China special: A little trouble in big China

On 19 January China’s two main stock exchange index values fell by 7.7%, wiping $315bn (£209bn) off the Shanghai exchange in a day – their biggest losses since June 2008.

Less than 24 hours later the government confirmed it had missed its official annual growth target for the first time in 15 years, with 2014 GDP coming in at 7.4%, the lowest annual growth rate since 1990 when the country was suffering from the economic sanctions imposed after the Tiananmen Square massacre.

Markets were already nervous from the news a fortnight earlier that Kaisa Group, a Shenzhen-headquartered developer listed in Hong Kong, had apparently become the first Chinese propco to default on overseas debt obligations when it missed interest payments due on its $500m (£331.9m) foreign-held bonds. Then DTZ released a report showing that commercial real estate investment volumes in Shanghai had fallen by 54% in 2014 and the proportion of deals carried out by overseas investors had dropped by 80%.

The driving force behind much of this grim reading has been the Chinese government’s attempt to rebalance the economy away from the state-led capital expenditure and grand construction projects that have powered China’s expansion for the past 20 years in favour of more consumption-led growth.

But how much of the story do these figures actually tell? How worried should the rest of the world be? And what will be the impact of the reported end of the country’s economic miracle on the Chinese appetite for London property?

Alarm bells in the West
The headline GDP numbers might have prompted alarm on the western news bulletins but the Chinese media was reasonably upbeat about the announcement.

President Xi Jinping reiterated his view ahead of the latest numbers that the slowdown represented a “new normal” for the maturing Chinese economy, which was perfectly healthy. After all, a growth rate of more than 7% is still comfortably above that of most developed nations, even if it falls short of the 10%-plus average for the two decades up to 2010.

And the facts beyond the headline numbers suggest that there are still plenty of reasons for optimism. The latest release by the National Bureau of Statistics showed that the service sector, which overtook the industrial sector as the largest part of the Chinese economy in 2013, was up by 8.1%, indicating that consumer spending is expanding more rapidly than the economy as a whole.

One of the biggest drags on the headline GDP numbers is the property market, which accounts for 15% of GDP, and in particular the residential sector, which accounts for 67% of Chinese real estate investment.

The speed at which residential prices are falling accelerated in the last four months of 2014, reaching 4.3% by December.

But there are huge regional variations in a country that contains more than 600 cities, 160 of which have a 1m-plus population.

Unsold residential space might have increased by 26.1% nationally by the end of December but prices in top-tier cities have performed much better. Shanghai luxury residential even registered modest growth in the final quarter, according to Knight Frank.

“Oversupply is dependent on local government,” says Charles Ma, head of global strategy, investment and new business at China Vanke, the country’s largest residential developer.

“Some local governments do a good job of planning their city in a sustainable and logical manner,” he says. “Some cities haven’t done such a good job. They think they can build New York city in the middle of nowhere.”

Despite being the largest developer in the country, China Vanke is active in only around 10% of Chinese cities, with a strong bias towards tier-one and tier-two locations. As a result it has, like most of the biggest listed developers, avoided the worst of the pain.

In fact, rating agency Moody’s has forecast that China’s top 20 rated property developers will continue to outperform the market. They achieved 17.1% growth in 2014 compared with a 7.8% average decline in the wider market.

“Their strong execution, reputable brands, and solid financial and liquidity position them to benefit amid the industry consolidation,” said Moody’s vice president Kaven Tsang in a January 2015 update.

The slowdown has hit developers active in the lower-tier cities much harder however; some companies have been forced to cut prices on schemes in oversupplied areas by as much as 30%, says JLL’s head of research in east China, Joe Zhou.

But while that has caused some developers to show serious signs of distress, there has not yet been widespread defaulting on loans in the real estate sector.

The high-profile Kaisa case, which attracted attention globally, actually has more to do with the government’s corruption crackdown than with the overheating property market (see box).

Instead, companies such as China Vanke have been willing to step in and snap up distressed operators, before they get a chance to default. And that consolidation has been widely welcomed in a heavily oversupplied market.

And for Zhou, the fact that the market is still growing despite the slowdown in the rate of growth, means that distressed developers, encouraged by their lenders, have so far been able to sell excess inventory even if it has meant cutting prices and therefore accepting that some schemes will not make a profit, limiting the risk of overexposure by the banks.

Rebalancing act
So if the real picture is not as alarming as first appearances suggest, does that mean the government’s rebalancing act is working? What will it mean for the property market?

“In order to boost consumption in the short term you need a lot of things to happen,” says Zhou.

These include consistent income growth, increased consumer confidence, lower taxes on goods to discourage Chinese consumers from doing all of their shopping overseas, and a strong social safety net to change attitudes towards savings and debt.

“The good thing is that all of these things are happening,” he says, pointing to social security reforms, uplifts in the minimum wage and rapidly rising real incomes for the ever-expanding middle class.

Thus far China’s jobs market has remained strong, which is helping consumers break with traditional attitudes towards credit and savings. “The young middle class spends much more and saves much less,” adds Zhou. “And they know how to use credit cards.”

But does this new-found fondness for credit mean that the banks are likely to see a repeat of the US subprime crisis if property prices continue to fall? No to both, according to Zhou.

The government placed tight restrictions on mortgage availability in early 2013 to head off the threat of a property bubble and the effect was felt almost instantly.

The new rules prohibited borrowing more than 30% of the value of a second home and said that consumers could use only a maximum of 50% of their household income to service mortgage interest payments.

“That killed speculation pretty quickly,” says Anthony Couse, managing director for JLL East China.

“There is little risk of consumers being in negative equity. Some developers might be overleveraged, but consumers are not,” he adds.

Outbound boom
With oversupply causing falling prices in lower-tier cities, many Chinese consumers and property developers have sought to diversify geographically.

Overseas real estate investment by Chinese firms rocketed by 46% to $16.5bn in 2014, according to JLL, surpassing the volume of domestic investment for the first time and accounting for 52% of total commercial spend.

London topped the list of destinations for this exodus with $4bn of investment out of a total $5.5bn spent in Europe, the top region.

“Chinese real estate investors used 2014 to strategically internationalise their investment portfolios,” said Darren Xia, the head of JLL’s International Capital Group, China.

“At a time when macro concerns around developers and residential prices dampened the market, diversification into international markets allow Chinese investors to continue to grow sustainably and ensure long-term returns.”

So while the headlines for China might appear negative, the outlook for the UK and other beneficiaries of the country’s international expansion is anything but.

And even within China, the picture is complicated. As well as diversifying offshore, major developers are refocusing on core cities. And for places such as Shanghai (see overleaf), the effect on commercial property could be unprecedented.

Corruption crackdown: the real estate impact

What was most shocking about the apparent overseas debt default by Shenzhen developer Kaisa is that its last reported results for 30 June 2014 appeared to show reasonably healthy finances.

The company’s net profit was up by 30% to RMB1.3bn (£140m) on revenues of RMB 6.8bn while its gearing was relatively modest with RMB6bn of debt compared to cash reserves of RMB9.4bn.

Instead, the company’s problems have stemmed from the fact the local Shenzhen government has blocked sales at some of its developments after it got caught up in president Xi Jingping’s widespread corruption crackdown.

JLL east China managing director Anthony Couse says the news may have been “jumped on internationally but we see that as an isolated case” that is unlikely to be the first of a series of major propco defaults.

But the corruption crackdown is having a significant impact on the property market nevertheless.

“The luxury retail sector was crazy several years ago because you had government officials purchasing luxury goods with gift cards,” says Joe Zhou, JLL’s head of research for east China.

“Then all of a sudden this anti-corruption campaign started and the luxury retailers stopped their expansion, which affected the shopping malls.”

According to Bain & Company, sales of luxury goods in mainland China fell by 1% to RMB115bn in 2014, compared with a year earlier, the first time the consultant has detected a decline since it first began monitoring the market in 2000.

The result, according to JLL Shanghai head of retail leasing Rebecca Tibbott, is that rental growth has slowed markedly to around 3-5%, with mid-market brands and fast fashion now driving demand and many luxury brands considering portfolio consolidation in China for the first time.

The result has also been felt in the Hong Kong market, according to Tom Gaffney, JLL’s regional head of retail.

“The years 2011 and 2012 were when the luxury retail market in Hong Kong posted an increase in take-up from watch and jewellery makers of 300%,” he says.

Those shops are dependenAdd New news articlet on demand from the 54m-plus predominantly Chinese tourists visiting Hong Kong every year, attracted by the lack of VAT and sales taxes that makes luxury goods around between 17% and 40% cheaper than across the border, he said.

“During 2011-12 we saw growth of around 45% in luxury good sales,” Gaffney says. “In 2014 we saw our slowest year in terms of overall sales growth, which was only 0.6% and that was led by fast fashion and cosmetics.

“In 2011 overall growth was 25% and in 2012 it was 15%,” he adds.

jack.sidders@estatesgazette.com