- The focus on real estate reflects the central government's determination to address growing systemic risks and to avoid a further increase in wealth inequality created by rising property prices.
- Real estate remains one of the key drivers of GDP and the most important revenue source for most local governments.
- Overall, we see value in the sector, but bottom-up research and careful credit selection are key.
Momentum in China's property market remains strong so far in 2021, driven by healthy demand for housing. Although we expect this demand strength to be partially offset by the government's recent credit tightening, the property market should remain relatively stable this year.
Government tightening aims to curb credit exposure to the real estate sector
China's resilient growth in 2020 provided an opportunity for the government to address debt levels in the property sector. In August 2020, the People's Bank of China (PBOC) introduced new measures to closely monitor and control the total debt level of major property developers. Under this policy, commonly referred to as the "Three Red Lines," companies are scored as green, orange, yellow or red based on their cash-to-short-term debt ratio, net gearing ratio and liability-to-asset ratio. In December 2020, the central bank announced a cap on bank exposure to the real estate sector.
This focus on real estate reflects the central government's determination to address growing systemic risks and to avoid a further increase in wealth inequality created by rising property prices. Housing affordability is a particular concern because prices remain at 15-20 times the average household income in major cities.
However, real estate remains one of the key drivers of GDP and the most important revenue source for most local governments. As a result, we expect this deleveraging to be orderly and controlled.
Property sector likely to remain largely stable
While we expect a tighter credit environment for developers, a variety of factors should provide support for the sector. Housing demand remains resilient despite recent tightening, underpinned by the continued domestic economic recovery. According to China's National Bureau of Statistics, property sales were up 64% year-on-year in 1Q 2021, albeit from a low base in 1Q 2020. On a normalized basis, property sales in 1Q 2021 registered a compound annual growth rate (CAGR) of 10% over the past two years. Listed developers have reported even stronger contract sales numbers in 1Q 2021, up 39% compared with 1Q 2019, translating to a CAGR of 18% over the two-year period. The average selling price has also recovered back to 2019 levels and inventory remains steady, with a pipeline of 10-12 months of sales.
Three themes for investors to watch
- Lower gross profit margins: While revenue was up 16% year-on-year for the sector, gross margins declined sharply in financial year (FY) 2020, down 4.6 percentage points on average to 23.8%. This was largely driven by the revenue recognition of expensive projects acquired during 2016-2018 and the strict price cap imposed in major cities since 2017. We expect this trend of lower gross profit margins to continue over the next three years, although the magnitude of the decline should narrow to around 0.5-1 percentage point per year. We expect gross profit margins for the sector to reduce to around 22% by the end of FY 2023 from 23.8% at the end of FY 2020.
- Race to meet the Three Red Lines leads to substantial increase in minority interests (MI): In response to the Three Red Lines policy, developers have made an effort to control their total debt and leveraged developers have scaled back their land acquisition. A number of small- and mid-cap developers have also enlarged their equity base through a substantial increase in MI on their balance sheet. The sector average of MI as a percentage of total equity has risen sharply over the past five years, up from 16% in FY 2015 to over 35% as of the end of FY 2020. We are concerned about this substantial increase since some of this MI could actually be debt disguised as equity and transparency is extremely low. This is an area we are monitoring closely.
- Idiosyncratic risks: Developers that rely heavily on joint ventures to drive their sales and revenue recognition might run the risk of not being able to consolidate as previously scheduled if auditors adopt more stringent standards. We have already seen one example of this and expect that it is unlikely to be an isolated incident.
Overall, we see value in the sector, but bottom-up research and careful credit selection are key as government policy and idiosyncratic risks will drive performance divergence and create both winners and losers over the coming years.
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