Chinese real estate is no longer the easiest legal risk-adjusted money-making business in the world. It’s been a swift reversal. The impact will be felt across the board, by larger publicly-traded real estate developers like Xinyuan Real Estate Co., Ltd. (NYSE:XIN) , SOHO China Limited (OTCPK:SOHOF), Sino-Ocean Land Holdings Limited (OTCPK:SIOLF) and Central China Real Estate Limited (0832.HK) as well as REITs with exposure to China’s property market.
For the better part of 20 years, there’s probably been no simpler way to amass a great fortune than developing property in China. The business model was as simple as it was profitable: acquire a piece of property from friends in government at a fraction of its market value, mortgage the property heavily with obliging state-owned banks, sell out most of the units (either offices or apartments) within weeks of construction beginning and then pocket returns of 500% or more before the building was even occupied.
Continuously rising property prices, often increasing by 10% or more per month, provided incentive to hold onto some units for later sale. A final wrinkle was to demand a cash advance from the construction company when awarding the building contract, which further limited the amount of capital needed, and improving return-on-equity even more.
There was just about zero risk in deals like this. Then, the Chinese government began clamping down -- starting gingerly about a year ago and then with added ferocity in recent months -- in an effort to restrain property prices and overall inflation. At this point, what was once the easiest business in China has become one of the hardest. Sweetheart land deals are far more rare as the central government in Beijing is no longer turning a blind eye.
More importantly, banks have all but stopped lending to property developers. This has dried up liquidity in an industry that was for many years awash in it. The projects getting built now, for the most part, are those where little or no bank debt is required. That means heavy upfront equity investment, or taking money from loan sharks who charge interest rates of 25%-30% a year. This fundamentally alters the arithmetic of a real estate deal in China. The more equity and high-interest debt that goes in, the lower the returns and, it seems, the more likely a project is to hit problems.
And problems have become the norm. Another government change, little reported but absolutely crucial to the change in fortunes of the real estate business in China, is that it’s no longer easy and cheap to get current residents off the land, so it can be sold at a high price to a developer. New rules make it very expensive and risky for any developer to undertake this process of relocation and demolition.
Any delay, and delays are rampant, can quickly drain away a developer’s cash. For example, if one old tenant refuses to take the relocation money and move out, it is no longer a simple thing in most instances to get the local government, or hired goons, to force them out. Until all old tenants are resettled, no construction can begin. This can push back by months or even years the date that developers can begin pre-sales. Meantime, you keep paying usurious interest rates to lenders who have taken the whole project, as well as many other unrelated assets, as collateral.
A final nail: residential real estate prices are now rising far more slowly. This is the result of tighter mortgage rules, property taxes in some cities, as well as new regulations that limit the number of apartments people can buy. In Beijing, for example, you need to prove you have paid local Beijing taxes before being allowed to buy.
Of course, taking the easy money out of real estate is a prime policy objective of the Chinese government. That the government would be successful in this was never much in doubt. The speed and geographical scope of the impact, however, has caught a lot of people (including me) by surprise. Projects that six months ago looked like sure things are today struggling. The sudden evaporation of bank finance, in particular, is playing havoc. Banks in China are state-controlled. When they responded slowly earlier this year to government suggestions they slow the flow of funds to the real estate sector, the government took more active measures, including raising six times banks’ reserve requirements.
Rocketing property prices are a major contributor, directly and indirectly, to inflation, which is now, by official figures, at its highest level in China in over three years. So, the government’s actions had a broader purpose than altering the return formula for real estate investment in China. At the moment, though, that’s been the main impact, to make it far harder to do both residential and commercial real estate projects in China. When and by how much inflation will be curbed is unclear.
The bigger question is: has the game changed permanently in Chinese real estate or will things revert as soon as inflation is down to where the government wants it to be? The rising real estate prices of the last 20 years have not only helped the country’s real estate barons, they have also been a main source of rising middle class wealth in China. That’s where the government policy becomes more an art than science: how to strip away real estate developers’ easy profits while keeping the middle class feeling flush and contented.