Trouble Ahead for Chinese Real Estate and Construction Companies
posted by The Traveller on Sunday, May 16, 2010
Over the past two decades, China's economic boom has created a new and fast growing upper middle class, people who made a lot of money in the private sector and can now be considered "wealthy" even by Western standards. For those wealthy Chinese there are very few options to put their money to work. Government laws forbid Chinese citizens from making investments in overseas stock markets, and generally there are many obstacles to pass before Chinese capital can leave the country. That leaves only domestic stock and property markets as an investment option.
If you have ever wondered why average price-to-earnings ratios on Chinese domestic markets are so much higher than in Europe or the U.S., there you have the reason. China's leading market, the Shanghai Stock Exchange, might look to be in a downturn now, but don't forget that the SSE Index is still up 50% since the beginning of 2009 and 130% since 2006. Adding to this rally is also that Chinese investors can usually only benefit from rising share prices, so the incentive to buy and hold is very high.
The peak of the stock market craze was reached last November when the Shenzen Exchange opened their "ChiNext" labeled Growth Enterprise Market for high-tech startups. On the first day of trading all of the 28 stocks listed on the new exchange skyrocketed by at least 76%. On average stocks more than doubled with gains up to 210%, just on the board's first day of trading.
According to the official Shenzen website the average P/E ratio of ChiNext listed companies still is a staggering 61.78, and both the board for small and medium caps (P/E: 42.29) and large caps (P/E: 33.53) sports much higher multiples than comparable American or European markets.
The domestic property markets are inflated as well, and for the same reason. Christina Larson wrote a very good article about the subject on the Foreign Policy Blog last week, which describes how Chinese real estate investors are thinking:
Ms. Wang, the wife of a successful Beijing businessman who gave only her surname, has purchased four homes in recent years. There's the apartment she and her husband live in, and three others they hold as investments. All three are vacant; she's making no attempt to rent them out. No property taxes are assessed in China, and so there's no financial penalty for simply buying and holding. The rental market in Beijing, in comparison to the red-hot real estate market, is fairly weak, and besides, renting out those apartments -- putting them to use and risking some wear and tear -- could diminish their value. So they remain pristine and empty.Commercial property developers have made good money of this thinking, however they are fully aware of the "bubble environment" as Zhang Xin, CEO of Beijing's largest developer SOHO, confirmed in a recent interview with China International Business:
The real estate business should really be looking at rental yield; build a building and then lease it out with the rent giving a decent return. But, because of where China is with asset bubbles, people want to buy the assets regardless of whether they can be leased out or not. Now, if you look at the prices for the property being sold versus the rent you collect there is a real disconnect. Prices are too high, rent is too low, so if you hold property in order to get yield you are likely to get very little. For us it makes no sense to hold property, so our strategy is to sell everything. We see ourselves very much as a manufacturer. We buy land, we build, and then we sell.Now this strategy to sell property into an inflated market does only work for as long as it stays a seller's market and this is about to change. Mid-April the government introduced new policies targeting excessive speculation in housing investment, mostly in Tier 1 cities like Beijing and Shanghai. For third-home buyers or anyone who already owns more than three apartments, down payments and mortgage rates will increase dramatically. In cities where housing prices are excessively high, or are increasing quickly, or where the supply is limited, banks can choose to reject mortgage applications. Furthermore, the new policies make it much harder for non-local resident buyers to access the market and even a trial property tax is being considered in the four largest cities.
Analysts and media were focusing on those Tier 1 cities and the fast growing cities in China's heartland were widely seen as less affected by the new policies. Brean Murray published a research note just 10 days ago defending Tier 2 developers like Xinyuan Real Estate (XIN) and China Housing & Land (CHLN):
Recent tightening policies targeting Tier 1 cities and third-time home buyers should have limited impact on Xinyuan Real Estate and China Housing and Land, given that first-time home buyers and first-time home upgraders now account for more than 90% of total sales for both companies. Mortgage rate and down payment requirement policies are being kept the same for the first-time home buyers, and are still very encouraging for first-time home upgraders. Both companies also have very limited non-local buyers who are also restricted from housing speculation.However, last week's quarterly reports have proven Brean Murray wrong. There are clear signs of trouble for real estate developers throughout China and the new policies do very well affect the housing markets in Tier 2 cities. Xinyuan added very troubling comments to their report last week:
While we do not operate in Tier I cities where speculation has been most rampant and the policies are most targeted, the new policies have nonetheless had an impact on our projects, most notably in our Kunshan project. Kunshan appears to be the Xinyuan project most affected where virtually no mortgage lending is taking place. 182 apartment units were sold in the first 18 days of April while just 8 units were sold in the subsequent 10 days. Potential apartment buyers are also seeking clarification of the new housing policy. While we continue to believe the attractiveness of the project due to its nice location, easy transportation to Shanghai and more affordable price, we do not know when buyer traffic will return and with what force under the new housing policies since the new policies have only been implemented by a couple of weeks. As the Kunshan project accounted for 63% of our contract sales in the first quarter of 2010, it is difficult for us to predict the sales trend for May and June.China Housing & Land has been somewhat more positive when they commented that "since government policies raised purchase hesitation in the Xi'an real estate market, the sales for the coming months have become less visible. That said, we are still confident with our project pipeline and market positioning and maintain our previous financial outlook for 2010."
It will be very interesting to see how the Chinese government will proceed from here. It seems clear that they are determined to curb speculation and possibly bring down the inflated market to a more tolerable level in an orderly way. However, construction and property markets are the main drivers for China's growth and there is a high incentive for officials to just do business as usual for as long as possible. Many local governments derive as much as one third of their annual revenues from land sales, and without that money some of the spending for desperately needed infrastructure projects might have to be cut.
As a private investor in US-listed Chinese equities you should be aware of this situation. Even assumed that the government will be able to deflate the property markets in an orderly way, even if you believe that there is no bubble to burst and China will be able to maintain annual GDP growth rates of 8-10% over the long term, some industries will most likely be affected by the new policies and the effects might be more serious than just stalling growth rates.
I would personally avoid those industries for long-term investments now, most notably real estate, construction and steel. Even if many of the stocks in those sectors might look cheap now based on trailing earnings, there is a growing uncertainty about future prospects, and if you put your money in "safe" sectors that are only marginally affected by those developments you will have a much better risk/reward ratio.