HOT MARKETS: How the mighty have fallen

When asked to name Asia’s hottest investment markets, for the past decade or so, investors would have put China near the top. And why not? With the largest population and decades of catching up on the development front, the Communist country was promising mouth-watering returns for property investors.
In the past six months, however, that sentiment has done a 180. As China’s overall economic growth slows, the real estate sector has shown some cracks, which mass media have pounced upon hungrily. Sales figures have fallen in the first half of this year, certain cities are burdened with irrational overdevelopment (hence China’s ever-popular ‘ghost cities’) and developers are overleveraged. What was recently a sizzling market now appears to have fallen victim to its own success.
When observing China’s volatility from afar, investors cannot help but draw parallels to the US crash in 2007 and 2008. Many of the same symptoms are present: overleveraging, a lack of regulation and a general market slowdown. Considering that China’s growth has all but fueled the world’s economy since the global financial crisis, investors seem to have every reason to bite their nails. The only question is how nervous should they be?
(Un)sustainable growth 
Unlike China’s previous downturns in 2007 and 2011, this one is not solely driven by harsh government policies, according to Wei Wang, managing director and general manager at Ping An Real Estate Fund Management. This time, the funda-
mental supply/demand dynamics for real estate are indeed “out of whack,” precipitating a market correction, he explains.
While investors can’t help rolling their eyes at the mention of China’s ‘ghost cities’ (there are ghost cities in the US, too), oversupply is unquestionably a problem. With approximately 45 billion square feet of new residential development started over the past three years, lower-tier cities are being hit particularly hard as supply hits the market. At its current absorption rate, for example, the city of Tangshan could take 12 years to exhaust the new housing supply coming up for sale, according to Chinese media.
According to Xiaoliang Xu, president of Fosun Property Holdings, the root of China’s purported ‘property bubble’ is that the residential sector grew too fast for industry to keep up. Xu calls this the Three Highs Model: land prices kept going up, the cost of debt also kept going up and, in the end, it all depended on housing prices continuing to rise. “And we all know this model cannot possibly continue indefinitely,” he says.
The 2014 figures speak for themselves: national sales volume on a gross floor area basis fell 5.7 percent year-on-year in the first quarter – the first drop in two years – and 9.3 percent year-on-year in the second quarter, according to research firm Real Estate Foresight. This decline in sales volume occurred even as prices retreated by 0.3 percent and 0.8 percent month-on-month in May and June, respectively, in an effort to tempt buyers.
Developers also have relied too much on debt, even moving to the unregulated space. In the face of government crackdowns on excess liquidity, CBRE estimates that China’s shadow banking sector has grown to as much as $5 trillion, with real estate representing about 10 percent of that. With very little transparency, interest rates often can be in the double digits compared to 4 percent offered by banks. For the almost 85,000 local developers that are forced to rely on the shadow system, the impact on profit margins can be crippling when sales are not booming.
A warranted reaction 
Such a stark slowdown and crunch has not gone unnoticed by investors, even those bullish on China. Indeed, Wang says Ping An has decided to slow down its pace of investment in mezzanine property deals, despite growing refinancing needs. Several mezzanine investors also tell PERE that they have tightened their underwriting requirements.
“We now need to at least make money back with some returns, even if the market goes down,” said Andy Wu, investment director at Forum Partners, at the PERE Forum China in Shanghai in July. Thomas Liu, managing director and head of greater China for Standard Chartered Bank’s principal finance real estate group, agreed that his bank will no longer project 5 percent to 10 percent growth, but a 10 percent drop in price. Only if the deal can be profitable after that price drop would the bank invest.
“It feels like we are now midway through a lull, so it is a better time to be more cautious,” says Calvin Chou, managing director for China at Morgan Stanley Real Estate Investing. “There are simply fewer opportunities that make sense, as the spread between sellers’ and buyers’ expectations is still fairly large.”
In its Mainland China Real Estate Markets 2014 survey, the Urban Land Institute (ULI) found that investors’ rating of the investment prospects in 36 of China’s largest cities declined to 2.75 on a scale of 5 from 3.0 just one year ago. The only cities considered to have ‘good’ prospects were the four Tier 1 cities. “Investors are realizing that it’s not as profitable to develop as it used to be,” says Kenneth Rhee, ULI’s head of China.
What is distinctly lacking from all these reactions, however, is panic. No one, not even the more cynical investors, is predicting another financial crisis from China. That comes down primarily to one reason: on the individual level, the market is not that dependent on debt. 
One large Shenzhen-based developer says the average homebuyer in China usually borrows only 50 percent and some as little as 30 percent, “insulating” the market from a broader collapse. “The problem in the US was that it was a domino effect, and it fell fast,” he explains. “Everyone was leveraged on nothing, and the pressure went back to the consumer.” Leverage in China, however, is mostly on the developer level.
Government has your back 
Investors generally see China’s changes as a “natural market correction” and, for the first time, the Chinese government isn’t stepping in. This year, it already has allowed high-profile bond and trust defaults, not to mention the collapse of developer Zhejiang Xingrun Real Estate, which left RMB3.5 billion of debt.
That is no accident. According to Keith Chan, managing director and head of greater China real estate at Macquarie Capital, the Chinese government wanted this property slowdown to happen to control speculation and weed out developers that cannot stand on their own. It is that level of control over the economy and banks that makes the biggest difference in investor confidence.
“The Chinese government has a contract with its people: its sole job is social stability,” concurs Goodwin Gaw, managing principal and co-founder of Gaw Capital Partners. China cannot afford a property bubble to pop as violently as the one in the US, or the streets would erupt in protest. 
“Real estate is just too big to fail because it will impact social stability,” the Shenzhen developer says. “The government will let the industry slowdown and normalize, but not drag the whole economy down.” 
To that end, the government already has nonperforming loan entities set up to swallow failures and, when any developer defaults, both local and national governments will stay involved in the cleanup to be sure the social repercussions are taken care of, Gaw explains. Even in a worst-case scenario, if the entire country faced defaults, Chou believes the government’s balance sheet could be big enough to absorb it.
Over the past few months, in fact, the government has shown it has the capacity to change policies and stimulate the economy if it wants to. Real Estate Foresight counts at least 11 Chinese cities that have eased housing policies locally to prevent upheaval. However, by and large, investors need to accept that the government won’t bail out struggling developers or projects anymore, Gaw notes.
A new reality 
“The days of investing in any real estate and making money are gone,” the Shenzhen developer says. “Investors need to pick the winners.” Still, he does not consider this bad news for business; in fact, he is expecting cheap deals as smaller developers default and the market consolidates.
“People who expect development margins to go back to where they were will be disappointed, but I don’t see any upcoming ‘doomsday’,” Chou agrees. “Larger developers have the ability to cut prices as needed to manage through slower market cycles, and I think there is still the demand to absorb the pipeline on the buyer side.” He and Rhee both underscore China’s continued urbanization and job growth as factors driving demand, as well as the need for redevelopment.
Rhee also adds that investors should not overanalyze this year’s sales drop because 2013 was particularly hot, with sales surging to RMB8.14 trillion. In fact, sales still are better than two years ago, and oversupply is often localized. Even within infamously oversupplied cities, like Shenyang’s retail, there are investors finding niches, he points out.
Indeed, over the summer, several large institutional investors made hefty bets on China’s growth. Dutch pension administrator APG Asset Management injected $650 million into a logistics developer, and the Canada Pension Plan Investment Board formed a $250 million residential joint venture with Vanke. 
To the Shenzhen developer, this current pain is one more step in China’s transition to a more institutional real estate market. “China is now kind of in between the ‘Wild West’ and a stable market,” he says.