2012-04-06

Chinese real estate market reaches critical stage; rising sales signal new price wave cut may start soon; ¥800 billion in debt offset by ¥723 billion in depreciating inventory

In March, real estate transaction volume by area increased in 33 of 40 cities monitored by China Index Academy. First quarter volume by area fell in most of 20 major Chinese cities tracked by the China Index Academy, while prices were down in all 20. On transaction volume by area, Suzhou led the six cities with increased volume, up more than 100%. Of the 14 cities with decreased volume, Dalian led with a 73% decline. The numbers are starting to improve a bit and year over year comparisons will start getting better as time goes by, but the absolute level of transactions remains very low.

Shanghai saw 800,000 square meters transacted, for example, the highest since May 2011. Shenzhen saw more than 300,000 square meters and 3,420 properties transacted, both 7-month highs. Shimao Cross Straits Plaza, a commercial property in Xiamen, has sold ¥1.2 billion of office space since hitting the market on March 24. Individual firms also saw an uptick in volumes, with Poly Group's March yuan volume of ¥9.6 billion up 267% from February, while Greenland was up 589%.

However, signs still point to weakness as land transactions and volume tumbled, showing that developers continue their pessimistic outlook. More importantly, 69 listed developers have a combined ¥800 billion in debt and ¥723 billion in inventory. When looking at Chinese developers ability to finance this debt, one must understand that these firms use advance sales tactics. Revenues are pushed forward under this accounting policy, while profits are reported when the transactions are completed. Thus, 2011 saw solid earnings from many developers, despite the balance sheet deterioration seen in inventory and debt levels, because 2010 sales were finalized in 2011.

According to E-House China data, last year in 30 representative cities, area volume was about 138 million square meters, down 26% from 2010. To break the transaction deadlock, developers slashed prices as much as 30%, which is why deputy director of E-House China, Yang Hongxu, says the developers' situation is not as good as their annual reports showed. (Some firms reported 30% earnings growth, even though many firms reported declining profit growth.)

Vanke's inventory is ¥208 billion against 2011 sales of ¥122 billion, or 21 months supply at the 2011 rate of sale. However, since sales growth declined during 2011, at current rates it would take the market even longer to digest this supply. Zhong Wei, director of BNU's Financial Research Center, said under the most pessimistic scenario where new construction falls 5% and area sold remains the same as last year, developers' 2012 year-end inventory will reach 4.7 billion square meters; and under the most optimistic scenario where new construction falls 15% and area sold increases 10%, inventory is estimated to be about 4.5 billion square meters. He estimates it would take about 3 years to clear this inventory when factoring in new construction. Also, this inventory costs roughly ¥345 billion to finance (interest and debt repayment), while 2011 profits were only about ¥500 billion.

If those ¥500 billion in 2011 profits are partially made up of 2010 sales, then a baseline earnings figure for 2011 would be lower. If one factors a 30% decline in area sold and a 15% price decline (thus far citywide average declines are in the low single-digits or less) since the fourth-quarter of 2011, the industry as a whole would operate at a loss.

Interest payments remain high, with Vanke's interest cost at ¥1.2 billion (last year the firm reported net profit of ¥9.6 billion), though still well within the firm's ability to pay. That said, many analysts are looking to the real estate trusts that are coming due this year. Shenyin Wanguo issued a report showing ¥306 billion in trust principal and interest coming due, with the peak payback period starting in March. The trusts are financial products sold by financial firms as high-yield products for investors and loaned to real estate developers (as high as 20% interest) who had trouble accessing bank credit. (Not because they were credit risks, but because state-owned firms were taking the lion's share of bank loans and the government restricted credit to the sector.)

China E-House data shows sales in January and February of ¥415 billion, down 20.9% from 2011. Developers have increased self-financing in the face of tight credit and a weak market, raising nearly ¥600 billion in those first two months, up 43.3% from last year and accounting for 42.3% of all financing, an increase of 1.3% from 2011. This scramble for cash has replaced the developers' strategy of "grab land when the market is bad, sell homes when the market is good." Now they are simply hoping to raise enough capital to pay back their creditors.

If the real estate market holds the line here and prices do not decline, developers as a whole may see another profitable year. However, if a second wave of 10%-plus price cuts begins as transaction volume picks up (which I predict will happen), then the industry as a whole may see net losses. Looking into 2013, the big question is whether the bubble continues to deflate. Firms may escape 2012 by paying debt with debt, but if the market weakens, their balance sheets will look much worse as debt levels stay high, but inventory depreciates.

There are two additional factors that make me confident things will get worse for developers. The first relates to inventory. In every bubble, assets are overstated and I would be surprised if Chinese developers didn't have write downs. Even assuming the numbers are accurate, a further price decline of 20% would lower inventory values and could wipe out the equity of many firms. Second, I believe the market has turned a psychological corner. Home buyers no longer believe prices always go up and they now expect price cuts. Government policy remains tight and lower home prices are conducive to building a consumer economy, by increasing disposable income, which is why I do not expect it will loosen much unless/until a disaster appears imminent.

We have yet to see a developer panic. At some point, however, I expect one of the financially weak firms will try to dump inventory (possibly into a second-tier city that hasn't seen major declines) and prices will tumble, setting off the waterfall price declines and the period of maximum pain for developers. General sentiment still seems to be that major price declines will end in the first half of 2012 and the government will ease up in the summer. If bigger declines are coming then, I expect they will arrive as the optimism for the second-half of the year (optimism means no or mild price declines) meets the reality of debt repayment and continued pricing weakness.

Finally, remember that many state-owned companies opened real estate development divisions, along with private firms. The focus on listed developers such as Vanke masks the weakness in the industry as it is the unlisted and small developers that will be forced out or bought up in a recession. Listed developers may eventually represent investment value, especially if restarted financial and economic reform lifts the long-term growth rate of the Chinese economy in the years ahead.

Source articles:
3月全国楼市成交参差不齐 价格以降为主
69家上市房企负债超过8000亿元 楼市进入去库存时代

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