Real Estate - China Special Situations
A series of intensive government tightening policies introduced since April 2010 to combat price growth in the Chinese real estate market led to 2011 being a tough year for developers.
On average, sales volumes in tier-one and tier-two cities fell by 19.5% and 18.01%, respectively, with a significant deterioration in transaction volume since September. The worst hit cities were Changsha (-53% year-on-year), Chongqing (-31%), Nanjing (-25%), Ningbo (-23%) and Beijing (-22%). By and large, developers held up their asking prices at the expense of softening sales volumes and it was really only until the fourth quarter of 2011 that prices began to soften.
Developers not only had to contend with softening sales volumes and falling prices, but tighter bank lending and narrower cross-border financing channels have added to cash pressures and caused their balance sheet to deteriorate.
The 2011 mid-year interim results of the listed developers showed net gearing increasing from 57% at the end of 2010 to 74% by June 2011. The balance-sheet position for thousands of small to medium-sized developers, which have even less access to capital, is likely to be much worse.
Against this backdrop, the problems faced by mainland developers in 2011 will follow them into 2012 and, the truth is, they are in for a difficult year. Given that sales prices have only recently begun to fall, after an 18-month policy-tightening campaign, we see little hope that the government will relax the policies affecting the property market until a more visible house price correction has occurred. The worst is yet to come, in our opinion.
This provides a window of opportunity for private equity real estate funds to invest in ground-up, partially completed or newly built projects at attractive discounts to market value. For long-term investors, 2012 is likely to present a good opportunity to assemble real-estate portfolios, as the sector is on a long-term growth trajectory underpinned by strong secular trends.
China’s population is expected to grow by 9.5% over the next 20 years and this is at a time when the populations of other major developed countries will be shrinking (UN projections 2009). Chinese demographics are favourable, as a large part of the population is concentrated in the low to middle-age bracket, which are likely to consume more and have increased demand for housing.
People over 60 represent just 14% of the Chinese population, with this number expected to increase to 21% by 2025, compared with 31% in the world’s more developed countries.
A report from McKinsey Global Institute argues that, based on current trends, another 350m people will be added to the urban population by 2025 - more than today’s US population. It is estimated that this alone will generate demand for 125m residential units.
A high proportion of the opportunities that have been evaluated in recent months are ground-up development projects, often where a cash-strapped local developer is seeking to sell or find a joint venture partner because of funding difficulties. Partnership risk should not be underestimated in China. TAN-EU Capital mitigates the risk when investing in China by insisting that third parties hold minority interests, while its development partner SOCAM Development is aligned through a 50% commitment of equity in every individual deal.
China has more than 160 cities, each with a population over one million people. As these markets are often very different, TAN-EU has focused on opportunities within one-hour commutes of the large tier-two cities, where SOCAM has on-the-ground project teams. We seek underdeveloped areas with strong growth potential that will benefit from improvements in infrastructure associated with public transport or other major community/civic facilities.
In addition to ground-up development projects, there are some attractive opportunities to participate in the development of partially completed developments or take ownership entirely. Such opportunities might have arisen because the current owner is in financial difficulty and/or sees the value of teaming up with a strong developer to maximise value.
Taking over such projects requires a detailed understanding of the project and, if not carefully managed, in our view, presents more risks than ground-up development. Local governments are also suffering from the tightening policies, since much of their revenue come from land sales. With transaction volumes down and many developers focused on completing and pre-selling current projects, some local governments are feeling the crunch.
In some cases, local governments have resorted to selling land more cheaply to the right buyers to maintain their budgets. Although TAN-EU is unlikely to participate in land auctions, a couple of recent opportunities have come from state-owned enterprises that have secured the land cheaply from the local government and need a joint venture partner with development expertise.
One of the persistent concerns about China’s economic boom since 2008 is that it was financed by excessive amounts of debt that could lead, in the medium term, to an increase in non-performing loans and could generate a systemic banking crisis and, ultimately, risk an economic hard landing. While we do expect the level of non-performing loans to increase, we believe China has the capacity to foot the bill by absorbing the expected increase.
China’s closed financial system makes a classic government debt crisis, as in the case of Greece, nearly impossible. China has only about RMB250bn ($39.6bn) of foreign debt, less than 1% of GDP, and foreign investors are not permitted to own significant quantities of domestic debt.
James Buckley is an executive director and fund manager at TAN-EU Capital