Two-thirds of high-end retailers missed their targets for new store openings in China last year, according to an analysis of 43 retailers published by development and design consultants Knight Frank and Woods Bagot.
Lower-priced fast-fashion brands such as H&M (>> H & M Hennes & Mauritz AB) and Zara (>> Inditex SA), however, beat their expansion goals.
The shift reflects a government crackdown on lavish gifts, a growing preference among many Chinese to take advantage of lower taxes and buy their luxury goods abroad, as well as an emerging middle class looking for affordable brands.
For brands such as Samsonite (>> Samsonite International S.A.), the move downmarket is a welcome change. Last year, the luggage maker opened 200 new outlets in China. This year, the target is 500.
"Before it was like we were unwanted people, illegitimate brands. They needed the luxury brands," said Ramesh Tainwala, Samsonite's president of Asia Pacific and Middle East. "The equation is changing."
Tainwala said he is now getting prime spots in department stores near Qingdao in eastern China and Urumqi in the northwest - places that would have relegated him to the luggage department just a year ago.
For developers who thought China would never tire of luxury, it could be a $25 billion miscalculation.
James Hawkey, an executive at commercial property services group Cushman & Wakefield, estimates that up to a quarter of the 700 malls, department stores and outlets currently under development in China's top 30 cities could fail, costing developers as much as 150 billion yuan ($24.60 billion).
"The mid-market retailers are expanding fast, but they are not expanding fast enough to fill all of the shopping centers," Hawkey said.
In some markets such as Chengdu and Shenyang, there are as many as 10 shopping centers in the works while the likes of Zara and H&M only plan to open two or three stores, he said.
For luxury brands that invested heavily in China, the stores are becoming expensive window-shopping destinations where customers can check out products before buying abroad.
Concerns about authenticity and domestic taxes that can top 40 percent have long lured wealthy Chinese to shop overseas. Now, easier visa requirements and a growing appetite for new experiences pushed the number of outbound Chinese travelers to 100 million last year, a 20 percent increase from 2012.
Brokerage CLSA forecasts the number of Chinese travelling overseas will hit 200 million by 2020.
"Really the investment we're making in China is so that we also benefit when they travel outside China," Burberry (>> Burberry Group plc) Chief Financial Officer Carol Fairweather told analysts in January.
Burberry, which has hired Mandarin-speaking sales associates globally, has 72 stores in China and will open its largest store in the Asia Pacific in Shanghai this spring. The luxury retailer will continue opening stores in mainland China but will be "making sure they're in the right locations with the right adjacencies," Fairweather said.
Gucci parent Kering (>> KERING) said in October that Chinese tourists had boosted the company's European sales by almost 10 percent and sales to Chinese visitors to the United States were "booming".
"Given the slowdown in luxury retail sales and more Chinese travelling overseas, the shops in China are now for window shopping. Instead of opening three or four in each city, they might just open one or two," said CLSA senior research analyst Susanna Leung.
Much of the new mall development is concentrated in smaller cities where average income is lower and customers are looking for mass-market brands.
A survey by the China Chain Store & Franchise Association last spring showed that about half of the developers surveyed would be expanding in top districts in these cities and nearly a quarter would build in average districts.
Luxury brands prefer downtown locations in big cities like Shanghai and Beijing.
The world's biggest luxury group LVMH (>> LVMH) plans to slow its annual China expansion to 4 to 5 percent, about half the rate it recorded in 2013.
"I can confirm that the idea is not to develop in the second-rate or fourth-rate cities in China. We do want to keep our presence in China in the iconic areas," Chief Executive and Chairman Bernard Arnault told analysts last month.
Luxury retailer Prada SpA (>> Prada S.p.A.) has also expressed concerns about extending its customer base too far in China and Gucci has said it will focus on renovating existing stores and renegotiating its leases as they come due.
Luxury brands' increasingly careful assessment of the China market could hurt developers' bottom line if it means cutting back on rentals.
The average rent in a high-end shopping centre in a smaller city fell 2 percent last year while the average vacancy rate rose to 10.9 percent, the opposite of what happened in bigger cities, according to the Knight Frank and Woods Bagot report.
"For the newer centers in non-core locations, the landlords don't have pricing power," said Steven McCord, local director for China retail research for property firm Jones Lang LaSalle.
"In order to fill up their malls they've got to be generous with rental terms," he said, adding that developers are also offering to pay fit-out costs and pursuing less-expensive luxury brands such as Coach (>> Coach, Inc.) and Michael Kors (>> Michael Kors Holdings Ltd).
The shift downmarket will challenge mall developers for years to come, said Paul Hart, greater China executive director with Knight Frank.
"Remember the movie, 'Field of Dreams'? It's a little bit like that, 'build it and they will come'. I think there is a lack of appreciation by certain people in the development community about the dynamics that drive retail," he said.
($1 = 6.0984 Chinese yuan)
(Additional reporting by Alice Woodhouse, Donny Kwok and Clare Jim; Editing by Emily Kaiser and Miral Fahmy)
By Clare Baldwin
Stocks treated in this article : HERMES INTERNATIONAL
, Apple Inc.
, Coach, Inc.
, Inditex SA
, New World Development Company Ltd.
, Wharf Holdings Ltd
, Burberry Group plc
, H & M Hennes & Mauritz AB
, Samsonite International S.A.
, Prada S.p.A.
, Michael Kors Holdings Ltd
, Compagnie Financiere Richemont SA