May 21, 2012
In 2010, China achieved a major milestone when it overtook Japan as the world’s second largest economy, the culmination of many years of double-digit growth and a quick rebound from the global financial crisis. At the end of 2011, the country achieved another milestone when new data showed that for the first time more than half of China’s 1.35 billion people lived in urban areas. This ongoing urbanization is a powerful trend that experts expect to continue: Some estimate 15 million new residents will move to China’s cities each year for the next 10 to 20 years. The urbanization, along with rising incomes, has helped keep the mighty economic engine in high gear. But China has not been immune to world events. The European sovereign debt crisis and ensuing European recession, and a barely growing U.S. economy, are slowing China’s exports, and government-imposed sanctions in China have thrown a wet blanket over the residential sector. What might be in store for property investors in the country in the near term?
In terms of economic growth, China remains a giant compared to most of the developed world. China’s GDP growth rate for fourth quarter 2011 was a healthy 8.9 percent, not quite double digits, but a far sight better than what came out of the United States (3.0 percent) or the former second largest economy in the world, Japan (–1.0 percent). Best of all, while Europe could be enduring a lengthy recession and the United States is, at best, projected to crawl along for the next couple of years with still-anemic growth, China is projected to continue on its current path, with remarkably similar GDP numbers between 9 percent and 10 percent between now and 2015, according to International Monetary Fund forecasts.
China’s projected GDP growth in 2012 handily beats the projected Asia Pacific average of around 6 percent. The likely recession in Europe and sluggish growth in the United States will combine to hurt those Asia Pacific countries more dependent on exports. “Export-oriented and open economies such as Hong Kong, Singapore, Malaysia and Taiwan will expand more slowly than their potential, while domestic-demand driven and closed economies such as China, Indonesia and India will fare better and serve as the engine of growth,” predicts the Cushman & Wakefield Global Office Forecast 2012–2013 report.
While China will weather the storm better than many Asia Pacific neighbors, there is no question that exports will be hurt. The weak global demand will likely negatively affect China’s export growth in 2012 and negatively affect its GDP growth, given the assumption of a global slowdown, says Richard van den Berg, country head for Greater China for CBRE Global Investors. However, he believes two factors will offset the drop-off in external demand. First, domestic consumption should hold up well, given the ongoing trend of rising wages in China. Second, it is the long-term ambition of the Chinese government to lessen reliance on exports and foster its own domestic consumption growth. “Current domestic demand will not immediately soften the full blow of declining export markets, but with appropriate, targeted stimulus, Chinese consumers can grow in importance,” says van den Berg.
In the wake of the global financial crisis in 2008, the Chinese government embarked upon a massive stimulus program that was so successful so quickly that property prices and inflation both skyrocketed. In response to that, the government instituted tightening regulations in 2010. The restrictions were put into place to slow the torrid pace of home price escalation, dampen speculation and ease fears that a huge residential bubble was forming. The People’s Bank of China also raised interest rates three times in 2011 and increased the bank reserve requirements six times. These measures have had the desired effect of cooling the market, but now, combined with economic troubles in Europe and the United States, some believe it’s time to loosen the restrictions to avoid a hard landing.
The Chinese government may be shifting gears a bit from fighting inflation to helping stimulate a slowing economy. In late November 2011, the People’s Bank of China, while making it clear it was not going to relax its fight against rising prices, announced a plan to inject more cash into the economy by lowering bank reserve requirements, which had been at record highs. The central bank may also lower interest rates this year, according to some analysts. And it may also relax restrictions on credit and bank lending in the near future. A new generation of Chinese leaders is set to take over this year, but they are not expected to make any radical changes.
How Well Has the Tightening Worked?
China’s clamping down on speculation in the housing market has had a measurable effect: As reported by Bloomberg News in January 2012, overall home prices fell for the fourth straight month in December 2011. Housing values dropped in 60 out of 100 cities, including the 10 largest cities, which includes Shanghai and Beijing. Luxury residential prices in Beijing are down 3 percent from 2010, another sign that the government’s policies are having an impact.
Restrictions include higher transaction taxes and higher loan-to-value (LTV) borrowing ratios. The minimum down payment for first-time homebuyers has been increased from 20 percent to 30 percent. For those purchasing a second home, the minimum down payment was raised to 60 percent, and purchasing a third home has been outlawed in most cities. In the few cities where it is not banned, buyers must pay all cash.
“The most effective regulation has been preventing buyers from buying flats if they already own two flats in their family,” says Goodwin Gaw, chairman and managing principal of Gaw Capital Partners in Hong Kong. The government also has introduced property taxes successfully in Shanghai and Chongqing, which has signaled to investors that nationwide property taxes could likely be forthcoming in the future, according to van den Berg. This, too, has made speculative buyers more cautious.
Most analysts think the housing restrictions have worked well, and they have been mostly well received. “The tough regulatory climate, including purchase restrictions, is having the intended effect of bringing down prices and curbing speculative activities in the sector,” says van den Berg.
“The Chinese government’s housing policies have largely been effective because they have appropriately targeted speculative home buyers, who tend to be wealthy,” says Tom Delatour, CEO and co-founder of Century Bridge Capital.
But the government policies have not worked perfectly. While they are having their greatest impact on speculative buyers in first-tier and certain coastal markets, they are also creating pent-up demand by affecting non-speculative buyers who are waiting for government regulations to loosen before making purchases, says Delatour. If the measures have generally caused investors to take a wait-and-see attitude, they also have created high uncertainty in the market.
“It is currently difficult to underwrite a project’s absorption rates and sales prices and, hence, overall return levels,” notes Nicholas Wong, principal with real estate investment management/advisory firm The Townsend Group. “Nevertheless, most investors remain confident of the Chinese property market’s medium- and long-term prospects because of continued urbanization and rising income,” he says.
Adds van den Berg, “We believe the real demand for housing is still very strong and is currently being pent up, especially among end-users.” From an investor’s point of view, what is good in the current environment is that many high-quality developers are in need of capital and are therefore willing to cooperate on favorable terms. “For investors with capital in hand, the current lack of liquidity in the market presents a considerable opportunity for profit and the creation of long-term relationships,” Delatour says.
“We expect some small- and medium-sized developers going bust and being absorbed by larger developers because of tight liquidity,” says Townsend’s Wong. “But we do not expect this consolidation to adversely impact the larger economy,” he adds. Gaw says consolidation is in fact the goal of the government, which will not dramatically change the landscape, and will help the larger developers and state-owned enterprises to get stronger.
Loosening on the Way Soon?
While the slowdown in 2011 was mainly driven by austerity measures, the 2012 slowdown will be external, according to Wong. In response to this, the Chinese government is expected to reverse some of the austerity measures. No one doubts the government’s ability to stimulate the property sector when it chooses to do so.
Hodes Weill & Associates, a real estate advisory firm, puts it into perspective in its first quarter 2012 market commentary. “Having assiduously managed the real estate sector for the past 20 years, the Chinese government is not about to let the market crash and put a very large dent in GDP growth at a time of domestic and global economic weakness,” states the report.
The lowering of the banks’ reserve ratios in December 2011 was the first small step toward loosening the regulations. Will more follow in 2012? Experts’ opinions on this matter are all over the map. Delatour thinks yes, probably in the second half of the year. “We believe it is likely the government will continue to relax monetary and fiscal policies going forward,” he says. “Residential real estate prices have started to level off and inflation is also slowing, so the government should have the flexibility to do so.” Even with the small lowering in the past year, reserve requirements for Chinese banks remain among the highest for any major country. “As inflationary pressures subside, the government is likely to increase the money supply in order to facilitate continued growth,” concludes Delatour.
CBRE Global Investors’ van den Berg says his company’s base case does not expect a general loosening of purchase restrictions in the first half of 2012, though, in a worst-case scenario, some of the stricter property-specific measures may be lifted to restart growth.
“The government is striking a delicate growth/inflation balance,” says investor Hing Yin Lee, senior executive director with China’s Ping An Trust Co., Ltd. “Now that inflation has come down somewhat, the government should have more ammunition to support growth through monetary loosening, against a background of looming uncertainty in the external environment.” But Lee expects that the loosening, either through lowered reserve ratios or lowered interest rates, will be marginal, because more excessive loosening could reignite inflation. He also believes measures to stimulate the economy will tend to be more targeted and sector-specific, rather than all-embracing.
But others believe that concerns about property bubbles will force the government to keep its restrictions in place. “Right now, many of the governments, including China and Singapore, see more risks in an asset bubble forming than a sharp fall in housing prices,” says Jinsong Du, an analyst for Credit Suisse, in a recent article in The Wall Street Journal. In December 2011, Moody’s rating agency gave the Chinese property sector a negative rating for the next 18 months, effectively through the middle of 2013. By their assessment, the government measures to cool the overheated residential property markets will not likely be relaxed in 2012.
Property firm Knight Frank has projected that residential prices in mainland China and Hong Kong could fall by 10–15 percent in 2012. However, the luxury end of the market will see less of a correction, 10 percent or less. These price corrections are already evident in first-tier cities and are now beginning to spread to second-tier cities. And according to Beijing Holdways, a consultancy firm that works with Knight Frank, the government will loosen some of its measures in 2012 if property prices drop more than 20 percent. Regardless of economic circumstances, van den Berg thinks the government will loosen the restrictions in a slow and measured fashion. “Even in a worst-case scenario, you will not find knee-jerk reactions from the government,” he says.
Opportunities and Challenges for Investors
One advantage of the liquidity crunch hitting developers is that some high-quality Chinese developers are now more open to partnering up with investors. According to the recent Hodes Weill market report, “Most managers who have been investing in China for some time are relieved to now be able to structure preferred equity deals on residential joint ventures with capable domestic developers (who previously did not need them), and they are seeing more rational pricing on retail and office property in first- and second-tier cities. Time is currently on the side of investors, and it is undoubtedly a good time to be shopping.”
Van den Berg notes that because the tightening efforts have targeted mostly residential property, some investors are now moving into the commercial sector or debt financing. “Investors also prefer mixed-use development projects to mitigate some of the regulatory risks,” he says. Additionally, van den Berg says the liquidity crunch among some developers and the threat of bankruptcy offers investors a good opportunity to assess potential partners’ strengths and weaknesses in such a challenging environment.
The government’s regulatory tightening has certainly dampened land sales, and land prices are at very attractive valuations. As a result, “As of now, relatively low-risk development plays in the mature areas of major tier II and tier III cities present an excellent value proposition for investors,” says Delatour. “Based on today’s land prices, margins for residential and retail development in these markets are extremely attractive.”
According to Ping An Trust’s Lee, there are M&A opportunities at the project level — though he doesn’t see fire sales or massively distressed assets in the market — and with smaller developers as the industry consolidates amid the market correction. “I also see opportunities for land acquisition, particularly in the secondary markets as cash-strapped developers are forced to dump land parcels,” he says.
He also thinks there are opportunities to form joint ventures with retail operators in the current environment. “Retail developers are cash cows who will take the opportunity of a market correction to acquire and develop property for their own use,” Lee notes. “But the fact that they have no expertise in the property markets means they need professional real estate investors to help execute.” Additionally, Lee sees some sale-leaseback opportunities from industrial operators as they offload real estate from their balance sheets, similar to what they did after the 2008 downturn.
The lower land prices probably won’t last that long. “Tight monetary and fiscal policies have dampened land sales, and land prices are likely to go up once the government loosens monetary policy and lifts home purchase restrictions and other temporary measures,” says Delatour. “2012 will be an excellent time for investors to break ground on new development projects, as land prices are attractive and property prices should resume growth by the time new products hit the market in 2013 and 2014,” he adds.
For investors, it is, of course, best to buy in the final stage of a downturn: It’s easier and cheaper to acquire land, it’s easier to acquire projects, and property owners can be very willing sellers. “I am convinced that we are now in the last part of the downturn,” says van den Berg. He expects the downturn to continue through the first half of 2012 and possibly the full year.
“The period of attractiveness for investing is this year, and maybe part of next year,” he says. “But it will evaporate very quickly. The slope of this correction has been relatively shallow, but prices will go up very, very fast in China.”
The biggest challenge Lee sees in residential for investors is that slow sales and construction delays continue to put pressure on investors’ IRR, and slow sales, difficult bank financing and higher cost of financing put pressure on cash flow and profit/loss. In the office sector, Lee says office rent in some second-tier cities will face downward pressure, particularly those with large supply, as he expects demand to ease because of the economic slowdown in 2012. “Investors in office in those tier II cities, notably those engaged in development, will encounter higher risk in execution,” he says.
Navigating China’s Property Market
Investors in China still need the benefit of having robust, long-term performance indicators that are common in developed real estate markets, says Richard van den Berg, country head for Greater China for CBRE Global Investors. They would make the market much more transparent for all. “Some private-sector companies are now developing these, and they can be used to measure against official government data, but we wonder why more efforts have not been made to develop such indicators,” he says.
One thing both van den Berg and Tom Delatour, CEO and co-founder of Century Bridge Capital, say hinders investors trying to navigate China’s market is a reliance on conventional metrics and rules of thumb in trying to make comparisons between China’s real estate market and more developed markets in the West. For example, some investors are concerned because the multiples of average household earnings versus average home prices in many Chinese cities are higher than what they see in the United States and Europe. This falsely leads many foreign investors to believe that housing has become unaffordable in China.
But Delatour and van den Berg say these metrics are misleading if not meaningless in China due to a variety of factors, including a very large amount of “gray income” (income not recorded by the government) and much higher savings rates in China than Europe or the United States. Delatour says incomes in China’s urban areas are far higher than official statistics suggest. “While estimates vary, one well-known study suggested that average income for China’s urban households was 90 percent higher than reported in the official data,” he says.
This implies that true affordability multiples are much lower than many investors believe.
Also, Chinese homebuyers are required to put down significant equity (currently at least 30 percent), with the majority paying more or all cash for their homes. “This means they are less dependent upon their current incomes to support their home purchase than a typical homebuyer in a developed country,” says Delatour.
Hing Yin Lee, senior executive director with China’s Ping An Trust Co., Ltd., says what is needed is “full-fledged understanding of macro trends and the government’s intent” with regard to policies. At the local level, he says investors must “grasp local market dynamics in order to dig out opportunities from market inefficiency at the micro level.” For foreign investors, that means partnering with a local player, either directly through club deals or joint ventures or indirectly as limited partners.
Beyond the fundamentals, in China as everywhere else, it comes down to the fact that real estate is a truly local business. “The key is picking the right local partner,” says Delatour. “One needs to understand the legal system, the government approval process and the local market. These factors vary considerably from city to city and sometimes even district to district. Regardless of your personal experience, the most critical challenge of Chinese real estate investment is picking the right local partners and advisers,” he concludes.
