Riding the cycle Finding opportunities in a complex market China real estate in 2018

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1 For professional clients / qualified / institutional investors only. Riding the cycle Finding opportunities in a complex market China real estate in 218 By: Hayden Briscoe, Head of Fixed Income, Asia Pacific After a week in China visiting firms and skirting the pre- Chinese New Year travel crush, we re back in Hong Kong and thinking about prospects for China s real estate sector in the Year of the Dog. After a longer than usual debate with our credit analysts and portfolio managers at our recent investment meeting, three issues are top of mind: will China s real estate sector support the economy in 218? Will developers start piling up inventory again, and why is the real estate cycle longer this time round?

2 How did China s real estate market perform in 217? Our rounds of meetings with real estate developer CEOs and CFOs in China yielded some fascinating insights, and we have built them into our outlook for China s real estate sector, economy, and bond markets for 218. National sales growth slowed: 217 was defined by the most strict policy environment yet seen for both developers and buyers. Brian Lou (BL), China Fixed Income Portfolio Manager Sales were actually a lot stronger than expected though, particularly compared with expectations going into the year. Sales growth was slower on a national level, but many listed developers reported record sales numbers. Ross Dilkes (RD), Asia Credit Portfolio Manager Sales trends differed by city tier. Purchase restrictions, pre-sale controls and price caps hit the demand and supply side and sales volume declined y-o-y in first-and second-tier cities. In contrast, relatively looser policy and government support for shantytown development drove y-o-y growth in third-and fourth-tier cities. Smit Rastogi (SR), Real Estate Credit Analyst Sales were actually a lot stronger than expected though, particularly compared with expectations going into the year. Sales growth was slower on a national level, but many listed developers reported record sales numbers. Inventories declined: Inventory overhang particularly in lower-tier cities disappeared and total saleable area has declined in successive years since peaking at the end of 215. (BL) Even amid controls on new releases, projects brought to market in first- and second-tier cities sold well, so inventories remain low in those areas. Ethan Wang (EW), China Fixed Income Credit Analyst. (See exhibit 1.) Exhibit 1: Inventories of unsold Residential property (million sq.m), Dec 211 Dec 217 Million sq.m 5 25 Dec '11 Dec '12 Dec '13 Dec '14 Dec '15 Source: National Bureau of Statistics, February 218. Dec '16 Dec '17 2

3 Price growth cooled: Purchase restrictions, higher mortgage rates, and local-level price controls cooled the red-hot y-o-y price growth of 2% 3% shown in government statistics in 216. Exhibit 2: Price growth (% YoY) by city tier, Jan 212 Dec 217 4% Tier 1 Tier 2 Other Growth in average sales prices (ASPs) reached their lowest levels since 215. Official government data shows that lower-tier cities saw better price growth of 6%-7% in 217 compared with.5% and 5% in first-and second-tier cities, respectively. (BL) (See exhibit 2.) % YoY Land sales picked up: Many developers posted strong sales growth in 217. Some of the larger players, particularly those with better financial capability, aggressively bought land to boost pipelines, diversify geographically and force competitors out of the market. There was a strong pick up in land sales in 217, with the total area and value of land sold increasing 16.3% and 47.% y-o-y, respectively, YTD at the end of November 217, according to Chinese government statistics. (SR) Financing costs rose: Onshore funding markets were more difficult in 217 China s deleveraging policies put curbs on debt issues and tightened liquidity conditions. That said, the situation remains much better than previous years. Don t forget that pre-214 only a very small minority of developers were allowed to issue onshore bonds. (RD) (See exhibit 3.) -1 Jan '12 Jan '13 Jan '14 Jan '15 Jan '16 Jan '17 Source: Bloomberg, January 218. Note: Tier-1: Shanghai, Shenzhen, Guangzhou, and Beijing. Tier-2: Tianjin, Nanjing, Hangzhou, Suzhou, Wuhan, Xi an, Shenyang, Chengdu and Chongqing. Exhibit 3: Onshore rates, Feb 218 Percent 6% 5 4 China Govt 3Yr ChinaBond (AA) 3Yr YTM ChinaBond (AAA) 3Yr YTM 3 2 Feb '17 Apr '17 Jun '17 Aug '17 Oct '17 Dec '17 Feb '17 Source: Bloomberg, February

4 So where are we in the cycle? We re at the tail-end of the latest market cycle. However, we believe this cycle will be longer than previous ones because there is little prospect of a sales rebound in 218. Little policy appetite to boost the market; structural reforms take precedence That s because China s top leadership are resolved to avoid the mistakes of the past. In previous years, they supported developers, relaxed sales restrictions, and offered discounted mortgages to boost turnover and sector investment. These moves helped meet pre-decided GDP growth targets but saddled the financial system with debt. The situation has now changed. Current policy stresses quality of growth over quantity and indicates little appetite for short-term boosts at the expense of longer-term sustainability. The government is now emphasizing market reforms to adjust the structure of the market. Progress toward creating a well-functioning rental market, property taxes, and a REIT market will be key to watch in 218. (SR) Continued differentiation amongst China s real estate developers China will continue with its deleveraging policy in 218, and that s going to cause differentiation in the real estate sector. Deleveraging policies have put smaller-scale unlisted developers under financing pressure and that s going to continue. We believe smaller developers will look to liquidate projects and land holdings and M&A activity will continue to be high during 218. Larger developers, backed by robust sales in 217 and better access to financing, will likely be leading market rationalization, and will further expand in 218 by taking market share from smaller, less financially capable developers in the market. China will continue with its deleveraging policy in 218, and that s going to cause differentiation in the real estate sector. Exhibit 4: National residential real estate monthly sales growth (% YoY-6M MA), Apr 29 Dec 217 8% 6 % YoY-6M MA months 19 months 29 months 39+ months Apr '9 Apr '1 Apr '11 Apr '12 Apr '13 Apr '14 Apr '15 Apr '16 Apr '17 Source: Bloomberg, January

5 What does this mean for the real estate market in 218? Policy will likely remain tight in 218. Tier-1 cities will continue to see tight restrictions on property sales and mortgages. That said, we ll see some differentiation at the local level. The government has spoken about differentiated policies with precise implementation this means an overall focus on tight policy, but some targeted policies in specific cities to support housing demand and promote migration and resettlement. Examples of this approach include recent cases where local governments in second-tier cities, including Nanjing, Wuhan, and Lanzhou, marginally loosened housing purchase restrictions on second homes and relaxed residency qualification rules to attract highly-qualified workers. (BL) Higher home loan rates, longer disbursal times China s deleveraging campaign is not only focused on corporate debt, but also household debt, particularly after rapid growth in the previous housing boom. (EW) With deleveraging ongoing, joint-stock banks and city commercial banks are getting squeezed on the funding side and mortgage rates have gone up from a 1% discount to PBoC benchmark rates to a 1% premium at the end of H Average disbursal times have also increased, making it more onerous to get a mortgage. This, plus rising mortgage rates, should impact the demand side of the market in 218. (SR) 218 sales: Flat y-o-y, or slight decline On the sales side, aggregate national sales will either be stable or see a slight decline in 218. Tier 1 and tier 2 city 217 sales growth has already slowed from 216, so the base effect will be low. Low inventories and a moderate supply side in these cities, combined with purchase restrictions, means sales will likely be stable. (EW) For lower tier cities (tier 3&4), sales volumes will likely decline compared with 217. This is because of high bases in the previous year, the tighter mortgage environment, and lower shantytown redevelopment. (SR) That said, a major drop in sales at the national level looks unlikely. Policy tightening has taken a lot of speculative demand out of the market, but there are other major sources of demand to support sales, including demand from rural-to-urban migration and resettlement after urban demolition. With shifting dynamics and tight conditions, more agile developers particularly those who have added scale and maintained decent leverage in the past years will likely grow sales by taking market share from companies either exiting the industry or scaling down their operations. Many of the larger developers who have added scale and fared well, despite government restrictions, remain positive on the sales outlook for 218, of the ten developers we visited in November 217, most guided for 2% to 4% sales growth in 218, on the back of increased saleable resources added in 217. (SR) 5

6 In focus Deleveraging and its impact on China s real estate sector In late-216, the Chinese government launched its deleveraging campaign to get serious about debt in the financial system. China s real estate sector took approximately 42% of total financing in the economy in 216, according to the UK-based Royal Institute of Chartered Surveyors, making it a prime target for the government. Part of the build-up of debt in the real estate sector has been down to the government because it has boosted economic growth by channeling loans to developers, allowing shadow bank financing to the sector, and periodically removing purchase restrictions to boost sales and investment. But the situation is different now that China s government is focused on sustainability. Developers must become more competitive, re-evaluate their business models, use resources more efficiently, and meet development targets and deleveraging policies are promoting change. Large-scale developers have used the opportunity and bumper sales in 216 and 217 to expand market share, pay down debt and focus on profitability. Market concentration has increased, with the top 1 developers by sales in 217 accounting for 24% of total sales, compared with 1.1% in 21. But China s deleveraging drive is by no means over. Policy statements following the October 217 National Party Congress reaffirm the government s commitment, and the industry will likely continue to face financing pressure in the coming years. Exhibit 5: China real estate M&A, (USD billions) $12 Major changes introduced in the past two years include restrictions on developer bond issues, curbs on financing via wealth management products, strict qualification criteria to enter land auctions, tough oversight over bank lending, and huge fines for bank sector loan officers if they don t comply with new rules. USD billions These policy changes have driven record levels of sector M&A. Smaller developers have been pushed out of the market and highly leveraged firms have liquidated their land assets and projects, resulting in M&A worth USD 18.5 billion in 217, up 112% y-o-y, according to data compiled by Pricewaterhouse Coopers. 213 Source: PWC,

7 China real estate where does demand come from? Chinese buyers bought an estimated 1.34 billion sq.m. of residential real estate equivalent to the land area of Berlin in 217, according to China s National Bureau of Statistics. Given the rapid price growth seen in some parts of China, it would be easy to say that the hefty sales number represented a speculative bubble. However, demand for real estate in China has four other distinct drivers that are both structural and long-term in nature. The first stems from urbanization demand. An estimated 25 million people will have moved from rural areas into China s cities between 21 and 22, and a further 124 million are forecast to move between 22 and 23, according to projections by the United Nations. The second source comes from new families. Approximately 12 million marriages get registered in China per year. As is customary, new couples start married life in new houses and that creates extra demand for property estimated at 186 million sq.m. per year, according to the IMF. The third source comes from resettlements after demolition. While China has produced modern properties at a breakneck pace, the majority of city center housing stock remains outdated. As China moves to make more efficient use of inner-city land, it is relocating residents and demolishing old structures, thus creating demand for new living space. The fourth, and final, demand driver comes from upgrading demand. Existing homeowners who are looking for a better property, possibly because they have made money on an investment a while ago, account for a large part of demand, estimated at around 18 million sq.m. per year, according to IMF estimates. So, while speculative demand might have been behind some of the recent gyrations in the Chinese domestic market, there are fundamental, rigid demand drivers in the market which we maintain will underpin real estate demand in the coming years. An estimated 25 million people will have moved from rural areas into China s cities between 21 and 22, and a further 124 million are forecast to move between 22 and 23. 7

8 What does this mean for the economy? We see little evidence of a coming pick-up in real estate fixed asset investment (FAI). With tight controls on the demand side, plus liquidity pressure on developers, investment is highly unlikely to rebound and that s why the Chinese Academy of Social Sciences is forecasting a 5.1% y-o-y increase for 218 compared with 6.9% y-o-y in both 216 and 217. This means slower economic growth in 218 since real estate FAI accounts for about 15% of GDP, according to IMF estimates, and reinforces our long-held conviction that the Chinese economy will experience a mini-cyclical slowdown through 218. Exhibit 6: Real estate fixed asset investment (FAI) & GDP growth (YoY-%), FAI Real Estate (LHS) GDP (RHS) Source: National Bureau of Statistics, January 218. Implications for Fixed Income in 218 Onshore debt markets to remain tight In onshore bond markets, we re expecting low supplies of developer debt in 218 principally because, on the channel side, primary markets are all but closed to developers. Those with real refinancing needs for maturing bonds or private placements may be given permission. On interbank markets, issuance will be on a highly selective basis, since China s National Association of Financial Market Institutional Investors, the interbank market regulator, has a conservative attitude to the real estate industry. Other channels, like non-standard financing and trust loans, will also be strictly controlled when new asset management regulations come into force (EW) Considering tight financing conditions on the domestic market and the government s ongoing deleveraging campaign, funding costs on onshore markets will likely rise in 218. (SR) 8

9 New asset management regulations will also reduce investors risk appetite. However, this will mainly have a negative influence on mid-to-small sized developers. Maturity wise, market data show that though only around CNY12bn onshore real estate bonds will mature in 218, around CNY 36bn worth of bonds have put options in 218 and around CNY 7bn in interest payments will come due. Because of price discounts in most bonds embedded with a put option, plus uncertainty about market prospects, investors have the incentive to secure yields by exercising put options, which will increase developers financing pressure. Larger developers will fare better in terms of funding access than smaller names. Despite a tighter environment, banks are still willing to provide facilities, and they favor the larger, geographically-diversified developers, most of who managed to achieve strong sales in 217. In contrast, smaller names that lack scale and have aggressively acquired land will come under a lot of pressure in 218. (EW) Heavy supplies possible in offshore debt markets Looking back on 217, the supply of debt to offshore markets was heavier than expected strong sales for the top developers in 216 and 217 led to aggressive restocking of landbanks. Onshore markets were challenging for refinancing and the RMB was stronger than expected against the USD. This increased supply in offshore markets was more than offset by robust demand, however, helping the sector perform well through the year. With additional RMB strength in early 218, higher yields, and a lot of debt falling due onshore, we may see another year of heavy supply offshore in 218 as developers look favourably upon USD debt financing. With slowing sales growth going into 218, plus continued supply and rising treasury yields, we ll probably see higher yields for developers in the market overall but we expect returns from the sector to remain positive. (RD) Exhibit 7: Debt supply (USD billions): Onshore & offshore markets compared, $14 12 China Real Estate Developers: Onshore Supply China Real Estate Developers: Offshore Supply 1 USD billions Source: Bank of America, January

10 Conclusion Despite policy restrictions, real estate sales performed better than expected in 217, with differentiation between city tiers. Many developers reported record sales, particularly by taking market share from smaller companies in the sector. Tighter financing, an outcome of the Chinese government s deleveraging campaign, is forcing sector rationalization and differentiation between real estate developers. Smaller firms are facing financing challenges and offloading projects and land resources. Larger developers are taking advantage and expanding aggressively through M&A. China s property market will be challenging for developers in 218. We see very little prospect of a policy-led sales rebound because the government remains committed to keeping prices under control, promoting sector rationalization, and passing structural reforms to improve the long-term sustainability of the market. However, sales levels will likely remain stable compared with 218. China still has robust real estate demand from underlying fundamentals like urbanization and property upgrading. We expect to see some targeted policy support, particularly in lower-tier cities looking to boost rural-to-urban migration and attract highly-qualified residents. Larger developers will likely see higher sales y-o-y, partly because of greater project diversification and partly because they will take market share from smaller players. Financing pressures will raise sector yields but, with a solid demand outlook, we re confident that the sector offers highly attractive yields for investors, and we particularly favor the larger real estate developers who have the scale to operate nationally and who are leading the ongoing rationalization process in the industry. Looking more widely at the economy, our expectations of stable sales levels and China s ongoing deleveraging mean that the real estate sector is unlikely to boost GDP growth through a pick-up in fixed asset investment in 218. We maintain our expectation of a mini-cyclical slowdown through 218. Against this macro backdrop, Chinese government debt continues to offer excellent value, with rates expected to pass 4% in 218. Exhibit 8: Nominal 1-year yields compared, Government Debt, Feb 3, 217 Jan 3, CN Gvt 1yr US Gvt 1yr Jap Gvt 1 yr Ger Gvt 1yr 4 3 Yield Feb '17 Mar '17 Apr '17 May '17 Jun '17 Jul '17 Aug '17 Sep '17 Oct '17 Nov '17 Dec '17 Jan '18 Source: Bloomberg, February

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