The ‘golden time’ for China’s property market may be gone, but there are good opportunities ahead for those developers and investors with a longer term view and which are well prepared.
The market will become more institutionalized and developers with better financial positions and ‘lighter’ assets will survive. Unfortunately, the vast majority, or two-thirds by my estimation, will have to find something else to do in the future. Indeed, a few developers have already announced their exit from the property market. With sales declining, which will likely continue, there is no way the market can sustain as many as 65,000 developers. Consolidation has and will happen.
There has been a fundamental shift in this market. China may today be the only market in the world where shareholder return (or return on equity) is performing worse than cost of debt – and by an increasing margin. This has had a profound impact on developers’ balance sheets over time. That is becoming more visible.
Developers’ debt burden has increased to a level that, while sales volumes have also increased, net profits have gone down. Developers will now have to think about how to deal with their land bank, millions of square meters on their books as these eat away at their profitability and have to be financed or refinanced. Debt is now not cheap at all.
As I predicted, while bank loans and other forms of debts are abundant, shareholders are indifferent in their land bank building from a profitability perspective.
They can always borrow, especially the off-balance sheet money, and use the money to buy more land. But when sales slow, coupled with higher financing costs, developers P&Ls are eroded and they have to rethink about what to do with their land bank. Average sales of land banks in China take average 12.3 months. That is meaningful time we’re talking about.
Let’s take a look at the reports at the mainland developers listed in Hong Kong. For the year ending August, property sales and total profits increased 15 percent and 6 percent, respectively. Nice, isn’t it? But gross profit margins dropped by 3 percent. As one report put it, developers are pocketing in their sales, but not cash profit. Unfortunately, I do not see this having any chance of change and sales will continue to slow down for a long while.
Putting various signals into perspective. Strong developers will become stronger and the less strong will disappear or to be consolidated. There will be very little in between. What developers, or those stronger developers, pleasantly discovered this year is that they can now raise cheaper debt in China by issuing bonds, which they could not do in the past due to policy restrictions against real estate sector. So they rushed into this market, like a gold rush, and issued record domestic bonds. From this January to August 24, all public and private bonds in China were about RMB232 billion ($36.5 billion). Almost half of this, or RMB104 billion. This is quite phenomenal given their close to zero issuance last year.
But then, all of a sudden, these developers ‘disappeared’ from the international bond market as a whole. The yield of one particular developer’s bond was even close to that of the treasury paper.
Average tenor for these developer bonds is 5 years, a significant stretch from their trust loans of averaging 12 months. That helps a lot. But what is more interesting is their cost of funding in RMB is, perhaps for the first time, much lower than in the US dollar space. This is perhaps one of the major drivers for them to go back home and issue bonds. It is may also be true that developers believe RMB will depreciate over time.
What are the implications of this bond surge? I would think there are multiple impacts. It is quite obvious that market only favors major national and regional players. People normally refer to them as the top 20. Not entirely true anymore. Investors now only favor the top 10 now. This will undoubtedly exacerbate the consolidation in this sector. Those less strong developers will have to continue to tap into expensive trust loans for financing (shadow banking). That is why we see, quite surprisingly, the costs of raising trust loans remain more or less the same (if not more so), despite the various rate cuts by the Central Bank in China. Unfortunately, this will create a negative impact on trust companies and I think their book quality will deteriorate further.
Raising long-term and cheaper debt will ‘repair’ part of the balance sheet problems for developers or at least it will prolong the problem to sometime in the future when sales can pick up again. That might be wishful thinking. But at least problems will be put aside for a few years for those stronger developers.
Chinese real estate continues to offer great opportunities for investors, but investment strategies must change, as the market is undergoing a fundamental shift. Today, given what is going on, the market looks even more attractive for investors with a long-term view which are prepared to take advantage of this short-term enlarged volatility.