Property market headed for
deflation By Laurence Lau
Deeply concerned with the red-hot property
market, the State Council, China's cabinet,
announced on Wednesday night some new
macroeconomic control measures to curb land and
housing hoarding and speculation. The new measures
include steps to readjust taxation and land
supply, and to build more public housing for
average-income families.
Whether the new
measures will be effective remains to be seen,
since the real-estate sector has been a target of
Beijing's two-year-old austerity policy, which
apparently has been unsuccessful. Hence the risk
of a property bubble bursting in China is on the
rise, as the housing vacancy rate has been
growing remarkably even as
prices continued to rise in the first quarter of
2006.
Taking Beijing as an example,
housing prices in the capital grew nearly another
15% year-on-year in the first quarter of this year
to exceed 7,000 yuan (US$876) per square meter,
after a 19.2% increase for the whole of 2005.
The odd thing is that unsold housing space
also shot up. In Beijing, the total area of unsold
housing floor space rose 22.3% year on year by the
end of April to reach 4.43 million square meters,
according to government statistics. According to
the National Bureau of Statistics, total area of
unoccupied housing across the country reached 123
million square maters in the first quarter of this
year, up 23.8% from a year ago. This put the
vacancy rate up to an estimated 26%, said Yi
Xianrong, a researcher with the Institute of
Finance under the Chinese Academy of Social
Sciences.
What does a 26% vacancy rate
mean to property developers? Normally, they will
start checking themselves into the hospital once
the rate goes higher than 10-12%, and start
writing their wills when it exceeds 15%. So we are
in very dangerous territory here.
No one
doubts that there is immense housing demand in
China, and that this will remain true for a long
time. What is at issue now is affordability, as
housing prices are becoming ridiculously high.
Hence only a minority of Chinese residents can
afford to buy property, and this small minority is
buying up an increasing percentage of the market.
Another big player in China's property
market is foreign investors, but the picture there
is not any more reassuring. Rents are struggling
to maintain their current level, as demand from
expatriate postings has begun to dwindle slightly.
Rental yields will not be able to keep up at the
current rates. In fact, current rental levels are
not realistic, because many investors do not see
rent yields as necessary since they are only in it
for the capital gains - the classic setup for a
market-exiting stampede.
When more than
70% of the population in the coastal areas cannot
afford property, it is not a good sign. Yet the
trouble with bubbles is that they are easier to
spot than to prick - to time a correction is
exceedingly difficult. Despite the rising vacancy
rate, there were still a massive 1.03 billion
square meters of housing under construction across
China during the first quarter. That figure was up
by 23.3% from a year ago. As if that was not
enough, in the first quarter of this year,
property developers put another 280 billion yuan
into construction projects.
Another sign
pointing to a possible deflation of the Shanghai property bubble
was the surprising rating given the Shanghai Real
Estate (SRE) bond issue by the ratings agencies
Standard & Poor's and Moody's. SRE is a
leading developer in Shanghai's financial hub, and
has proposed a US$150 million (HK$1.17 billion)
bond issue. It was rated as non-investment, or
junk status, as the rating agencies were concerned
about the company's narrow focus and limited cash
flow. Standard & Poor's assigned a "BB-"
long-term corporate credit rating to the
seven-year bonds, three notches below investment
grade, while Moody's Investors Service assigned a
similar "Ba3" rating.
The ratings reflect
the key challenges facing SRE, including a lumpy
operating cash flow, resulting from its
single-business focus on property development. The
significant geographic concentration on Shanghai
alone did not help either, and the company's
rising leverage was a big concern.
In
Shanghai, leverage is not just an option: it is a
necessary tool to compete. Developers there have
to get the biggest projects and complete them the
fastest, and try to sell them as quickly as
possible. To enable the retail side to buy, many
developers have innovative financing schemes to
help the buyers/speculators, increasing the
dependence on leverage.
SRE announced last
month that its 2005 profits surged 234% to HK$301
million (US$38.59 million), from HK$90 million a
year earlier. The company plans to use the net
proceeds from the proposed bond sale to replenish
its land bank, rating agencies said. It has a land
bank of 1.4 million square meters in gross floor
area in Shanghai, which the company estimates will
be sufficient for its developments for the next
four to five years.
However, S&P did
say that SRE's low-cost land bank, good locations
for its properties, and expertise in the industry
are offset by its high concentration risk,
small-scale operations, and lack of stable,
recurring income. After the bond sale, SRE's
earnings before income tax (EBIT) will fall to
about three times its interest expense in 2007,
down from 10 times in 2005 - showing how the
firm's interest burden has become dramatically
heavier in just two years.
Cases like
SRE's are being replicated all across Shanghai.
There is not sufficient cushion for even a minor
blip.
There has been talk that increasing
real-estate investment trust (REIT) involvement in
China's property market will maintain its
momentum. But even an aggressive REIT boost for
commercial properties may not save them, because
most of their yields are not sufficiently high to
attract REITs; in addition, the bulk of the
problem is in residential housing, which is not
REIT-able (to coin a phrase).
A bursting
bubble is bound to happen, and if you don't want
the "bubble gum" on your face, a reduction in
exposure is recommended - although staying away
from China property when one has already made
millions may be very difficult.
In the
property market's current state, it will take just
one event to trigger the domino effect, and that
one event could be anything, from the raising of
interest rates, to a small developer absconding, a
developer stretching capital too far, or buyers
forfeiting their deposits. It will happen, and the
best guess is it will be way before the 2008
Summer Olympics, not after.
Laurence
Lau has more than 18 years of experience in
business and finance. Born in Malaysia, he has
worked in Sydney, Singapore, Hong Kong and Kuala
Lumpur. He was head of research for two securities
firms and a portfolio manager for a UK firm.
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