China’s residential woes Despite stimulus measures, oversupply problems are creating a sluggish recovery for China’s residential sector

by Mard Naman

Xiamen Land supply China BeijingHengshui Baoding Handan Land supply Anti-corruption People’s Bank of China campaign XiamenHengshui Handan Shenzhen Oversupply First-tier cities

Fourth-tier cities Handan ChongqingPrice declines Government intervention People’s Bank of China OversupplChina y President Xi Jinping

People’s Bank of China Demand

Baoding Slow recovery Stimulus measures Sentiment Baoding Shanghai Third-tier cities Hengshui President Anti-corruption campaign Oversupply Xi Jinping Residential People’s Bank of China Government intervention Second-tier cities Interest rate cut Interest rate cut Hengshui Xiamen China Chongqing Stabilising Xiamen BaodingSlow recovery Anti-corruption campaign Interest President Xi Jinping rate Xiamen cut Baoding Shanghai Chongqing

The Letter – Asia Pacific| 1 | April 2015 hat is going on with China’s hous- “Some cities show clear improvement in sales vol- ing market? Sales volumes, prices and umes, albeit at lower prices.” Wnew development all declined in 2014, China’s despite the lifting or relaxation of home purchase The price is not right restrictions almost everywhere except the first-tier How far have prices dropped, and when will they cities of , Shanghai, Guangzhou and Shen- start moving back up? National average selling prices zhen. In addition, an interest rate cut this past declined about 9 percent in 2014, which includes –3 November was designed to help stimulate sales. percent in first-tier cities, –7 percent in second-tier residential woes In December 2014 and January of this year, cities, and –12 percent in third- and fourth-tier cities, sales volumes started to increase, but prices gener- according to Huang. ally did not. The main culprit appears to be excess Prices may not be at the bottom yet, but with supply in almost all markets. The underlying growth expected steady sales volumes, and the ongoing in demand has not kept up with the pace of new inventory-reducing effect of fewer construction starts construction the past few years, and the market and fewer land sales, Delatour says the supply of resi- now is feeling those effects. dential units will continue to diminish. As a result, he A year ago the word on most people’s lips was expects prices generally will begin to recover by mid- “bubble”, but no national residential real estate bub- 2015. But as with supply, the pace of price recovery ble emerged. However, some cities do have over- will vary widely in different tiered markets. supply issues, according to Joseph Huang, executive Huang projects average selling prices will director and China country head for Forum Partners. decline another 3 percent nationally in 2015 in total, “The structural oversupply issue is unlikely to be but that first-tier cities will be up 4 percent, second- easily resolved in some tier 3 and 4 cities, even with tier cities will be flat, and third- and fourth-tier cities the expected loosening of policy controls and/or will be down 8 percent. Using a different metric, credit easing,” says Huang. According to UBS, the the SouFun-CREIS 100 Cities Price Index, Ciemniak oversupply issue will persist throughout 2015, with expects the average house-price growth for the 100 a noticeable improvement in the demand/supply cities to bottom out at about –6 percent year-on- balance expected in 2016. year for the first quarter of 2015 and finish 2015 up The excess inventory reached an average about 1 percent year-on-year. durational high of 19 months in 2014, according According to the recent China Forecast from Real to Thomas Delatour Jr, co-founder and CEO of Estate Foresight, after hitting bottom the first quarter, Century Bridge Capital in Beijing. As a result of this the residential market will start a cyclical rebound in large inventory overhang, land sales in the second the second quarter of 2015 (see graph, below). “We half of 2014 dropped 50 percent, and construction may not yet be at the bottom of the cycle, but there starts for the year dropped 15 percent. are more and more signs of upcoming cyclical pickup But before all this sets off too many alarms in in volumes and prices,” says Ciemniak. Even though investors’ minds, it is best to step back a bit and China’s average home prices extended their year-on- look at this in the context of a longer timeframe. year declines through January 2015, for example, According to Delatour, sales volumes were down Ciemniak’s latest research shows on a sequential 10 percent in 2014 from 2013, but 2014 volumes month-on-month basis, prices recorded their first were 10 percent higher than in 2012, which had set increase after eight consecutive months of decline. a previous annual sales record. So it is not as though A Knight Frank news summary from February con- sales volumes suddenly dropped off a cliff. firms prices of new homes in 100 mainland cities rose In the meantime, the relaxation of restrictions slightly (0.21 percent) in January 2015 from December on home purchases and looser credit have begun to help clear the inventory overhang. According to China house price growth forecast Delatour, the demand/supply imbalance is starting 15% to work itself out, and over the next six months the 2014 actual

pent-up demand for housing will drop the excess 10% inventory from 19 months to 18 or 17 months. It is important to note, however, the amount of oversup- 2015 forecast 5% ply varies widely among cities; according to Huang, first-tier cities now have 12.7 months of inventory, while third-tier cities still have a whopping 33.6 0% months. Second-tier cities now have about 20.1 2014 forecast months, down only slightly from a historical high of –5% 21.2 months in July 2014. Actual year-over-year of SouFun-CREIS 100 Cities Price Index Recovery and progress? Yes, but very slow and 2014 forecast 2015 forecast not yet steady. “The easing measures are gradually –10%

making an impact,” says Robert Ciemniak, founder -2011 -2012 -2013 -2014 -2015 Apr Apr Apr Apr Apr Oct-2011 Oct-2012 Oct-2013 Oct-2014 Oct-2015 Jun-2011 Jun-2012 Jun-2013 Jun-2014 Jun-2015 Feb-2011 Feb-2012 Feb-2013 Feb-2014 Feb-2015 and CEO of Real Estate Foresight, an independent Aug-2011 Dec-2011 Aug-2012 Dec-2012 Aug-2013 Dec-2013 Aug-2014 Dec-2014 Aug-2015 Dec-2015 research and analytics firm based in Hong Kong. Source: Analysis by Real Estate Foresight based on data from SouFun-CREIS

The Letter – Asia Pacific| 2 | April 2015 Shenzhen, China 2014, with Beijing recording the biggest growth of of the recovery. In previous cycles, developers usu- 1.15 percent, followed by Shanghai and Chongqing. ally have turned very positive when the PBoC steps Whether this is an aberration or a trend remains to be in. Not this time, says Felteau. He believes another seen, but it appears the bottom may be near. sign of ongoing weakness for the residential sector is But the recovery still may require another push that most developers he met, apart from state-owned from the People’s Bank of China. “We believe one enterprises, said they would slow down their land- rate cut alone from November does not quite cut it,” replenishment strategy in 2015. “Some developers says Ciemniak. “‘Mr Property Market’ would likely even mentioned they would completely stop con- say, ‘Give that to me one more time’.” And indeed, he struction process on some of their projects, especially expects further easing and further declines in mort- those in tier 3 and tier 4 cities,” notes Felteau. gage costs. Whenever the cyclical rebound officially Ciemniak also sees sentiment going a bit south. starts, third- and fourth-tier cities almost surely will At his company’s Third Annual China Property Out- lag behind. “The general view is that home prices in look seminar in January 2015, Ciemniak reports the first- and second-tier cities will stabilise, while prices sentiment among more than 50 fund managers, in third- and fourth-tier cities will continue to fall in investors, lenders and researchers was slightly more 2015,” concludes Forum Partners’ Huang. negative and divided compared with the previous year’s seminar, with about 30 percent being nega- Sentiment heading slightly south tive compared with about 20 percent in 2014. Late last year, Vincent Felteau, portfolio manager At the end of the seminar, Ciemniak held a for Presima, travelled to China to see firsthand the debate between the “bulls” and the “bears” on China’s impact of the relaxation of home-purchase restric- residential sector. The bears focused on the oversup- tions. He and his group met with more than 20 ply issue, deteriorating demographic fundamentals, developers of varying sizes. Most developers noted and concerns about buildup of credit and debt. The a significant spike in sentiment and sales volumes bulls, on the other hand, focused on government- since the relaxation measures this past September driven cyclicality and the Chinese government’s abil- and the interest rate cut in November. But they ity to stimulate the market, as well as the ongoing also agreed that while first-tier and provincial capi- urbanisation drive and upgrade demand. tal second-tier cities were selling well at reduced prices, third- and fourth-tier cities still were going Moderate government intervention through a very difficult time because of oversupply. viewed positively What was surprising to Felteau, however, was that Despite this slight increase in negative sentiment, most developers were unsure about the sustainability most analysts believe the Chinese government

The Letter – Asia Pacific| 3 | April 2015 knows what it is doing. The government’s approach Top 10 in terms of house price growth in 2014 — reflects its view that market conditions are not as year-over-year price growth severe or dangerous as many perceive. “Their approach of applying moderate regulation in sys- Baoding 12.4% tematic small increments recognises the maturity Xiamen 12.3% of the residential market and its ability to adjust to Shijiazhuang 8.2% temporary supply and demand imbalances without Hengshui 5.1% significant government intervention,” says Delatour. Handan 4.6%

Like Ciemniak, Forum Partners’ Huang expects 4.2% the government to cut the interest rate further in 2015 3.9% to lower financing costs, which will help. But Huang says it is important for local governments in third- and 3.8% fourth-tier cities to reduce the land supply in the next Shanghai 2.5% few years to help reduce the current inventory. He Weihai 2.2% also sees a need for looser restrictions on home loans 0% 2% 4% 6% 8% 10% 12% 14% and lower taxes on the trading of properties, both of Note: Cities highllighted in dark blue are in China’s province which would assist the residential market recovery. Source: Analysis by Real Estate Foresight based on data from SouFun-CREIS Presima’s Felteau says the central government did the right thing during this downturn by stay- due diligence on the political background of devel- ing on the sidelines for as long as possible, and it opers. In general, says Huang, developers who is much better for the market to function naturally acquire land mainly through formal channels, such without artificial forces. “At this point, we believe it as public auction, are less likely to be embroiled in makes sense for the market to go through a con- political scandals. And institutional investors should solidation phase,” he says. For investors, careful insist on a strong deal structure to prevent or reduce developer selection becomes more important than loss under a worst-case scenario. Huang says gener- ever. As it becomes increasingly difficult to generate ally a debt/mezzanine structure with a certain level profits, Felteau notes the largest players will be best of equity subordination protects the investor better positioned to gain market share because of their than an equity structure. lower cost of capital and better access to land. While most people have focused concern on To protect their investments, Huang says inves- excess supply and lower selling prices, Huang does tors need to consider some key factors in a down not think the chief concerns for 2015 are average sell- market. Of course, project location is crucial, and ing prices or a sales-volume collapse. Rather, he first projects with easy access to public transportation, foresees problems because of margin pressure, given schools and hospitals usually are more resilient dur- the continued price cuts and the slower decline in land ing downturns. Also, developers with proven track prices than in property prices. And second, he sees records and robust financials (such as leverage political risks because of the ongoing anti-corruption level, liquidity and access to cheaper financing) are campaigns initiated by the central government. more protected in a down market. Felteau applauds the central government’s The recent problems of developer Kaisa Group recent focus on eliminating corruption as much as Holdings certainly heightened investor doubts possible. He believes better governance practices about Chinese property developers. Shenzhen- need to be implemented by the different property based Kaisa missed an interest-rate payment to players to bring more trust back to the sector. “Right international bondholders in January 2015, and the now, the significant discounts to net asset value are cash-strapped developer finally made the payment a clear sign that global property investors are still almost a month later after being bailed out by rival very reluctant to give full credit to residential devel- developer Sunac China Holdings. Sunac, which is opers,” says Felteau. headquartered in , acquired a 49.3 percent For investors, Felteau sees a silver lining behind stake in Kaisa. This may calm the market, but prob- the anti-corruption campaign. Because of the ably will only partially alleviate investor concern amount of turmoil in the market, such as Kaisa’s about property developers. missed debt payment and corruption allegations against high-level executives at other developers, Getting a handle on scandal Felteau thinks more developers now might finally President Xi Jinping has been conducting a national focus on what institutional investors want for the anti-corruption campaign that has netted more sector: profits over volumes, conservative leverage, results than most first expected. The campaign higher payout ratios (or not aggressively reinvesting nabbed 66 central and local government officials proceeds into expensive land plots), and the adop- in 2014, and it is now expanding its scope to the tion of better governance and disclosure practices. private sector to indict business officials involved in graft, bribery and other forms of corruption. Size matters Given this lengthy and expanding anti-corruption Interestingly, Felteau believes in 2015 the size of campaign, investors need to conduct more thorough units will matter a lot more than in the past. He

The Letter – Asia Pacific| 4 | April 2015 says the anti-corruption campaign is likely to affect the latter three all being lower-tier cities benefiting larger and luxury units more than smaller ones. from being near major cities (see graph, page 21). Because larger flats are obviously more expensive Delatour of Century Bridge believes the best resi- and require higher down payments, “people buying dential investment opportunities today are in middle- larger units are much more likely to be investigated class high-rise developments in second- and third-tier versus people buying smaller ones,” reasons Felteau. cities. He likes infill locations with pre-existing infra- Further impacting larger and luxury residential structure, transportation and amenities including property is the slower overall economic environ- educational, retail and healthcare facilities. Delatour ment in China. Some wealthy people are diversify- believes second- and third-tier cities will continue to ing their holdings in residential property by moving experience job growth and create additional housing money outside of China, a process that has acceler- demand. He notes the critical relationship between ated over the past couple of years. household income and housing prices will further improve as per capita income continues to grow faster Best opportunities for investors today than housing prices in second- and third-tier cities. Given the serious oversupply issue in many third- and Furthermore, Delatour says a good strategy fourth-tier cities, Huang believes the best opportunities is to target middle-class buyers, who are seldom for residential investment are in first- and second-tier affected by the home-purchase restrictions because cities, which also benefit more from the urbanisation they do not generally buy multiple homes, and process because of their superior infrastructures and they often either pay all cash or make substantial access to medical and educational facilities. down payments. In terms of the underlying market economics, With careful selection of city, developer and Real Estate Foresight’s Ciemniak believes good inves- type of development, good opportunities for inves- tor opportunities lie within some second-tier cities tors indeed exist. But given the overabundance of with reasonable price and supply levels, and within supply, the financial strains many developers are select lower-tier cities that benefit from a genuine experiencing and the ongoing anti-corruption cam- urbanisation drive and the spill-over effects from paign, investors would be wise to proceed with an major cities nearby. In fact, the top five cities with abundance of caution. v the strongest price growth in 2014 were Xiamen in Fujian province and four cities in Hebei province Mard Naman is a freelance writer based in Santa Cruz, — Shijiazhuang, Handan, Hengshui and Baoding — Calif, USA.

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The Letter – Asia Pacific| 5 | April 2015