Chinese real estate: Regulation is another buying opportunity

On the face of it, there are few better industries to be in today than Chinese property development. China’s economic growth fuels greater demand for offices, creates disposable income to spend in retail malls and, most of all, increases the wealth and aspiration of Chinese individuals who buy residential property.

In addition, there’s the world’s most buoyant stock market – China’s A-shares – to provide more capital if it’s needed; there are precious few other places for Chinese people to put their money. Government measures to reduce supply in order to calm down the market have simply added to scarcity value. Mainland property prices were up as much as 30% in primary cities in the first nine months of the year, with a similar pace expected in the fourth quarter.

"Market fundamentals are pretty strong across all sectors," says Chris Brooke, president and chief executive of CB Richard Ellis for Greater China in Beijing. "In residential, the trends are rural migration, increased affordability and income levels, and good steady demand from all different levels. That includes new entrants into the market as they begin to generate wealth; and the upgrading market, as people move up the ladder from their first purchase to bigger units."

Correspondingly, China’s developers continue to grow rapidly. Macquarie Research reckons that by October 2007 the eight mainland developers it tracks had expanded their land banks by an average 5 million square metres each in the year to date, and increased their net asset value by 47% over the same period. Some have been still more gung-ho: Guangzhou R&F had acquired 9.3 million square metres in 2007 by early October, while the most extraordinary story of all has been Country Garden, the mainland developer that listed in Hong Kong in April, raising $1.9 billion. By September 30, it had attributable gross floor area with land use rights certificates of 37 million square metres and a further 15 million where construction permits were not yet signed but expected by the year-end. Most of this land bank was accrued in the few months after the flotation. "Developers are focusing on acquiring land in second-tier cities and developing a national portfolio and brand," says Brooke.

For the moment, investors are lapping it up; Shimao, Agile and Hopson Development have all raised significant sums in IPOs and, most recently, Beijing developer Soho China raised $1.7 billion in October, again in Hong Kong. Country Garden’s stock climbed 35% on its first day of trading, reputedly making billionaires of its five founding shareholders.

But some market observers feel there could be storm clouds ahead for these groups. For one thing, with many aggressive developers out there, competition at public auction has become keen. The government has tried to slow the pace of land release, meaning that there isn’t as much new land coming on to the market as expected: according to government statements and Macquarie, in the first half of 2007 Shanghai released only 14% of its full-year budget for land supply, Guangzhou 8% and Tianjin 34%. The combination of competition and tight supply has meant that some bidders have come away with land that is unlikely to be accretive, and instead is denting margins rather than improving them.

"Developers are focusing on acquiring land in second-tier cities and developing a national portfolio and brand" Chris Brooke, CB Richard Ellis

Foreigners have come in for particular attention. In May, the commerce ministry and State Administration of Foreign Exchange (SAFE) issued Circular 50, on "further enhancing the monitoring and approval of foreign direct investment in the real estate industry". The second circular in this vein (the first, Circular 171, was released in 2006), Circular 50 means that anyone wanting to establish a foreign-owned, onshore, real-estate entity must have land use rights or property title first. It also increases control of foreign investment in high-end property, and makes it more difficult for new entrants to get development rights in the open market, or to purchase income-generating properties from local partners, according to CB Richard Ellis. Finally, there is stricter regulation of an approach called return investment, in which a local property company sets up an offshore firm to reinvest in China’s property market.

The foreign restrictions might actually have been to the benefit of domestic developers. "It hasn’t slowed activity for people who have been in the market for some time," says Brooke. "It has had the effect of removing speculative money from the market, and it may have allowed domestic developers to acquire assets they might previously have been competing with foreign investors for." Brooke says he still sees plenty of foreign investment in the market but from people with a long-term view and established presence. "My own view is that the Chinese government hasn’t been trying to stop foreigners investing in the market, it’s been a question of making sure it’s more focused on the longer term."

Whatever the effect of the restrictions on foreign investors, there have been other measures that clearly do have an impact on domestic developers. They have also had to deal with the enforcement of a land appreciation tax in February, a September increase in the minimum down-payments for individual householders financing their second homes, and a requirement that all developers pay the land premium in full before being allowed to begin property construction.

Pressure on margins

None of this is too heavy-going, although it does put pressure on margins; it’s the fear of more strident regulation that concerns some in the market. "In our view, investors in mainland developer stocks have to factor in the risk of regulatory measures, given that changes will continue to be implemented," says Eva Lee at Macquarie Securities in an October report. "The goal so far has been consistent: to nurture a stable property market that will provide affordable housing for end-users and a steady stream of new property developments with slowly rising prices." But it does come at a cost to developers. "We believe the regulatory measures will make the operating environment in the property market more challenging," says Lee. "All these measures have placed more pressure on the payback period, and eventually property companies’ ROE." She notes initial signs that weaker financial property players are being forced out, and expects consolidation.