By Tammy Lloyd, Analyst, Emerging Market Fixed Income
Which Real Estate Developers in China?
Size really counts in the competitive world of China’s real estate developers. On a recent visit to Shenzhen and Dongguan, we found big national developers are resolutely focused on growth. Many large developers are forecasting annual sales growth of at least 20% in 2018, on average. Some have even forecast over 100% year-on-year sales growth this year, despite sluggish overall market growth. This focus is explained by China’s policies to reduce leverage and speculation in key economic sectors such as real estate. Below we explore:
- How tighter lending standards are benefiting larger property developers
- Property market movements in tier 1 cities that are spilling over to periphery areas
- Opportunities for US dollar focused debt investors
The consequences of stricter lending standards
Developers told us that local and national banks have been asked to reduce exposure to real estate lending, both construction loans to developers and mortgages to borrowers, to cool market speculation and soaring price appreciation. That has created a waterfall effect whereby the largest developers have reasonable access to low cost bank lending and the smaller, less operationally viable, developers are cut off. Growth to the right relative size and ranking – a moving target – has become a race to survive and prosper. It also becomes, when implemented in a competent way, self-fulfilling. Hence, in a country that has over 4,000 developers looking for ways to grow, it is those that rank among China’s largest that are most able to focus on growing sales and buying land in 2018. Their goal is to climb the ranks and achieve lower funding costs for themselves and their customers. Larger companies often pay a lower premium over and above the People’s Bank of China (PBOC) rate on loans than smaller developers (though debt ratios also play a role).
The good news for investors in the larger companies is that big developers have taken advantage of scale and funding costs to gain market share. The estimated market share held by the top 10 developers has doubled from 15% in 2012 to around 30% this year*. This has created an alternative source of land supply whereby bigger developers can cherry pick the best projects from financially strapped smaller developers. These opportunities have been reducing their reliance on highly competitive local government land auctions, but have also helped the smaller developers by reducing the likelihood of a swathe of defaults given many of these smaller developers may have onshore bonds.
On the ground analysis of Shenzhen and neighbouring cities
Most development projects are thriving in Shenzhen, one of 19 tier one1 cities in mainland China just over an hour’s drive from Hong Kong. It has 13 million permanent inhabitants and reportedly the city’s population has been swelled by around 20 million migrants from other parts of China. Most of the major developers issuing bonds have at least one project there or nearby. An increasing number of these companies are keeping the apartments they develop to build a rental portfolio as the government tries to encourage a rental market. Shenzhen has started to compete with Guangzhou, another tier one city and Shenzhen’s politically prominent neighbour, for attention and resources. Tighter restrictions amid the city’s growth are evident: the government has controlled average selling prices (ASP) since mid-2016 after they shot up 40%. First time home buyers now need a 50% cash down payment and the second home requires 75% cash up front. No consumer lending is allowed to fund that cash – banks have become more diligent about checking. Secondary market volumes are slim, as restrictions on owning two properties and the area’s growth ensure many of these new builds are actually lived in. The government hopes a secondary market will develop by 2025. For now, average rental yields are just 2%. Buyers unable to afford Shenzhen have moved to Dongguan, historically a sparse industrial area around an hour’s drive away, in the Greater Bay Area. Dongguan is now targeted for expansion: locals say 120 new companies register in the area each day. These sparks of activity are happening right across the Greater Bay Area as other districts such as Qinghai will benefit from the new Guangzhou rail links, connecting highways being built and favourable tax policies designed to attract skilled workers. The Greater Bay Area’s population of around 80 million could double by 2025, according to one property expert. Developers are excited about the area as a way to buy land at a reasonable cost and sell where prices are appreciating due to migration and government development policies. Importantly, there are no formal pricing controls in these areas to skew the market.
The investment opportunity for emerging market corporate investors
Shenzhen and parts of the Greater Bay area are bright spots in China’s real estate market. China’s national sales have hardly grown YTD to April (up 1.3% yoy), reflecting the stark differences between large and small developers and different parts of China. Financing costs have increased for all companies due to tougher regulation and skittish markets. Figure 1 demonstrates how US dollar bond yields have also risen as local investors have reduced the amount of these bonds they buy because RMB bonds yields have risen more, they are less interested in US$ exposure while the RMB remains stable and US$ issuance has increased significantly as developers refinance debt and fund expansion.
Figure 1: Yields on property issuers in China
Source: HSBC, 31 May 2018
This has created opportunities for investors interested in US$ bonds. Developers are being forced to pay higher yields in US$ markets to fund their growth and use multiple sources of funding including convertible bonds - or simply reduce their growth targets and deleverage. We do not expect the tightening in real estate to undermine China’s overall growth, at this stage. Hence, investors can benefit by choosing companies that are well placed geographically or able to capitalise on lower funding costs to expand in good areas. We are avoiding smaller developers where their expansion is fuelled by higher funding costs, but we believe average yields approaching 6.5% for established developers with a bond rating above BB with a focus on good locations still look attractive.
*Bank of America ML estimate, April 2018.
1 Refers to the Chinese government ranking system first introduced in the 1980s to facilitate a staged rollout of infrastructure and urban development throughout the country. The ranking reflects the government’s development priorities.
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