Chinese real estate: Regulation is another buying opportunity

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By:
Chris Wright
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The Chinese property market is booming, even when the pace of land release is restricted. But concerns about policy and that some developers’ stocks might be overvalued have injected some caution into the market. Chris Wright reports.

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
Chris Brooke, CB Richard Ellis
The slower pace of land release is part of a broader effort to cool the real estate sector and keep it moving along in a manner that the state finds comfortable. At the macro level, this is evident in policy: the People’s Bank of China raised the bank deposit reserve ratio five times in the first half of 2007 alone to pull liquidity from the market.

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.

Christopher Gee, head of Asian real estate for JPMorgan, says that greater regulation might be a bigger threat to the market than oversupply. "You will get pockets of oversupply, but that’s not necessarily the biggest risk," he says. "That corrects itself at the end of the day. The problem comes where you get a regulatory response to real estate price appreciation: a sledgehammer being taken to the sector. That kills everything off and you go quickly from a bullish environment to a negative one." That said, the market has behaved curiously towards regulatory change so far. "The market seems to be conditioned to any new regulatory measures so that it sees them as a buying opportunity," says Gee, who is cautious about Chinese developers given their recent price runs.

Eric Wong, co-head of Asian property research at UBS, thinks there are constructive regulatory positions the government could take. "One is to try to foster a more robust system that allows supply to get to market," he says. "China developers have a deadline by which they have to start work when they get a piece of land, but that just means you put a shovel on the ground. It doesn’t say you have to be sold out in X years. Something as simple as that would cause disciplined supply on to the market, instead of developers sitting on land and waiting for automatic land appreciation."

This is a curiosity of Chinese real estate law: whereas in most countries developers are not permitted to pre-sell before starting construction, in China they can. This is good news for them – it means they can enjoy cashflows much more quickly after purchasing land than is the case elsewhere – and, to take Wong’s point, it reduces any incentive to get started, which in turn puts another twist into the supply-demand equation.

There are some other potential headwinds for Chinese developers. One is a changing interest rate environment. Most obviously, this is an issue for developers with heavy gearing. Yi Chen, a China property analyst at ABN Amro, has a sell recommendation on Guangdong R&F, for example, whose first-half net gearing was more than 120% (Yi also has his doubts about Guangzhou itself, considering it an oversupplied, overheated and risky market to be in). "Developers with low gearing are well positioned," he says. "If the central bank increases interest rates another two or three times, it follows that those with high gearing will be hurt. It’s very risky."

Eric Wong, UBS"In China, if you have negative real rates of return on deposits, what do you do? You put it in the share market or property"
Eric Wong, UBS
There is a secondary effect too: the relative merits of the different things Chinese people can do with their money. "In China, if you have negative real rates of return on deposits, what do you do?" says Wong. "You put it in the share market or property. The best cure for hyper-demand is to bring it back into the banking system by offering an attractive enough interest rate." So further interest rates increases in China, in improving the allure of bank deposits, could take some heat out of the property market. By increasing the cost of borrowing to invest in property, there would be a double impact.

Another issue to consider is the extraordinary behaviour of the local stock market. By November 5, the CBN600 index, a measure of the Chinese A-share markets, was up 159.2% year to date, and 235.2% in the 12 months to that date. Nowhere else on earth does the stock market look remotely like this. That’s handy for Chinese developers wanting to use equity to fund themselves but it is clearly showing bubble characteristics. Chester Kwok at Credit Suisse argues that it is important both to look at the physical market (which is fine) and the stock market when considering Chinese developers: he says the bigger and better ones justify their extraordinary P/E ratios because they are growing year-on-year earnings by 30% to 60%. However, for smaller, less well-managed companies with less of a track record, there’s real bubble potential.

If that bubble bursts it will have an impact on the ability of developers to expand, but it might also push a lot of money out of the share markets and back into property again.

It’s a changing environment, and some market watchers expect developers to change too. "Land is a scarce resource and, until now, the key focus has been to acquire it," says Macquarie’s Lee. "Having a superior quantity and quality of land gives the developer a tremendous head start and is at the centre of a company’s Nav calculation. Now that the developers are much bigger, though, acquiring more land only contributes marginally to the company’s value."

A bigger issue, instead, becomes how skilfully and efficiently a company can turn over its assets through sales and pre-selling, for example, to create the most value for shareholders. Alongside this, developers then have to make sure they complete developments on schedule to keep their reputations intact.

One way or another, the big guys are at an advantage. "The stronger, quality developers should continue to lead in terms of sales and margins, and be able to expand their market share in the consolidating market," Lee says. And one of the reasons they are able to keep margins strong is because they have a greater range of means for getting the land in the first place. They’re more likely to be able to acquire land through private negotiation or the secondary market. "Obviously, if land prices continue to rise at a faster pace than residential prices, it won’t be healthy for the market over the medium to long term," says Lee; avoiding the public auctions and going private gives a better chance of insulation from this trend.

Another shift is that, after two years of rapid land acquisition, developers have started to boost production, with some developers planning as much as 3.5 million square metres of production in 2008. "Most investors are questioning whether the residential developers can deliver the fast expansion in planned volumes required," says Lee. "Most investors, including ourselves, assume that the developers can only complete 70% to 80% of their planned completion." Those that do deliver on time are likely to be rewarded by the market.

To meet this demand, strategies have included the acquisition of construction companies to ensure capacity; shifting the construction approach from on-site building to prefabrication; expanding into more cities; tying up with foreign partners such as property funds; and accessing the A-share markets.

Positive outlook

Although developers do face challenges, the overall outlook is good. The growing middle class – the engine of the residential property industry – is only going to get bigger, given China’s continuing exceptional economic growth, which has so far translated into much higher disposable incomes among ordinary Chinese. Disposable income grew by about 18% year on year in the first half of 2007, according to government data; salaries have grown at a 12% compound annual rate since 1998, and savings by 15%. Analysts tend to expect year-on-year property price rises of around 10% in 2008, with higher rates in the primary and (especially) secondary cities.

The same growth in Chinese consumerism is also positive for retailers, and for shopping malls. This is good for groups such as Hang Lung Properties, which has experience in managing malls, and the Singaporean group CapitaLand, which launched a highly successful Singapore-listed real estate investment trust holding Chinese shopping malls.

"The retail sector is going through a period of transition from the traditional department store structure of five or 10 years ago to the international shopping centre format," says Brooke. "Demand from local and international retailers remains strong: there are lots of international chains rolling out." There’s less experience domestically in running malls but developers are using consultants or partnering with experienced managers to get around it.

The office market is also clearly linked to Chinese economic growth. "The demand is still strong in Shanghai, Beijing, Guangzhou and in the second-tier cities such as Chengdu, Hangzhou and Tianjin," says Brooke. "In the next batch of cities there’s less demand for top-quality, grade-A space at this time; that’s more a medium-term play. But lots of developers are starting projects that won’t be finished until 2009 or 2010 in anticipation of higher demand in those cities."

Other new sectors of Chinese real estate are emerging. One is industrial logistics, a sector that only really emerged with land tenders about a year ago, although so far it has been dominated by the government doing direct deals with occupiers.

So it’s a vibrant market, and a challenging one, but still a good place to be, despite the intrusion of the state – or, in fact, because of it. "So far all the property measures have been restraining supply," says Wong. "The natural conclusion is very high prices."