varying sizes) per year for the last five or six years, perhaps more than any country has ever built per year in history. However, very few of these centers actually meet mass market retailer or consumer expectations, let alone those of luxury players. After all, the essence of luxury products is to satisfy the highest possible aesthetic expectation.

Why are these centers not succeeding in the face of so much demand? The root of the answer lies in the bedeviled relationship between the industry’s key stakeholders: developers, government, banks, retailers and consumers. The frenetic growth of China’s retail landscape has been its own undoing - perverting the natural market forces that would typically shape the industry. Instead, growth in retail space has been driven by the wrong stimulants.

As part of the enormous national push to modernize, unbridled energy, human resources and financial capital have been allocated to development of cities. Government officials eager for personal advancement have facilitated almost any form of economic development in their district, regardless of its situation or appropriateness. Banks, lending on a relationship basis, have funded almost any real estate development to curry favor and support the broader authoritarian initiative. In this feeding frenzy, two important ‘checks’ to development – government and banks, have joined the chorus of developers, and in doing so fuelled an ill-fated generation of shopping venues that corrode the urban core of many new cities. These venues are known as China’s ‘ghost malls’. Perhaps 90% of China’s shopping centers today are in this category.

Without a stringent responsible urban planning regime administered by knowledgeable and professional government officials, developers have been able to conceive of schemes without a rational development premise. Without arms length credit based lending enforced by experienced professional bankers, developers have been able to build these projects without proper risk mitigants in place. The result of this dizzy feast is lots of venues but still an un-met demand from retailers and consumers.

More thought, less haste
Retail developers are the intermediary between retailers and consumers. They are responsible for not only creating a venue where a transaction takes place but crafting an environment where a lifestyle experience can unfold. There is a social and civic responsibility in this process that goes beyond other forms of real estate. Overzealous developers either underestimate or dismiss this role in their haste to make money.

Developing a successful and sustainable shopping center requires know-how, application and patience. The process starts with logical site selection based on current and future transportation systems, surrounding land uses and the demographics of the trade area; not whatever land is available or where a government official dictates is suitable. An intimate appreciation of end users acquired through experience and thoughtful research is essential. The reality that hundreds of shopping centers have already opened in China yet the research industry remains embryonic gives a sense of the dismissive haste of developers. This dangerously expeditious approach is facilitated by the stimulants above but inherently stems from shopping center developers’ history of rapidly selling out of residential projects before or on completion of construction. In fact the speed at which China’s residential developers have matriculated to retail projects is like jumping from primary school to a PHD.

Physical planning and design is the most important aspect of creating a successful shopping center. It is an onerous and highly iterative task that typically takes 18 to 24 months to complete. A developer only has one chance to get it right as it’s usually impossible to correct mistakes once built. Done properly, a shopping center’s design can become the enduring essence of its commercial success. It is an intuitive process during which a developer has literally hundreds of decisions to make regarding scale, configuration, accessibility, convenience, circulation, materials, retail uses and customer requirements among other things. In China the design process is often short-circuited to around 9 months and rarely entails any consideration or consultation with end users. Many developers make the easy mistake of retaining a prestigious international architect to illustrate their defective ambition, but only long enough to then hand their partially considered schematic to a cheap local design institute to document. No matter how experienced, how intellectually adept or how thoughtful the architect may be, it is a mighty task to appropriately balance all the nuances of such a complex social organism as a shopping center. Today, China possesses 6 of the 10 largest shopping centers in the world, all of which were borne of a flawed vision compounded by a diluted design process and now struggle to survive commercially. Designing a shopping center is a developer’s responsibility not an architect’s. If China is to address the paradox of luxury retail space, its developers cannot continue to abdicate accountability for the outcome.

Apart from appalling design, the most bewildering tendency of retail developers in China is the belated stage at which they think about merchandising and leasing of the space. Instead developers have been inclined to focus simply on building the space, presuming any retailer can use it. This is yet another example where underestimating the complexities of creating a sustainable social venue has contributed to China’s proliferation of ghost malls. Best practice retail development calls for consultation with significant retailers, like anchors and majors well in advance of construction commencement. Yet in China, projects are often only 6 months shy of completion when the first retailer discussions take place. The implications of this haphazard approach are numerous and frequently fatal. It means the space mostly doesn’t meet the retailers’ requirements, therefore the best retailers don’t want to be there, nor can they build their ideal store layout if they do. It means the retail uses, like fashion versus food can’t be organized in the optimal manner. By not being thoughtful about retailer needs upfront, it effectively renders the space inflexible, unusable, and therefore less marketable, or in the most extreme cases, worthless. From an investment perspective, the developer’s disregard for merchandising and leasing makes the project entirely speculative and thus high risk to the very end.

Bad habits die hard
The most successful residential developers are not those with the best product, but those that know how to sell product fast. Without question the most profitable real estate business in China over the last 10 years has been residential development. The ability to sell apartments off-the-plan has created extraordinary wealth for developers, but it has also made them lazy. When a residential developer can make a profit before a project is even completed or been tested in operation, it breeds a mentality that is incongruent with the long-term place-making approach required for shopping center projects.

Over the last 10 years there has been widespread strata-tiling of shopping centers in China. Whether done as a cheap form of construction financing or with a quick profit in mind, the practice of selling off individual shops is disastrous for a shopping center. Creating a patchwork of separate ownership inherently eliminates the developer’s sense of responsibility and stewardship of the venue. Instead, it creates a multitude of landlords with different agendas leading to inevitable conflict. In the average shopping center there can be as many150 different owners after a concerted strata-titling effort.

It is widely accepted, even in China, that operational management of a shopping center is critical to its long-term commercial success. Implicit in effective management though is a coordinated single point of decision-making and accountability. In the hundreds of strata-titled venues in China today, it is abundantly clear there is little consensus on any operational matters. Shops owned by individual owners compete for tenants – driving rents and investment returns down. In the absence of umbrella ownership, the merchandising of the center completely falls apart, with individual shops operating whatever business they can regardless of adjacencies. With no common operational guidelines, shops adopt their own individual standards for signage, fit-out, waste and materials management, and even opening hours. Individual owners end up misaligned on promotional activities, unable to agree of annual budgets for center maintenance, and most alarmingly - not contributing to any sort of sinking fund for major capital works required in the future. The cumulative effect of all these bad practices is a venue that fails to provide a business opportunity for retailers, consumers that don’t want to shop there, and a physically decaying property for the community.

The causative contribution of strata-titling to ghost malls in China is not easily rectified. Re-amalgamation of ownership from dozens, and in some cases hundreds, of non-institutional landlords will be extremely onerous. To recycle the precious urban core of so many Chinese cities tainted by ghost malls is an undertaking befitting governmental action. Perhaps the private sector will navigate the logistical obstacles of remedying strata-titled assets, thereby unlocking the latent value in these prime sites and restoring much needed civic centers to the cities.

Cross roads
Against the backdrop of global recession, China now has the timely opportunity to stimulate domestic consumption and, while the world pauses, to get its urban planning, social infrastructure and lifestyle venues right. Through systemic improvement in all aspects of the retail development industry from site selection to planning and design, financing to merchandising and on-going management, China’s retail industry can add even more to the broader economy. The transition from an export-led to consumption orientated economy is foreseeable and provides the perfect impetus for this industry evolution to occur. International retailers are committed to growing in China, domestic retailers continue to compete across all categories and the public has an increasing propensity to shop. To stem the flow of luxury goods expenditure outside China the industry needs to lobby the government for tax relief, produce higher quality venues, and be committed to long term ownership and responsibility.

China will become the world’s largest luxury goods market at some point in the future. The challenge is to make it the world’s most luxurious.