Are Land Regulators in China Doing Developers a Favor?

Includes: CAF, FXI, GXC, PGJ
by: China Analytics

Land regulators in China apparently plan to take steps to prohibit real estate developers with land on their books that has been idle for more than a year from buying up new plots in order to restrain hoarding and other nefarious activities that drive up prices. For listed property developers that need to maintain a constant pipeline of projects as future income streams this may seem like an onerous regulation (assuming it is enforced with any stringency).

But there could be a silver lining to such a regulatory step in that it could prevent some companies (some of them at least) from acquiring pricey land inventories ahead of additional residential property price control measures that could ultimately reduce unit sales margins. New measures on second the third home mortgages are likely to come out soon, as are limited trials with a property tax in selected cities.

According to official statistics, measures to cool growth to residential property prices in China have been moderately effective in stabilizing prices, albeit at a high level. Such figures seem to be at odds with general household sentiment, and based on what developers have been paying for parcels of land around the country their expectations for future prices do not appear to have fallen very far.

Official housing and real estate statistics in China are easy targets for derision, as too are recent official proposals that have been released in the domestic media to reform practices for the collection and dissemination of official market data. Our operating assumption in this article is that whatever the effectiveness of the measures taken to date, additional regulatory steps are imminent.


Be that as it may, one area where there appears to be less incentive to fudge the numbers in the interest of social stability is land transaction prices. Where land prices are concerned official data does not point to a broad based slowdown in the property sector, yet.

At the end of August, year-to-date growth to land purchase prices had come down a bit from earlier highs, settling at around the 30% level, with the corresponding rate for eastern China heading towards 20%. At the same time, industrial profit growth has also slowed, to a cumulative rate of 55% for the year through August 2010. As explained below there is good reason for linking cash on corporate balance sheets - especially those of central and local SOEs - and trends in land prices.

In a July working paper from NBER titled “Evaluating Conditions in Major Chinese Housing Markets” Jing Wu, Joseph Gyourko, and Yongheng Deng (© 2010 by Jing Wu, Joseph Gyourko, and Yongheng Deng) produced just about the best analysis of property price trends in China that we have read in a long time. Findings to note include the following: price-to-rent ratios in major urban markets across the country have increased from 30% to 70% since the beginning of 2007, with the cost of land as a component of unit housing prices having increased by about the same margin; very low yields on residential investment properties mean that high expected capital gains are necessary to justify the cost (both cash and opportunity) of carry; as an example, in Beijing real constant quality land values have increased by nearly 800% since 1Q03, with state-owned enterprises (SOEs) having been major purchasers of land, paying close to 30% more than others for comparable plots; of China’s 129 central SOEs, 94 have real estate subsidiaries.

Regulators have made some efforts to force SOEs to divest real estate operations that are non-core businesses, but for many this has been an area of high returns relative to core businesses and there are deeply vested interests preventing such efforts from getting to far in reality. Local governments rely on pro-cyclical real estate related revenues to make up for massive imbalances in China’s system of public finance, so there is little incentive to question outsized bids for land resources.

Despite popular resentment on the part of the hundreds of millions of middle income households who, in the absence of connections, such as having an SOE employer who gives preferential pricing to employees for buying into its own development projects, have long been priced out of the market, there are huge political and economic risks associated with precipitating a substantial correction to residential property prices. If we assume that one possible political equilibrium is to take measures that will send prices sideways, allowing rising household incomes to make up some ground relative to house prices, this would mean that unit sales margins for developers would continue to fall based on current trend rates of growth to land purchase prices. Margins would continue to be weighed down as they work through high-priced inventories of land holdings on their balance sheet and financing costs rise.

Another political consideration in this equation is that there are at least as many households who would howl if the value of their properties fell by a wide margin as those who are grumbling about the unaffordability of housing. If regulators are serious about exorcising the ‘demons’ in China’s urban property markets they would probably find more of them at the stage of land auctions rather than in the residential property market. But then again, given that households are carrying relatively low levels of leverage (and at least a 20% to 30% equity cushion based on down payment requirements) the trigger for Andy Xie’s “slow leak” in the real estate sector could come from measures that curb land auction prices.

Taking all of the factors mentioned above into consideration, it would still seem that price control measures targeting household and speculative demand for real estate in the form of a property tax and mortgage restrictions may be the “lesser dominoes” favored by regulators. If these measures are effective, it would obviously dent land auction prices in the process. On a more basis level, however, land in China is scarce and housing is not, so land prices may not have too far to fall.

Returning to the original topic of this post, are regulators doing developers a favor with measures to limit purchases of new land until they have processed old inventory? Maybe, but just a small one.

Disclosure: No positions