GLG News by Sam Crispin

Implications: Shanghai has a lot to offer the foreign investor who are still able to deal in China despite the approvals needed. But the story has moved on to the 2nd tier cities and increasingly the 3rd tier cities, investors just need an investment committee comfortable dealing in cities they have never heard of.

Analysis: The result of the macro economic controls and high interest rates means that local developers need access to partners with money. Getting money into China is still a key hurdle but most foreign investors are able to get over that one provided they show the patience and wherewithall to deal with Chinese bureaucracy.

Foreign investors like the Shanghai real estate story, they are comfortable with the city and exposure to the Renminbi appreciation.

But there is another story emerging and that is for the 2nd and now 3rd tier cities that offer good returns for residential development. Net IIRs of over 30% and equity multiples of over 2 are on offer for a bit of development risk. It involves getting out to some of China's more 'exotic' parts, these cities resemble the Shanghai of 10 years ago when few foreign investors understood it, but the rewards are certainly there for those that take the trouble and some great projects and local partners are there already. 

Implications: Money flows from middle east to China set to increase after long wait

Analysis: Middle eastern investment firms are relatively late to the China property party. They will find many opportunities not to their liking for various reasons and that the best core asset deals have been picked over by others already.
Their best strategy will be to target property development when the risks are manageable and concentrate on targeted geographic areas such as the Bohai Bay Area which have been overlooked by many investors and are seeing increased central government investment and economic restructuring

Implications: Chinese property markets have grown at a tremendous rate over the last 5 years and the government regulator has made great efforts to slow things down to more manageable levels. The implications of a Chinese property crash are unthinkable but not unimaginable and there have been many recent articles on the subject. It is important therefore to understand the background and the context before raising the alarm. This article notes the risks and gives a balanced view.

Analysis: The main impact of a Chinese property downturn will be on the homeowner and thus the consumer. This will affect the local economy and push China towards greater dependence on exports at a time when those export markets are themselves slowing. Also exposed are China's banks but with relatively high downpayments, generally of 30% or more, there is a 'comfortable' space before buyers find themselves in negative equity. Of course there is little real comfort in that should such a cushion ever be leant upon.

There is little evidence to suggest such a downturn is imminent. Despite the sometimes feisty rhetoric there is still plenty of space to grow for Chinese property prices. A relatively modest annual rate of increase for capital values of 15% would be equal to prices doubling over the next 5 years. This growth rate exceeds current economic growth but not greatly and even if a more modest 7 year period to double prices is used we are still only in line with economic growth rates.

Articles like this, and there are many of them, are useful to remind us of the risks. A property downturn in China is inevitable, there are no prizes for knowing that. The key issue is in the timing and understanding how to manage the implications. With little likelihood of an economic slowdown there is no prospect of a property downturn, thus todays buyers, like the banks, are cushioned by the prospect of several more years of growth before any unravelling comes onto the horizon.

The report is right to point out fraudulent mortgage applications but the process has improved over the last couple of years and such risks are being managed in a far tighter fashion.

So for now, it is business as usual for China's property markets.

Implications: Reform of the way secondary market transactions are handled are urgently required to mitigate risk for buyers, sellers and brokers

Analysis:  This story has been some time coming and I am surprised it has not happened sooner. The means of selling property on the secondary market leaves all involved exposed to an unreasonable amount of risk that could be easily mitigated by title insurance or more secure conveyancing practices including use of escrow accounts.

The scope for theft by the owner of a broker or the staff is unecessarily vast.

Implications: In 2002 it was announced that Chinese rates of home ownership had reached 80%, this was repeated recently by The Economist newspaper in passing. Deeper analysis reveals that this is not all that it seems.

Analysis:  If anyone had asked me a week ago what home ownership rates in China I would have made a half educated guess of 40 to 60%, let’s say 60% in Shanghai, Shenzhen and Guangzhou and half that or lower for other cities. So when The Economist recently mentioned in passing that home ownership among China’s urban households was 80% I nearly fell off my chair. Could this really be true and how could my half educated guess be so far wide of the mark?

In global terms 80% home ownership is extraordinarily high. According to the London Times (http://www.timesonline.co.uk/tol/news/politics/article1567419.ece) only 70% of UK households own their own home on the other hand the European Foundation for the Improvement of Living and Working Conditions (Eurofound) says that the EU states of Estonia, Hungary, Lithuania, Slovakia, Slovenia, Bulgaria and Romania all have home ownership rates of over 80%, the highest rates in the EU. Mass privatisation of housing in formerly and currently (with Chinese characteristics) communist States the quick explanation then, or…?

The most likely source of the 80% figure, it seems, comes from a statement from the Ministry of Construction, as reported by Xinhua, which actually states that 4 out of 5 urbanites (not households) own their own home and 94% own some kind of accommodation. If that was not enough, this report is not dated 2007, it actually dates back to August 2002 (http://www.asiamarketresearch.com/news/000200.htm) and (http://english.peopledaily.com.cn/200208/09/eng20020809_101182.shtml). I quote ‘between the mid 1990’s and 2002 80% of China’s public housing was sold to local residents’. Sale of 80% of public housing does indeed translate into 80% home ownership among the same group of people. Assuming the equivalent figure is even higher today, this gives China one of the highest rates of home ownership in the world. All news to me.

A crucial breakthrough in my clarification of what this might really mean in my Google assisted research came in an excellent paper published by no less august institution than the Joint Centre for Housing Studies at Harvard University http://www.jchs.harvard.edu/publications/international/w05-7.pdf, dated July 2005. This paper confirms my understanding of the difference between fully transferable property rights that come with commodity housing (shangpin fang) and usage rights (shiyongquan). For the latter the rights are inheritable but there are restrictions on other forms of transfer including paying back to the work unit (danwei) from which they originally came, ownership of a sort then but probably not really in quite the way that I suspect The Economist thought. Nice to have Havard to back me up.

Bear in mind that the same 2002 report states that ‘67% of the people who had bought public homes wanted to improve their living conditions by purchasing new homes or exchanging houses’ but their ability to do so is restricted. Those that own usage rights find they have to pay a premium to sell, again this matches my experience in trying to manage transactions of old houses in Shanghai under multiple occupancy which apart from anything else require payment of a land premium (budijia) to be able to convert use right ‘ownership’ in the form of a brown book into a saleable title, green book.

I don’t know anything about ownership rights in eastern Europe and I don’t intend to use up the rest of my weekend finding out, but in the PRC it seems that ‘home ownership’ is not quite what the term might suggest. So back to the Economist and the question of 80% home ownership among urban households. Having sought truth from facts, I cannot say that they got it wrong but let us diplomatically assume that of that 80% half is usage rights and half is commodity housing with fully transferable title. This allows us both to be more or less correct and let us furthermore forget my assumption that the 80% figure is 5 years out of date. The assertion that this figure had been put to use on was that a property market crash would be ‘much nastier for China’s economy than a share-price crash’. Given the complexity of real estate ownership rights in China it is very difficult to draw any real conclusions from the 80% home ownership figure and given my forecast for Shanghai commodity property prices to double over the next 5 years or so property should be OK for now. Stock Markets on the other hand have been known to crash during economic boom times.

The true significance of this is that we lack quality statistics with which to accurately measure home ownership, price increases etc and that policies are being drawn up without a clear picture of the real situation. The result is that new taxes, slowing land sales, delayed development approvals, tighter credit etc is all inexorably contributing to hitting my 100% in 5 years forecast.

Implications: However well intentioned, often it seems that government measures to slow real estate market investment and price increases are having the opposite affect to that intended. There are some very basic reasons.

Analysis:

Chinese property prices continue to rise despite the regulators throwing all the taxes they can think of that are readily implementable and squeezing credit for developers and buyers. It says a lot about the investment options available to wealthy Chinese that property is still an attractive option. When interest rates on deposit are less than inflation you can understand why leaving money in the bank is not an attractive option.

What is most startling is that home ownership is already 80% if you include all the usage rights that are owned. These are halfway between a full title and a protected tenancy and are a hangover from the days of allocated housing. What this underscores is the still huge demand from upgraders, those that have a place they can call their own home already but still want somewhere better. Many of these people still live in hovels.

Demand from foreign investors is insignificant in the China market, they tend to be active only in certain parts of the country and in certain types of property. Hong Kong and Taiwanese investors are classed as ‘compatriots’ and are active in a wider range of locations but still there are limits on how many properties they can buy.

Impact of raising mortgage interest rates during 2007 will only be felt early in 2008 as mortgage rates are only revised once a year. Rather diminishes the point of small incremental rate increases. Expect a few more properties on the secondary market by March 2008 as the squeeze is on for those empty properties.

A final word on some of those statistics. They often exaggerate the problem and even some of these Year on Year figures are not always comparing apples with apples. For the rapid increase in Chinese GDP we would expect a rapid increase in property values and remember many of the ‘administrative measures’ are actually having a side effect of restraining supply which is not something that will slow price increases any time soon.

Implications: The Beijing market has shown considerable improvements in the last 2 years with some new offers with a higher level of retail tenant. In some respects Beijing can be said to have overtaken China's commercial capital Shanghai 

Analysis:

Kicking the tyres of the Beijing retail the other week was a far more pleasant experience than expected. Admittedly it has been a year and a half but nothing had prepared me for the change. Change not just in the quality of tenants in the shopping centers but the presentation of indoor and outdoor public spaces. This is about more than just begonias on every street corner, the little patches of desert that used to be on every street corner are now covered in green grass and not a drop of Dulux in sight. One is only left wondering where the water is coming from to support all this blooming foliage.

Anyway, back to the shopping. Beijing now has a significant number of sophisticated major retail destinations, more than just a couple a few years back. And Beijingers have found their wallets. Conventional wisdom always had it that Beijingers do not do conspicuous consumption, at least not in their hometown, but in the run up the Olympics the self imposed moratorium on spending seems to have been lifted.

The greatest contrast came visiting Shanghai’s Cloud Nine shopping centre in ZhongshanPark the day after my return from the Capital. Cloud Nine is a disaster. Having seen crowds of people at the entrance I had hoped that my previous impression of the place had been wrong and maybe, like Beijing, it had turned a corner. I soon realized, however, that the crowds were outside gulping in fresh air, someone with their head in the clouds has turned the ventilation off. In any case, no one goes past the main atrium either since no one thought of putting anchor tenants at the back. Compare this to Beijing’s, admittedly not yet perfect, Shin Kong Centre and I think you will know what I mean.

Likewise, I had always enjoyed a quiet little chuckle walking through Oriental Plaza, ‘Beijing retail, pah!’ But now I am chuckling on the other side of my face. Some excellent retailers and a good selection of F&B outlets to get people moving around, bits and pieces of building work going on here and there, a seminar going on in the central plaza, all signs of active management; more than mopping up after the dripping air conditioning.

Even Finance Street has a retail play now. Four Seasons Mall is fully leased ahead of completion and even now in its ‘not quite open’ state has the look and feel of something special. Good sight lines cunningly placed vertical transport, graceful lines and excellent materials. Not only that, but the Westin and Ritz Carlton are within walking distance of the office buildings. When did you last try walking from Shanghai’s Grand Hyatt to anywhere, let alone to the office entrance of the same building around the corner on a thundery day?

New Sanlitun, also not yet open so a bit unfair to point at them, but stunning enough in design, conceptualization and positioning. It shows flair and imagination that BigThumbPlaza doesn’t get near. Dare I say it, is this what Xintiandi was meant to be before it became an overpriced food court?

And in case you’re thinking this is just Sam prattling on about a trip to Olympic ready Beijing and a bunch of shops, remember, I’m a man; I don’t go shopping unless I have to. Next trip I’m looking forward to taking my better half.

Implications: Several rounds of tightening regulations around foreign property investment in China. Despite this investment has increased as have property prices across the country due to high returns and currency appreciation.

Analysis:

This is the latest in a series of measures targeting foreign investment as well as other measures aimed at slowing the pace of property price inflation in China.

In recent years no foreign investor that I am aware of has used local debt to buy land in China. So the new regulations have no effect on this.

A clear set of regulations would probably be more beneficial that this creeping barrage of hurdles to foreign investors. Interestingly a couple of years ago foreign investors were most concerned about repatriation of funds. Now the question is more about whether they can get the money into China at all or not which requires several layers of approval. No one is asking about repatriation anymore.

Chinese real estate investments are sought by overseas individuals and investment funds because of the attractive returns available and the prospect of currency appreciation. It is unclear exactly how these investments have been illegal in the past; undesirable may be a more accurate term to use.

Usually in Chinese legislation a set of enforcement guidelines are issued after the main regulations. Often the regulations are issued and may not be followed by any enforcement guidelines which means the regulations are quietly being dropped without being formally rescinded. Foreign investors typically have trouble coming to terms with this feature of Chinese law.

Foreign investors have mixed track records. Some with a decade or so experience are still able to find ways to get things wrong. Later entrants like Morgan Stanley and Macquarie have the best track records to date.

Second and third tier cities have much to benefit from foreign investment and are therefore attractive but investing in locations that are entirely unfamiliar to investment committees in San Francisco, London or New York can be troublesome.

Implications: The recent record land sale in Shanghai's prime Nanjing Road will set a new benchmark for the city's commercial real estate market raising expectations for other developers and pushing up costs for end users. This comes at a bad time for the regulator who for the last 4 years have been issuing edict after edict aimed at slowing the market

Analysis:

Following Shanghai’s latest land sale (Rmb67,000 per sq. m. accommodation value for a site on Nanjing East Road) one can’t help but sympathize with the regulators over their efforts to restrain the property markets. They have thrown pretty much everything they can easily throw at the market and still someone is willing to place a massive bet that commercial (retail and office) space on Nanjing Road will be worth Rmb100,000 or more per sq. m. in 3 to 5 years time. I wouldn’t mind taking that bet myself, after all I have forecast residential prices to double over the next 5 years, but just imagine how disheartening this sale must be for those given the task of slowing the market down.

Truth be told, there will always someone willing to take a punt like this and historically, if we conveniently forget about 1997 to 2000 office market downturn, they have always won (jury still out on the deliriously priced Tomson Riviera). One could even argue that the nature of last downturn will not be repeated since it was supply led and any new oversupply will have less effect on a mature that the last glut did on an immature and much smaller market. A future market downturn must surely be led by economic factors but no one seriously mentions China and economic recession in one sentence. Not such a crazy gamble perhaps.

If the developer chooses to lease the building, after allowing for construction, tax and contingencies on top of the land cost and assuming average rental income of Rmb10 per sq. m. per day (today’s prices) I calculate a return of 4% based on developers cost including financing on 50% of cost. If he chooses to sell, based on a completed sales price of Rmb100,000 per sq. m., which is more or less double today’s prices, my envelope spits out an after tax return of 8% which increases to 16.5% if he finances out of his own equity, although this of course excludes opportunity cost. The developers gamble of course is that the upside is stronger and presumably higher than can currently be imagined by anyone else in the bidding hall.

This auction result does achieve two other things however. It goes someway to answering the fears mooted some months ago of a Japan like meltdown affecting China, prices will have to see their way to late 1980’s Tokyo levels first, this auction result says they are on course to do that. The other thing it has achieved is to put the ball firmly back in the regulators court.

As an isolated case none of this need matter, except for the fact that every other landlord in town has taken note and shifted their prices up citing this land sale as the new benchmark. Suddenly a building in Huangpu that was asking Rmb30,000 per sq. m. last week was no longer for sale this week. Some of the commentary has been interesting, in case you missed it: ‘flour more expensive than bread’ was one comment which sums it up rather nicely, while another was reported as saying ‘it gives the commercial market a shot in the arm.’ Commercial space is expensive enough in Shanghai already and that’s before it has gone through the roof, up into the sky and into the stratosphere. ‘Messes up everything for everyone else’ is what I say.