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Living in the iron bubble -SinoSage

Living in the iron bubble2010-05-26: China Housing’s (CHLN.NASDAQ) business model is a leveraged play in a declining market. Any China company without some kind of state-sponsored protection is likely to feel the impact of the growing uncertainty in the property market

Everyone – apart from sellers, local officials and some consultants – agrees that China’s property prices are unnaturally high, regardless of their propensity to keep rising. But what many in the West do not understand is that the China’s property bubble is made of iron.

State-owned enterprises (SOEs) are major real estate players, and have the resources to push a market pretty much wherever they want it to go for the foreseeable future. The government is tightening regulations in order to reassert control over the market, and these regulations include banning participation by SOEs not directly involved in property development. But the smart money would be on the business being transferred to other SOEs or else kept in-house under some other pretext or label.

Many Western investors are convinced the Chinese property bubble will burst spectacularly as it did in the US, and they want to short the market. They are great believers in the power of supply and demand to determine price, and the speed of the pricing mechanism in the US both contributed to the crash, and contributed to the recovery.

SinoSage would say, in typical Chinese fashion, that they are both right and wrong. Chinese property also operates under conditions of supply and demand, but there is a third, equally important, variable: the state. The iron bubble – a product of the state’s interest in specific supply and demand issues as well as its control or heavy influence over pricing, timing and demand – will protect large parts of the market from a collapse.

China Housing & Land Development (CHLN.NASDAQ) is not necessarily an assumed part of the iron bubble. On the other hand it has debts with several state banks – US$12 million owed to China Construction Bank (601939.SH, 0939.HK), US$22 million to Xinhua Trust Investments, US$5 million to Industrial and Commercial Bank of China (601398.SH, 1398.HK) and US$22 million to Bank of Beijing (601169.SH).

China Housing is a property developer in Xi’an. It is currently building two projects there: JunJing II, a 1,015 unit family residential complex that has sold 752 units as of end-March; and the Puhua project, a 5,000 family residential development that began construction in 2Q 2009 and started pre-selling in 4Q 2009.

The first project looks okay; the second appears to have run into some problems.

Puhua is a 79 acre project in Baqiao, a district that Xi’an has designated a major resettlement zone. The city government wants 900,000 middle- to upper-income residents will move in and it has spent more than US$6 billion on infrastructure. The plan is that Baqiao will become comparable to Shanghai’s Pudong district.

Riding on this development wave, the company predicts that Puhua will generate US$700 million over the life of the project, but so far only US$31.7 million is under contract. By end-March, only 393 units had been sold.

In November 2008, Prax Capital China Real Estate Fund I bought into the project for US$29.3 million to become China Housing’s minority joint venture partner. It acquired land use rights in 1Q 2009. In 1Q 2010, China Housing said it was going to redeem the Prax shares in order to fix the maximum return on the fund’s initial investment. On May 10, 2010, it was agreed that Prax would receive a total of US$84.4 million within three years. It certainly seems like an odd time to repay an investor, especially if housing sales are slowing and cash is becoming harder to obtain.

China Housing’s CFO, Huang Cangsang, spoke to SinoSage about these issues.

“We have been thinking to redeem the Prax Investment for quite a while as it is really a good investment given the current development of that area,” he explained. “Recently, a series of policies have been released and we think it is a good time to negotiate with Prax to redeem the investment so that we can maximum our initial investment and lower the redemption cost. There is no other additional reason or internal change for this redemption.”

This answer is not convincing. The markets are peaking, and virtually every real estate investor SinoSage has spoken wants out and would be happy just to get their principal back. The idea that China Housing “negotiated” a return of 188% for the minority partner in a project to maximize its initial investment is improbable.

When asked about the three-year payment schedule, Huang said: “The main concern is to reduce the liquidity pressure. We would have no problem to pay all the cash upfront but it would tie up our working capital.”

China Housing’s 1Q results, however, suggest that the company is not in a position to pay cash upfront. It had reserves of US$66 million at the end of the quarter, but that included a new bank loan of US$31 million while the redemption cost is US$42.6 million. China Housing decided to hold on to the money.

Huang went on to discuss the current property market trends, admitting that business is likely to be difficult in the short term due to government tightening policies. “Market participants are being very careful for the time being. But small-to-medium sized cities in northwest China are less influenced by these factors,” he said. “Therefore, we are very confident of the property market in Xi’an in the long run.”

The fabled long run. Every bankrupt real estate company began by focusing on the long run.

Huang was keen to talk down suggestions that the Puhua project might be behind schedule. “There is no problem so far at all. The whole project will provide 5,000 family units and it is divided into five years construction plan with four phases of sales,” He explained that China Housing has only US$3.7 million under contract because it Puhua is only in the first phase of construction.

China Housing’s positive outlook is both unsurprising and dubious. SinoSage contacted several property developers in Xi’an and they all said the same thing: the residential market is weak, the number of enquiries and deals done has dropped dramatically, although quoted prices are static for now. One property agency said the number of clients checking on opportunities had dropped from an average of 20-30 per day to an average of only 2-3.

China Housing is a developer in difficulties disguised as a US$2.00 stock. It is being kept afloat by bank loans and, given the banks in question are government sponsored and for a variety of reasons it is not in the state’s interest to see the debts called bad, there is a reasonable belief that the company will survive. This is the iron bubble in action.

So China Housing still has a pulse, but its stock value is not compelling. If the price reaches US$5.00, sell it; if it goes below US$1.00, buy.

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