The world’s biggest property market, China, might be headed for a slowdown.
So if you’ve been thinking about investing in Chinese real estate stocks, or already have them in our portfolio, you may want to reconsider.
What’s been going on
According to data from China’s National Bureau of Statistics, the average price of new homes in 70 major Chinese cities rose 0.9 percent in September from a month earlier.
Compared with a year ago, new home prices climbed 7.9 percent, the fastest year-on-year gain since August 2017. That was also much higher than the previous month’s 7 percent year-on-year increase.
Higher prices might sound like good news for property developers. But it’s not.
You see, ever since Beijing amended the constitution in 2004 to give its citizens protection on private ownership of property, the country’s real estate market has been soaring almost nonstop.
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From under 500 million square meters a year, annual sales of property (mostly condominiums and apartments) in China have more than tripled to 1.44 billion square meters. That’s nearly twice the size of New York City (including all 5 boroughs), in residential real estate space, each year.
Average property prices have been going up as well, increasing 160 percent since 2004. And in the major cities like Beijing, Shanghai, Shenzhen and Guangzhou, prices have risen more than 500 percent.
So after years of breakneck growth, the Chinese government has been trying to prevent unsustainable and potentially dangerous asset price increases since early last year.
In March 2017, the government ordered that the largest cities in the country to limit the ability of people to purchase a second home. They did this by increasing the minimum down payment requirement from 70 percent to 80 percent.
When that didn’t work, Beijing began imposing rules that made it more difficult for real estate companies to fund their businesses.
At the end of June, Beijing instructed real estate firms to stop issuing U.S. dollar-denominated debt to finance their projects. Any new U.S. dollar debt issuance could only be used to refinance existing dollar debt. This cut off one of the low-cost funding sources for the property industry.
And in September, Beijing required that buyers in major cities be prohibited from re-selling their property for five years. Meanwhile, buyers in smaller cities could not buy a second home until three years after their first purchase.
But prices have continued to rise
So far, none of this has done that much to keep prices down. In fact, the rate of increase in property prices in China has only accelerated since the start of the year.
So Beijing is now considering an all-out ban on another major source of funding for the industry: the pre-selling of projects.
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Pre-selling is the process where a real estate developer launches a development and entices potential buyers to get in early on a project before it’s broken ground. They either offer discounts or indicate that prices will rise once construction starts.
It’s a very common practice throughout Asia. And in China, revenues from pre-selling are often enough to sell more than half of the available units of a project (many times even more). In this way, pre-selling has enabled many property developers in China to recover almost all their construction expenses before they even start.
A ban on pre-selling would cut off the last leg that’s been keeping many of the industry’s smaller players from going completely under, while opening the door for larger, well-funded developers to pick up real estate at a bargain.
A major shakeout is a necessary evil
It’s estimated that there are over 100,000 housing developers in China’s real estate market. That compares to 48,000 housing developers in the U.S.
There are thousands of small and poorly-financed developers operating in China trying to make a quick buck. Many of the owners of these small firms borrow money from friends and relatives to acquire land, with the promise for a quick return as pre-selling activity brings cash through the doors.
Meanwhile, larger (but still relatively small) developers with less than US$1 billion of assets are paying a high price, with bank loans carrying interest rates well above 10 percent a year. Borrowing costs in dollars for China’s high-yield issuers, most of whom are property developers, almost doubled this year to 11.2 percent, the highest in about four years, ICE BofAML indexes show.
Rising interest rates are poison to an industry that still has an average debt-to-equity ratio (the amount of interest-bearing debt to total stockholder equity) of 116 percent.
With most Chinese property developers’ operating profit margins ranging between 10 to 15 percent, the inability to raise money from pre-selling will force them to take out expensive loans. Servicing these loans will likely wipe out their profits.
That’s going to be made worse by the fact that expensive loans will likely stay on their books for at least a year before projects reach a stage of completion where they can sell.
If Beijing pushes through with its plan to scrap pre-selling activities, it will mean a lot of pain for the industry in the short term.
Smaller developers that have already pocketed money from previous pre-selling efforts could choose to abandon projects and leave a long trail of very unhappy homebuyers. And rioting consumers is something Beijing doesn’t like to see appearing on the news and social media sites like Weibo and WeChat.
What’s more likely to happen is that Beijing tests the waters in a few pilot cities (some news outlets are already reporting one city testing this out). That should give China’s real estate developers reason to slow down their projects and shore up their balance sheets.
Whatever the case, China’s real estate industry is likely going to slow down, whether it wants to or not.
But the property boom is far from over
But even if it does slow down, selling real estate in China will continue to be a huge business over the long-term. There are still 600 million Chinese living in the countryside, or nearly half of the population. That’s double the size of the U.S. population.
With an urbanisation rate (the percent of people living in urban areas or cities) of 58 percent, China still lags behind the 80 to 90 percent urbanisation rates of the U.S., U.K., France and even Colombia.
But the people living in these rural Chinese provinces are also seeing some of the fastest rates of growth in GDP per capita in the country – with the Shanxi and Guangxi provinces, for example, both posting growth in excess of 12 percent last year. Their urbanisation rates are catching up fast.
As incomes soar in these rural areas, millions more Chinese will be trading up their shanty homes and farm dwellings for apartments. So while China’s property boom may be taking a break, it’s far from over.
But for now, it’s best to avoid Chinese property investments – like the Invesco China Real Estate ETF (NYSE: TAO), which invests in China’s largest property developers – until the market fully discounts Beijing’s persistent and intensifying efforts to slow down the market.
Editor, Stansberry Churchouse Research