China’s property markets have been on a three-decade tear; but a combination of spent one-off propellants and the moderating intensity of remaining push-factors suggest more measured progress ahead.
‘Measured’ though, in the context of what for years will remain among the most vigorous economies on the planet, doesn’t capture the still considerable potential these markets represent. Better to think of the future as a Dynamic-Maturity; measured, with Chinese characteristics, if you like?
Summary Conclusion
To be clear, on one point above all, a collapse of the China property complex is so remote a possibility I’ll address it, but only at the end of this note, with reminders then why it’s an all but impossible outcome.
More realistically, I want to think-out-loud about the changed pace of China’s property markets’ development. A place where old-certainties need revision and new-realities need incorporation into thinking. For the avoidance of doubt. I remain heavily invested in this sector and have no intention of reducing exposure. However, I believe a more critical approach to listed company valuation is now appropriate.
As these companies are traded on already extremely low valuations there’s nothing to do for now; but the next time the sector is taken up, because there’s always a next time, investors should pay closer attention to company specifics than many (I include myself) have done in the past.
To help think about where we’re headed let’s first look at how we got to where we are today considering some important historical…
Drivers
Three, never-can-be-repeated events explain most of what’s gone on in China’s property markets since the 1990s. The first will never happen again; and the effects of the other two will decrease in intensity, with mathematical certainty, from here.
Let’s consider these factors in turn. First, the never again…
The Great China Land Grab
Chinese property developers began listing in Hong Kong in large number early in the new millennium. These companies, in most cases, were not multi-decade operating entities. Prospectuses showed many having little if any land a few years earlier; but, by the time of listing, they had amassed multi-million square meter land-banks.
This process appears to have begun in earnest in the 1990s. At that time a number of well-heeled/informed/connected/financed entities and/or entrepreneurs saw an opportunity and ‘went for it’. These companies have since evolved but in nearly all cases you can trace the roots of today’s successful operators to this time. With a little digging you can also discover which combination of the well-heeled/informed/connected/financed DNA was most present at their creation.
There are books to be written about that period and I know, from first hand experience, relations with local authorities were then often (quite literally) lubricated with gifts of expensive hooch. Sales of luxury watches to China also began flourishing at this time, which is probably not just coincidental, and many of today’s by-the-book-operators likely have skeletons of various sizes in closets from way-back then.
There’s no space here for, nor purpose in dwelling on, the how-much-went-to-whom-for-what of those times. The bottom line is they’re gone, forever.
Then there’s…
The Great Recycling
One of the characteristics of China’s property markets new analysts are surprised by is the level of home ownership. According to aggregated Wikipedia information in 2014 it was 90%. That compares with America at 65%, Japan at 62% and Germany at 52%. This statistic doesn’t say much about the quality of those homes though; which in many cases was/is poor.
As China progressed economic reform one of the changes has been the relationship many of its citizens have with their government via employment at State Owned Enterprises (SOEs). Cradle to grave care is no longer the norm and as SOEs rationalized many staff found themselves property owners as work units (effectively) gifted them their accommodation (in many cases a quid pro quo for retrenchment). The homes may have been shabby but locations were, in many cases, golden.
At the same time the government was building new transportation infrastructure so run down apartments next to now shuttered inner-city steel mills could be swapped for others (in most cases two or more) far spiffier 30-minutes away on a new train. The old steel mill often becoming a shopping/office complex in the process and thus a win-win-win recycle for developers, local governments and former employees took place.
Even today you still find these sites in the big cities pending transformation; but there are less of them; and again, this is a one-time process.
Finally, and this one’s a long way from over, there’s…
Urbanization
Shanghai is a city today of 24-million souls . That makes it the biggest city in China and the biggest city in the world. Impressive. However, the population is forecast to grow to 34-million, an increase of just over 40%, by 2035; and this pattern of growth repeats in nearly all of China’s major conurbations. Forget impressive, wow! Right?
Right; but if I know this, and now you do too, so do a lot of other folk. There’s no doubt billions more tons of concrete need pouring to facilitate this smooth transition (to remind, China doesn’t do ‘crunchy’ urban planning), and on a recent visit to China’s largest city I visited a new town around 40-kilometers from the city center, an hour on the train. It was clear there, and doubtless in thousands more places like it, planning is already at an advanced stage to handle newcomers.
The trend of urbanization isn’t stopping in China; but it’s pace will slow if only due to base effects. Moreover, this process is proceeding in a highly organized and planned fashion. There’ll be no more grabbing of farmland on city peripheries from rubes, so no more exceptional profits for early-worm seeking developers. Worms are still available; but in future only at the right price via auctions.
Urbanization will remain a potent development driver; but unless it’s pace accelerates much of it’s effect is now likely reflected in prices.
Party On
To be clear and as I wrote above. I don’t believe the party’s over, nor likely to end soon; but it’s changing and investors must begin to think how to operate in a market transitioning from high growth to…
Dynamic-Maturity
It’s necessary to qualify ‘Maturity’ with ‘Dynamic’ because China’s economy will continue at a rate unparalleled by any other for the foreseeable future. In the process businesses that elsewhere that are just ho-hum in China’s case will continue to grow not cyclically but structurally; transportation and the finance sector are some more obvious examples.
Property too will, for the time being, remain a business characterized by structural growth; but here and there pockets of mature cyclicality will emerge. Especially in the biggest cities where progress has been most rapid.
How does this change the way we invest in China’s property markets? Most will understand the ‘Dynamic’ part of Dynamic-Maturity, it’s the ‘Maturity’ bit we have to shift focus in favor of.
What To Look (Out) For In Mature Property Markets
Elsewhere in the world we have examples of mature property markets and from those four points stand out as features that are likely to show up, in time, in China.
In no particular order they are:
- The numbers game; REITs (Real Estate Investment Trusts), rentals and institutional investment demand. Today, China’s institutional investors are not big players in the commercial property market; but they’re likely to become so. As they do they’ll bring a more scientific approach to asset valuation, particularly with regard to commercial property. A more developed REIT market is also likely (a new code has been in the works for some time) and so too is a more institutionalized residential to-let market. All of these developments call for a hard nose from investors when calculating theoretical asset values in future.
- Hoarding; China’s major listed real estate developers suffer from the same governance problem as China listed shares in general i.e. a lack of professional managers. Firms are either government extensions or the multi-year curations of gifted entrepreneurs. Face, inertia and rentier-bad-habits will play a part in how portfolios will be managed in future; and this will almost certainly lead to asset hoarding (HK, a good example). Investors must therefore be realistic in terms of how much of a theoretical NAV will ever be monetized and therefore include harsher discounts when calculating ‘fair’ share prices.
- Debt; despite a series of rolling flaps by poorly informed skeptics (Chanos 2010, 60 Minutes 2014, Bass 2017, et al.) the level of debt in listed China property companies has remained modest. To remind, a property company can handle a significantly higher debt burden than, say, a manufacturing company on account of the nature of its assets. It’s rare for a company in the sector today to have a debt to equity ratio in excess of 100%; but this will change and investors should be vigilant for gearing-creep.
- Location, location, location. In the past an analyst might inquire a company’s total China land-bank and base an estimate of value on that. Then, a distinction was drawn between first and second-tier cites. Then the cities themselves became the subject of specific inquiry. In future analysis will have to be more granular still. City? Which? District? Up and coming or dud? Street? Which end? To safely invest in future analysts and investors will have to do more leg-work than many have been accustomed to in the past.
Finally, A Little Time With The ‘C’-Word
We know why we’re where we are today and above have outlined some features of the landscape into which we may be headed; but isn’t there another possibility? That of a wholesale failure of the entire China property complex?
Click-baiting journos and attention seeking pundits refer to this possibility as a ‘crash’ (or, ‘CRASH!!’). This isn’t an impossible outcome; but it’s one so unlikely we don’t need to figure it into calculation for now.
There are five major factors that differentiate China’s property markets and why China isn’t, and can’t become, an Ireland, Dubai, Japan or Spain.
They are, and again in no particular order:
- Demand. China’s property markets are the product of real demand; they are not the product of a policy to get low income families on the property ladder or build-it-and-they-will-come schemes scrambling for occupants. Broad prosperity and economic gains in recent years have also been very real and the development of the property market is a no-less-real, rational and coincident-phenomena.
- Absence of financial engineering. There is no wholesale mortgage securitization market in China. Loans to home buyers and commercial property developers remain nearly all where they were originated, with the cautious lenders (of whom more below) who are now on the hook for non-performance. There’s also no ‘no-doc’, ‘low-doc’ or similar flim-flammery to sucker-in feeble borrowers.
- Low levels of household debt. Mortgage lending has increased in recent years; and, from a very low level, the numbers for overall bank lending and total household commitment have gone up. The starting points though for these trends were practically zero so rate-of-growth alarmists should be ignored. China’s savers remain keen and their thrift a habit likely to persist for some time.
- Robust financial institutions. What was the capital to assets ratio of Lehman Brothers prior to their collapse? It had been higher but was down to the low 20’s prior to failure. In China the same ratio for the banking system (according the World Bank at the end of 2017) is around 8x. The China-And-Its-Wobbly-Finances trope has been so wrong for so long we can, at least here and now, ignore it.
- Government control. China’s property markets are not a free-for-all. As noted, cities are planned in meticulous detail. Developers can neither buy land nor sell finished inventory at will, permits and permissions are required at every step. Mortgages are not granted freely and banks (and who controls the biggest of these?) strictly control the level of lending and their exposure to the sector.
Never say never and one day, perhaps, there’ll be widespread distress in the sector and associated financial complex; but that day is not today. Nor is it any day I can see in the foreseeable future.
In Conclusion
The great party, that has been China’s property markets for the last three decades, is nowhere near ending. It’s evolving; some things that mattered in the past won’t in future, and some things that didn’t will.
China’s property markets may have progressed to a dynamic-maturity, but I believe investors will be sowing capital profitably into this still-fertile soil for years to come.
More mindful though, perhaps, of the price in future they should pay to play.
Nial Gooding