little over four years ago, I was doing the rounds of the real estate scene in Xian, home of the famous Terracotta Army, and the ancient capital of China, located in present-day Shaanxi Province. We were visiting a few housing and commercial projects and checking on the mood of the market (looking at things like prices and sales volumes). Xian is a Tier 2 city (generally defined as cities in China with roughly 3 to 15 million people), with a population of around 8 million (about the same size as London or New York). Having checked out a low-rise completed development on one side of the city, we drove through the centre to another development under construction on the other edge of town.
Development in Xian at the time was in full flow. There were cranes everywhere. The city’s development had lagged behind the country’s Tier 1 cities and many of the Tier 2 cities as well. Xian was now catching up with a vengeance. I casually started counting cranes. It wasn’t easy given the number of them. But I ran out of steam at a little over 200 cranes during the 30-minute ride across town. Moreover, we had travelled east/west across the middle of the city, and had not ventured into the suburbs, where I am sure the crane count continued. Nor had we done a north/south crossing of the city.
Given that each crane probably meant one high-rise apartment block, the inescapable conclusion was that there was an awful lot of building going on. Yes, the city had lagged behind in the development stakes, but I hadn’t seen this scale of building before.
Top value fund managers are ready for the small cap bear market to be done
During the bull market, small caps haven't been performing well, but some believe that could be about to change. Breach Inlet Founder and Portfolio Manager Chris Colvin and Gradient Investments President Michael Binger both expect small caps to take off. Q1 2020 hedge fund letters, conferences and more However, not everyone is convinced. BTIG strategist Read More
It was clear to me that Xian was about to experience a massive oversupply of property that would pressure the market for years. Well, that was partially correct. It did produce a substantial oversupply and an overhang of unsold property inventory equivalent to more than 22 months of average monthly sales. That kind of overhang could be expected to cause price declines and take a very long time to absorb. For a couple of years, policy concerns centered around how to get inventory down and avoid financial problems in the local banks and other financial institutions.
Fast forward to mid-2016, and property prices in Xian had not moved much. There had been no crash, despite the big overhang. But unsold inventory was down substantially to almost “normal” levels of around 14 months of average sales.
Scroll forward to August 2017 and we see a totally different picture again… one that looks more like a property bubble than the supply-induced meltdown that I had been fearing earlier. In the year to end of August, average home prices in Xian have soared by 66 percent to around US$1,670 per square metre (US$155 per square foot) according to real estate data provider and consultancy China Real Estate Information Corp.
Banks and policymakers are scrambling to change tack
Xian is a typical example of how quickly real estate markets in China can go from huge oversupply to bubble conditions. We have seen this happen on numerous occasions in many cities.
So after policy prescriptions that were focused on absorbing excess supply and preventing financial distress associated with excess real estate inventory, local policymakers in Xian are now focused on curbing a massive housing bubble… all in the space of less than three years.
The city has tightened controls on the property market four times in the past nine months in an effort to rein in skyrocketing housing prices. Xian has joined many other Tier 2 cities that have seen property prices soar as they did earlier in the bigger Tier 1 cities.
The controls include:
- Prohibiting residents from buying third homes
- Restricting non-residents from buying a second home
- Prohibiting resale of new homes within five years of purchase
- Tightening bank scrutiny of borrowers
- Effectively banning lending to non-residents
- Banks extending the loan application and agreement period substantially
If experience of other bouts of tightening in recent years and experience of other cities in this recent cycle are anything to go by, Xian will see some slowing of the pace of sales, and the pace of price increases will slow. But whether prices will go into reverse, and actually fall in the coming year, is less than certain. This has not happened in other cities in the past year or so where tightening has occurred.
Investors may have noticed that China’s housing market has gone through three cycles since the Global Financial Crisis in 2008. The current cycle is peaking (and has already peaked in some cities). In recent cycles, any downside on an annual basis has been very modest… no more than a few percentage points.
This is a “cooling,” not a “crashing”
China’s policymakers are constantly tweaking the real estate markets at both the national and local levels. They ease the reins if things are slowing down, and apply the brakes when the pace is getting too fast. Policy setting is more focused on the latter today across most of the larger Tier 1 and Tier 2 cities. The objective is not to generate a big tumble in the market, but to dampen enthusiasm that might pose risks to banks and also housing affordability.
The measures are working. For the top 26 cities in China, the year-on-year pace of sales of new housing is down around 20 percent from a year ago. For Tier 1 cities, prices have flattened out but are still moving up at this point in Tier 2 and 3 cities. Prices in smaller cities have lagged way behind the moves in the big Tier 1 cities in the past two years.
Most of the big picture demand and supply indicators for the housing market are looking OK:
- Completed inventory has fallen by around 25 percent to about 330 million square metres
- Inventory as a percentage of annual sales has fallen from more than 40 percent to 23 percent
- Floor space starts have fallen from a peak of around 1,500 million square metres per annum to about 1,100 million square metres
- Floor space starts as a percentage of sales has fallen from a peak of around 153 percent to around 86 percent today
- Real estate investment has also slowed from around 103 percent of annual sales to about 69 percent.
These figures show that the supply overhang that worried investors and policymakers back in 2013 has been reduced… and will likely stay low (or fall even lower). The pace of investment in real estate has slowed, and for that reason there will be fewer starts and a lower supply of new units.
So what does that mean for investors?
There are good reasons to stay invested in the big Chinese property companies listed in Hong Kong.
They are consolidators in a very fragmented industry. Many are absorbing companies and projects held by less well-financed players. For example, one company I am closely involved with acquired eight projects via this route in the first half of this year. The top ten listed property companies now have about 28 percent market share compared with about 20 percent a year ago, and about 14 percent five or six years ago. This could go to around 35 percent by 2019.
These top companies will post sales growth in the region of 30 percent on average in 2017. Compound annual net profit growth in the three years to the end of 2019 is likely to be around 25 percent, and could be higher. Visibility of 2018 earnings is good.
Stocks have rallied from historically low valuations of around 4-5 times forward earnings to around 7.5 times forward earnings today. They are cheap against their global peers, which trade at around 16 times forward earnings. Return on equity (at 13.5 percent) is almost twice the global average. And these stocks will give investors a very respectable 4.5 percent dividend yield versus about 2.5 percent globally.
Gearing has been a concern in Chinese companies. The average net gearing for Chinese property companies is around 70 percent versus about 68 percent globally.
I also like that many of these companies are growing their investment property portfolios strongly, which should produce reliable and steady long-term rental income. Government policy is encouraging property companies to build more housing for long-term rental to meet the demand from those who do not want to own their own homes, or cannot afford to do so.
The long and short of this? Stay invested in China’s property sector via Hong Kong-listed