CHINESE REAL ESTATE AND FURNITURE MARKETS OVERVIEW

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1 Beijing Office CHINESE REAL ESTATE AND FURNITURE MARKETS OVERVIEW Two factors contribute to the growing demand for residential furniture in China: the rising disposable incomes of Chinese consumers, and the housing reform laws that permit and encourage Chinese citizens to purchase their homes and apartments. China's economy has developed rapidly with large-scale construction projects. There is also a strong growth of factories, offices, hotels, schools and other facilities that require furniture. Rising tourism demand has created good opportunities for hotel furniture manufacturers. The momentous urbanization of huge numbers of Chinese citizens has also contributed. Living space for urban households is increasing as residential housing projects grow at a rate of about 15% annually. As living standards improve, people will often place a higher priority on the interior design of their home. In 1994 the average per capita living area for urban residents was only 15,7 square meters; in 2005 this figure had increased to 25 square meters, up 59%. In 2008, this figure had increased to 28 square meters, up 78.3%. In 2010, it had risen to 30 square meters. 1) THE REAL ESTATE MARKET As for the current trend in the real estate market, in 2010, encouraged by the strong performance of the previous year, newly started gross floor area (GFA) of buildings in the real estate sector increased by 40.7%. During the year, total GFA of buildings under construction also increased by 19% to 7.0 billion square meters. However, completed GFA of buildings increased by just 5.9%. During the second half of the year, affected by the slowdown in the growth of housing sales and the governments' strict macro-controls on real estate market, China's real estate developers delayed the projects completion time. In 2010, the Central Government issued a series of policies to prevent the overheating of China's real estate market, such as increasing mortgage rates on second apartments. As a result, the trading volume of apartments decreased in the year, leading to decreased demand for household decoration and completion services. During 2011, the Chinese Government has supported the development of low-income housing. In 2012, amidst a general economic slowdown, the Government is widely expected to relax its restrictive policies on purchases of residential housing. This, in turn, should allow for a mild recovery of housing prices and of construction projects. In China, residential housing can be divided into 3 main categories: 1) low-income, affordable dwellings, which in 2011 made up 4,4% of total GFA (gross floor area) and only 1,5% of sales revenues; 2) standard residential, which made up 80,4%of total GFA, but only 75,1% of revenues, showing that the average price of this type of real estate is lower compared with other segments in the real estate industry;

2 3) villas and high-end residential, which made up 4,9% of GFA and held a 10,1% share of industry revenues. The annualized GFA growth rate in this segment from 2002 to 2011 is expected to be 17%. This rapid growth rate is also partly due to the expansion of large cities, such as Beijing, Shanghai, Guangzhou and Shenzhen, where prosperous economies tend to attract people with high income levels. In addition, this segment is preferred by large real estate companies as it allows for higher returns on investment. Buyers in this segment are also the main buyers of high-end furniture, Other non-residential segments within the real estate industry are: 4) office buildings, which in 2011 made up 1,7% of GFA and 3,7% of sales revenues; 5) commercial buildings, which made up 7,1% of GFA and 8,3% of revenue. Building Segmentation in China by sold gross floor area Building types Sold GFA (million sqm.) Share % Normal residential buildings Economically affordable dwellings Villas and high-end apartments Office buildings Commercial buildings Others Total As for the high-end residential segment, its construction costs and sales prices significantly exceed those of ordinary residential housing. Villas are mainly built in the suburbs or in scenic areas within the cities, and have private garage, gardens, courtyards, etc. Luxury apartments are often duplexes, and usually within their compound have some sort of green area, business services, sports and recreational facilities and efficient property management. In the tier one cities - like Beijing, Shanghai, Guangzhou, and Shenzhen - the sale price of high-end residential is above RMB (Euro 5.000) per square meter. 2) THE FURNITURE MARKET With constant improvements in household living conditions and standards, consumers are purchasing more furniture. Increases in household disposable income and improved living conditions are the two major factors driving this growth. In 2007, total furniture expenditure per household was about $60, rising four-fold since In contrast, the average German household spends an annual amount of $420 on furniture.

3 The recent construction boom in many major Chinese cities has resulted in significant increases in office space, with significant requirements for office furniture. Most newly constructed prime office space in China now features airy, open-concept plans typical of American office layouts. Previous Chinese office buildings typically comprise long corridors with closed offices on each side of the corridor. As a result of these architectural changes, many companies in China are now converting to modular-style office furniture, resulting in greater demand for new office furniture. The recent construction boom in many major Chinese cities resulted in a market surplus of prime office space. Companies that upgrade their offices also upgrade their office furnishings when they move, creating a significant rise in the middle and upper-end office furniture markets. It is to be noted, however, that the current prices for office furniture in China restrict high-end imports to an extremely small market niche. A successful strategy in this segment can not ignore the price factor, and therefore implies producing in China at local costs. At present, there are almost 15,000 star-ranked hotels in China, and it is estimated that more than five million hotel rooms require refurbishing and upgrading. The development of the tourism industry will promote the construction and reconstruction of hotels and, in the meantime, create a good market for the hotel furniture segment. But as noted for the office furniture in the hotel and contract sectors price pays a dominant role, and local (Chinese or foreign-owned) manufacturers enjoy significant competitive advantages. For outdoor furniture a relatively new segment in the Chinese market that has been developing in parallel with villa construction projects - the purchase decisions are also heavily influenced by price. As for the furniture customers, a research conducted by the Shanghai Furniture Association in 2006 showed that those aged 20 to 30 accounted for 42% of the market; those aged 31 to 40 accounted for 22%; those aged 40 to 50 accounted for 16%; and those aged 50 to 60 accounted for 10%. Therefore, young people made up the majority of the industry's final customers. It is expected that the number of young adults (20 to 34 years) will increase by 77 million between 2005 and The educational level of customers of modern furniture was generally high. Consumer personal income levels directly affect furniture demand. The survey showed that those with a monthly household income ranging between $120 and $360 accounted for 26% of the furniture market; households earning $360 to $480 accounted for 43%; and those with an income above $480 accounted for 31%. The type of houses and the living space available offers different opportunities for furniture manufacturers. Those who possessed 60 to 80 square meters of living space accounted for 30% of the market; 80 to 100 square meters accounted for 20%; over 100 square meters accounted for 38%. Brand loyalty in the furniture market is getting stronger in China. With greater product awareness, there is a trend towards consumers preferring to purchase furniture displaying reputable brand names. From 1988 to 1992, only 5.9% of consumers purchased brand name furniture. This figure jumped to 73% between the years 1993 and By 2002, 86% of the

4 consumers preferred brand name furniture. This trend will continue to increase as consumers are more quality-conscious and seek value for money. At present, brand establishment is mainly in the form of advertising and sales promotion. The growing brand-consciousness, however, is somewhat unsophisticated and, thus, detrimental to the perception of quality. High income consumers who are willing to pay premium prices for their furniture tend to focus on established brand names, and rarely opt for high-quality craftsmanship, or one-of-akind artistic items. Brand-building is particularly hard and expensive to achieve. The lack of promotional investment by furniture manufacturers has prompted many successful distributors to affirm their own brand. Among others, Da Vinci is one of these cases: it distributes many brands under its name, but it is the Da Vinci brand that appeals to Chinese consumers. Success keys: manufacturers that are more conscious of the needs of consumers are more likely to succeed in the market. Some customer services include: 1) warranties, which are generally offered for one to three years, with the most common warranty provision being replacement at no cost or monetary refund; 2) repair services, which are expected to become more common in the future as Chinese consumers become more aware of their rights. Most companies charge for repair services. Deficiencies in product quality are common in local production. Some furniture enterprises overlook product quality in their pursuit for extra profits. Poor production processes, inferior product design, and sub-standard materials are common problems As furniture in China is mostly made-to-order, delivery time is also an important product feature. The delivery time for imported furniture averages several months, as compared to several weeks for locally finished products. Many savvy Chinese manufacturers now compete successfully with foreign manufacturers by offering to finish their locally-manufactured furniture bases with coverings made from high quality imported fabrics that they carry in their inventory. With regard to current market trends: there is a desire to embrace natural wood products, while metal furniture is more popular among young people; plastic and glass are increasingly replacing wood furniture in products such as dining tables and bookshelves; a trend toward green and environmentally friendly product has contributed to bamboo and rattan furniture s recent popularity. Although solid wood furniture is desired by a majority of customers, 70% of the buyers finally select panel furniture, because it is cheaper and because it may offer more variety in terms of design. Most customers have a very basic understanding of green products. Nonetheless, increases in disposable incomes, improvements in living standards and growing environmental protection awareness will lead to greater demand for environmentally-friendly or green furniture. During the next five years, purchasing concepts among consumers will change from seeking cheap, durable furniture to green and environmentally-friendly products. The same underlying cultural trend favors natural wood furniture products.

5 Another current trend that must be taken into account is product safety, which nowadays is frequently and broadly discussed in China for all product categories and with significant media coverage. Any health-related problems, even in the form of mere allegations, will bring a heated reaction from the market and the press. The divide between modern and classic furniture is still there: imported classic furniture is still pretty much sought after, as it s more recognizable as a luxury item by the Chinese consumers, who are comforted by the similarity of values incorporated in Western classic furniture to their own classic Chinese furniture tradition. On the other hand, consumers in the younger age bracket, who often have or will have higher incomes, tend to favor modern styles as they complement their aspirations to a modern, urban, classy lifestyle. Demographic dynamics should turn the tables, favoring the modern over the classical style. The current quality of life improvement in China implies that consumers require more personality and comfort from their living space. Trends focus either towards an urban, fast, modern lifestyle or a peaceful, natural, old-world lifestyle. While the living room, bedroom and kitchen are generally considered the core function areas in modern life, the Chinese traditional lifestyle focuses on the living room as the main pubic relations area. Hence, it has been the only space really worth caring about, and spending for, in terms of furnishing. However, this trend is slowly changing especially among higher-income consumers and the bedroom is gaining importance. As families become smaller (1-3 components), individuals, especially young and middle-aged, tend to desire a certain degree of privacy and see the bedroom as their private quarters. The importance of a healthy sleep is also an underlying trend. Having finished equipping bedroom and living room, kitchen furniture enters the purchasing list. Usually, kitchen furniture accounts for one fifth of total furniture expenses. It is to be noted, however, the kitchens encounter some problems. The first one is substandard building. Pipelines in the kitchen are not laid inside the walls. The water and gas pipes often block the way for kitchen furniture installation. Flatness and walls verticality are often not good enough to fix kitchen cabinets. Secondly - and more important to foreign manufacturers high-income consumers do not normally use the kitchen personally, and are quite satisfied with what their high-end apartments or villas come equipped with. This implies that foreign products must enter via the contract channel. Price-dominated, the contract channel can be attempted only by those manufacturers who have localized their production in China, or Asia. Kitchenware encounters cultural obstacles; house ware faces stiff local competition. Both can address only a niche market and have to rely on effective brand-building. Appliances are seldom substituted during renovation work. Again, they must take the contract path, where they are challenged by local competition. One-of-a-kind, artisan pieces can count on a small niche market. As mentioned, Chinese consumers are in a relatively early stage of sophistication, whereby they fall prey to the

6 brand s appeal (often the distributor s brand, if individual manufacturers lack the necessary advertising investment) and to a much lesser extent to the item s intrinsic quality or artistic value. Chinese fashion and luxury consumers have for long showed similar characteristics. But recently, more sophisticated consumers fed up with the luxury brands massification are emerging, especially in tier one cities. These individuals tend now to purchase a more qualitybased and less brand-based kind of product. Under this aspect, the furniture consumer lags far behind. Another aspect which must be kept in mind is the strong cultural competition from local artisan pieces, as China can boast a centuries-long tradition in craftsmanship (e.g. wood and stone carving, china and pottery, etc.) As for the materials employed for furniture production and their market share: Wood products make up the largest proportion of the Chinese furniture market at around 54.3%; metal furniture takes up around 29.1%; rattan/bamboo and plastic furniture captures a small part of the market. As for wood furniture which makes up the largest proportion of the Chinese furniture manufacturing sector and the largest market share - the major segments are: household wood furniture, accounting for 46.5% of the wood furniture industry revenue in 2011; hotel wood furniture, accounting for 23.5%; office wood furniture, accounting for 30%. Competing imports represent 0.7% of domestic demand. Major sources of competing imports into China include Germany, Italy, Vietnam, and the United States. Since 2005, furniture import tariffs are equal to zero. Most local producers are small and medium in scale. These enterprises often use low technology levels and produce low value-added wooden furniture products. Some domestic enterprises have improved their production and technological levels to meet the more diversified demands from customers. Now, many furniture styles, such as American, Swedish and Japanese, are manufactured in China and sold in the domestic market. In recent years, rising labor costs, higher raw material prices and currency appreciations have had a negative influence on the industry's profit level. Some foreign and publicly listed domestic enterprises reported higher profit levels in recent years due to higher management and technological levels. Based on market trends, stronger demand is expected for furniture made of solid wood for bedrooms, dining rooms and living rooms. Office furniture made of wood is also expected to gain popularity.

7 Although wood furniture still dominates the furniture market, the increasing price of timber and wood products has had positive impact on metal furniture demand. Its modern and fashionable appearance makes it more popular among young consumers. Metal office furniture makes up the largest segment in this industry in 2011, accounting for 47% of revenue; metal household furniture is expected to account for 28% of industry revenue in Metal is used more in public housing, while the private household market accounts for a small proportion of total metal furniture consumption. However, with technological improvements and more diversified consumer demand, the use of metal furniture in households is expected to increase in the future; automobile and aircraft seats are forecast to account for 19% of total industry revenue in Notwithstanding the increasing volume of imported metal furniture, imports as a share of total domestic demand have been stable at less than 1.0% in the past five years. Major sources of imports are Italy, Canada, and the United States. Metal office furniture makes up 62.9% of imports. Imported metal furniture prices are usually two or three times higher than domestic furniture prices, as their products are confined to the high-end markets. With regards to distribution channels: independent retailers usually retail one or several different types of furniture. Generally, sales representatives from manufacturers contact independent retailers and sell products to them, or independent retailers attend furniture exhibitions and negotiate with manufacturers. In China, independent retailers are the most competitive in providing specialized guidance and service to clients, particularly for medium- and high-end products. In the direct sales channel furniture is sold to end users in exhibition halls, manufacturers' outlets and the internet. In China, office furniture is commonly sold via direct sales, in contrast to household furniture, which is more commonly purchased in retail and wholesale outlets. Franchised stores are a relatively new concept in China for furniture sales. Most of the furniture sold in department stores is aimed at high-income consumers. Warehouse clubs and mass merchandisers are the largest distributors for the low-end segment. The main opinion leaders are furniture/design magazines and interior design professionals. Design Magazines are the main information source for the general public, whilst interior design firms are the consultants to those private clients who are willing to seek out quality products. Their influence may be limited to styles, but sometimes it stretches as far as endorsing individual brands. Lastly, the manufacturer s publicity (more often the distributors ) also affects the potential customers. Outside of the real estate developer-based market, when it comes to purchase decisions, both final customers and interior designers/architects play a part - but their roles are different.

8 Usually, customers make the final purchase decision, while designers set the overall project style on the basis of more or less precise instructions from the customer. Even though generally designers are not supposed to offer brands in their proposals, they are sometimes in the position especially if the design firm is particularly prestigious - to recommend specific furniture brands or specific furniture showrooms.