The Chinese property market: heading for a crash or a good bet for sustainable long-term growth? There are plenty of proponents of both arguments, and some who agree with both. Of course, it also depends on which segment of the market you’re talking about.

Hong Kong-based private-equity real-estate firm Gaw Capital Partners is certainly less positive now about the prospects for tier-one cities on the mainland – namely Beijing, Shanghai, Shenzhen and Guangzhou.

Its third fund – the Gateway China Real Estate Fund III, which closed this week with $373.5 million, despite a tough fundraising environment – will invest some 60% of its portfolio in mass-market residential development in tier-two and tier-three cities. The remainder will go into tier-one cities.

Fund I closed in 2005 with $200 million in AUM and is invested mostly in tier-one cities, while fund II closed in 2007 with $800 billion and is more focused on tier-two and three cities.

“We’ve been citing for six months now that the situation in tier-one cities is definitely worrisome,” says Christina Gaw, managing principal at Gaw Capital in Hong Kong. “We have seen some corrections and vendors cutting prices to sell developments.”

While there is some liquidity in tier-one cities – the asset manager acquired a property late last year from a foreign fund, for instance – attractive deals are few and far between, she says. That said, with foreigners now not investing so aggressively in tier-one cities, there may be more available now, says Gaw.

Still, the government is not taking such a heavy hand to dampen the property market in tier-two and three cities, she says, as it wants to see a more gradual move to sustainable price levels. “So we’re not too worried that it will slow down quickly or crash, and that’s how we’ve been thinking for the past six months.”

Tier-two and three city prices are not in bubble territory at all, says Gaw, because affordability is growing, particularly among the middle classes. She cites a report saying that the income growth of the middle class has increased by 11-12%, while property market price growth is in the high single digits in the same time frame.

“Our anecdotal evidence shows properties selling well in tier-two and three cities, where pricing of mass-market developments is really based on demand from the local market rather than speculative flows, which tend to drive the tier-one market,” says Gaw.

Gaw Capital started soft-marketing the new fund shortly before the crisis hit in September 2008. The firm realised it wouldn’t raise $800 million this time around, so the target was set at between $350 million and $400 million, says Gaw. This also reflects the fact that many LPs were looking to move towards “more manageable” fund sizes, she adds.

The eight-year investment vehicle targets returns of more than 20%, leveraged at a loan-to-value ratio of no higher than 50%. It targets the residential sector, while expanding into commercial sectors such as retail, offices and hospitality.

With regard to the institutional clients investing in fund III, Gaw says demand from European investors is higher than for the other vehicles. There was only one European institution in fund two, but a couple more have come in for the new fund. “We still get a lot of support from US-based investors, and some of the larger LPs from the previous funds came back in, such as endowments and pensions funds,” she adds.

There is a small amount of investment by Asia-Pacific institutions in countries such as New Zealand, and a minimal proportion from Japan and Korea. But she expects the number of Asian investors to rise.

As for regional asset allocation, the new fund – like the previous two – has a mandate that allows it to invest outside Greater China (up to 20% of the portfolio). Gaw Capital likes certain opportunities in Singapore and is looking at assets in Vietnam, for example.

The first two funds can each invest up to 30% outside Greater China, but fund I is 100% invested in Greater China and fund II over 90%, says Gaw, as the firm saw better opportunities there.

So how have the first two funds performed? Fund I has realised six out of 10 projects already, for which it has posted an aggregate realised IRR of 46.6% and has a cash multiple of 2.57 times, but no realised figures are available yet for fund II.

Gaw Capital may think a crash is unlikely, but how well is it protected were a downturn to happen? “First of all, our leverage is quite low,” says Gaw. “Fund I, which is a very mature portfolio and is fully invested, has an average of 50% leverage – that’s relatively low compared to real-estate funds globally.”

And fund II has leverage of less than 20%, because the firm doesn’t borrow against residential land purchases which fund II has more exposure to.

“So this is already a conservative way of managing our risk,” she says. “That leaves a lot more cushion, which means we can sit through down markets.”

Another way of managing potential risks is that Gaw Capital has its own team controlling sales and developments, which means it has full control over the construction and sale process. “We can manage the progress of a sale, time it; and we don’t have to build the next phase of a development that quickly,” says Ms Gaw. “That’s useful for protecting against a worse-than-expected correction.”