Sector recovery key for growth
Understanding the outlook for China’s property market is crucial for investors due to its extensive value chain and c.20%* contribution to Chinese GDP. The poor performance of China’s equity markets can be attributed, in part, to the slump in China’s real estate sector since its peak in 2021.
The troubled sector has seen property sales and prices tumble, widespread private developer defaults on debt repayments and largescale unfinished building projects.
A series of supportive demand-side policies have been rolled out over the past two years, including the relaxation of home purchase restrictions, cuts in mortgage rates and lower down payment requirements. However, despite these measures, sales have not recovered as hoped. They remained weak through 2023 and into 2024, leading us to ask why, and what needs to be done to support the sector? We arranged a research trip to Guangzhou, Changsha and Xiangtan, representing tier-1, tier-2, and lower-tier cities respectively, to gain insight into what has been happening behind the scenes and to better understand how we have got to this point.
Falling prices and sales trends
Secondary listing prices have fallen by 14% as of February 2024 compared to the peak in September 2021 according to GXD, a leading Chinese real estate data company. Lower-tier cities experienced sharper corrections, with a 16% decline from their peak, while tier-1 cities have only seen a 6% adjustment.
Figure 1: Prices in Tier 1 cities a lot more stable
Source: Wind, April 2024.
Furthermore, China Real Estate Information Corp. (CRIC) data suggests that inventory levels reached 25.8 months in the 80 cities it monitors, the highest in the past 10 years (see Figure 2). Inventory in tier-3 and tier-4 cities surged to 33.8 months, surpassing the levels of tier-1 and tier-2 cities at 18.5 and 22.9 months respectively.
Figure 2: Inventory levels rising more quickly in lower-tier cities
Source: CRIC, April 2024. Avg = Average.
From the data above, we can quite quickly paint a picture that prices have held up better in higher-tier 1 and 2 cities, which by definition are more desirable places to live, but also that low-tier cities are experiencing much lower demand, in addition to oversupply, which is prompting buyers to delay purchases in anticipation of further price reductions, thus creating a downward spiral.
No quick fix on the horizon for low-tier cities
We visited Xiangtan, the lowest-tier city on our trip, to witness this supply/demand imbalance first hand. Almost immediately, we were met with a sense of abandonment. One high-end project we visited was Lotus Front Mansion, located in the Jiuhua Development Zone, developed by Midea Real Estate, a private developer backed by the holding family of home appliance giant Midea. The land was acquired in December 2016, with a land cost of RMB 1,700 per square meter (sq/m). This particular project comprises around 5,600 units in total, with approximately 60% of the units already sold. According to the sales manager at Lotus Front Mansion, overall demand this year has been weaker compared to 2022. We believe the reasons for this to be threefold:
High-end development in a low-tier city
Source: Ninety One, April 2024.
01 The golden era for projects like this in low-tier cities peaked in 2021, as they benefited from the government’s shanty town redevelopment programmes, which provided cash vouchers to buyers to relocate and purchase new units. This programme is now largely completed, therefore we are unlikely to see subsidy programmes of this level from the government again.
02 Policy measures introduced in 2023 did encourage demand as buyer affordability improved. However, this demand was mainly in higher-tier cities as purchase restrictions were relaxed. This resulted in population outflows, especially among younger people, from lower-tier cities to tier-1 and 2 cities, as shown in Figure 3.
Figure 3: Talent outflow from tier 3 and 4 cities
Source: Zhaopin, Zeping Macro. April 2024.
03 Another concern for potential homebuyers is the sheer volume of half-finished projects or ‘ghost towers’ in plain view as a result of construction stoppages by indebted developers, despite some units already being sold. This has significantly impacted the confidence of local buyers in private developments and should not be underestimated.
Two uncompleted blocks
Source: Ninety One, April 2024.
Excess inventory
Source: Ninety One, April 2024.
Inventory levels remain very high, with the sales manager estimating that around 40-50 new projects are currently on sale in the city, many of which are adjacent to Lotus Front Mansion. Weak sales volumes have led to significant price reductions in Xiangtan. The sales manager recollected that the selling price for a bare shell unit was around RMB 5,500 sq/m in 2021. However, some local developers with weaker brands have already reduced their selling prices to approximately RMB 3,500 sq/m (a 40% price cut). Despite this, Midea Real Estate remains confident in its own brand and has only reduced the selling price of Lotus Front Mansion to around RMB 4,600 sq/m (representing a 15% price cut from the peak). More positively, at these current price levels, there should be limited new supply entering the market.
Upgrade demand propping up tier 1 and 2 cities
As we arrived in downtown Changsha, the difference versus Xiangtan was stark. There was no doubt that Changsha was a more desirable place to live rather than the lower-tier cities nearby, and oversupply seemed less of an issue. It quickly became clear that projects in high-tier cities catering to upgraders’ demands, in particular those offering mid and highend properties in prime locations, with three or more rooms, are in a healthier position. We explored a project called Fengqi Luming, situated in the Tianxin district or city center. This development enjoys a waterfront location on the Xiang River and was developed by the semi-state-owned enterprise (SOE) developer Greentown China, renowned for its brand reputation, chic design, construction quality, and property services. The land for Fengqi Luming was acquired in May 2021, with a land cost of approximately RMB 14,300 sq/m. The project consists of nine blocks, encompassing around 800 units. Greentown China initiated sales for five blocks in August 2022, achieving an initial sell-through rate of about 70%. However, sales have gradually weakened since then, but interestingly, units larger than 300 sq/m with good views have been almost entirely sold out, indicating a robust demand for upgrades.
An ‘upgrade’ property in tier 1 or 2 city
Source: Ninety One, April 2024.
High quality finish and appliances
Source: Ninety One, April 2024.
While there are some new competing projects in the district, supply was not overwhelming. The sales manager expects that sales could improve once more inventory in the district is absorbed. Additionally, the relaxation of home purchase restrictions may also support demand in the medium term. In contrast to Xiangtan, where prices have witnessed significant cuts, nearby competitors in Changsha have reduced their selling prices by around 10% to approximately RMB 25,000 sq/m over the past few months, demonstrating a more stable pricing environment.
What is UVR and what can we expect from it?
Investors have been crying out for substantial government intervention to prop up the market. The shape and quantum of this intervention is ultimately what is required to restore confidence. We met with a local think tank that provides advisory services to the Ministry of Housing and Urban-Rural Development and gained very helpful insight. We learned there has been meaningful movement on the supply side, in the shape of urban village renovation (UVR) and social housing in mega cities**, which has sparked debate on whether it can stimulate a recovery in China’s property sales. According to the think tank, there are approximately 1,800 urban villages in major Chinese cities, with around 1,000 of them located in the Greater Bay Area, including approximately 500 in Guangzhou and Shenzhen.
The UVR initiative builds on the success of the shanty town redevelopment which took place between 2015-21. This occurred primarily in low-tier cities with the government compensating residents directly in the form of cash vouchers, which enabled them to relocate and purchase new properties outright, so they didn’t have to wait for the re-development to be completed. This took a significant cost burden away from the developers, freeing up cashflow, which ultimately gave rise to the large-scale development we see today in low-tier cities and was a huge driver of ‘new home’ sales over that period. The question is can it be repeated or is there the same willingness on behalf of the authorities?
An urban village
Source: Ninety One, April 2024.
The differences between the shanty redevelopment and the new URV initiative is dividing opinion about whether it will be able to stimulate a recovery. The first is that existing urban villages tend to be located in the tier-1 and 2 mega cities, which means land costs are considerably higher, so the economics for the developers are already less attractive.
The second key difference is the level of government compensation. The URV initiative is expected to offer rental compensation to existing residents for the duration of the redevelopment until they can be re-housed in the new social housing. This is a very different proposition to the cash voucher scheme as it won’t have the same positive impact on new home sales, which was a key growth driver within the sector.
UVR in action
We can tell from the very limited number of UVR projects undertaken to date by the private sector that the economics are far less attractive, and unsurprisingly, only those projects with the highest return profiles have been considered. This means that in the absence of higher subsidisation by the authorities to entice the private sector, it is more likely the bulk of this initiative will be carried out by SOEs.
We visited a pilot UVR project in Guangzhou in the city center, owned by the Guangzhou local government, named Pearl River Enterprises. In this pilot programme, the SOE will contribute 20% of the estimated re-development cost, while the remaining 80% will be provided through special loans from the central government via China Development Bank. This budget includes expenses for clearing existing properties, providing rental compensation to current residents, developing infrastructure (sewage system, stadiums etc.), implementing green initiatives, and constructing new homes for the returning residents. The local government will be able to raise cash for additional land purchases through special purpose bonds and will ultimately own the asset. Once the development has been completed and the original residents are relocated in the new social housing, the local government is free to sell the remaining units or the additional land purchased, however it sees fit, to generate revenues and pay back the central government loans.
So where do we go from here?
The Chinese authorities have just announced a new round of property supportive policies in May 2024 for destocking existing housing, including bank loans to selected local SOEs to acquire completed housing inventory and convert them to affordable housings, cutting downpayments and removing the minimum mortgage rate. Property sector valuations have recovered slightly in response from extremely depressed levels. The impact of these new policies on the property market will depend on execution and whether it can lift sentiment among potential homebuyers. But the outlook for the larger, more traditional private developers remains complicated due to the significant debt levels and the large-scale over-development in lower-tier cities.
We learned first-hand that opportunities exist for SOE developers and construction companies likely to be involved in the UVR initiative, although it is still too early to conclude whether it is going to be value accretive for them. An example of a company we like in this space, should it become involved in the UVR scheme, is China Resources Land (CRL).
One positive to come from this protracted sector downturn is that it has forced developers to adapt their business models to become more resilient in order to survive. Companies that have been able to diversify their revenue profiles away from a purely residential focus, to include a wider mix of commercial property, investment property and rentals, and property management, have a much better chance of survival and recovery. CRL has spent the past decade building its property portfolio. Its property management arm CR MixC has also been expanding, benefitting from the property expansion, while also attracting third-party businesses.
The biggest opportunity we see at present lies in the strong upgrade demand in tier-1 and 2 cities. As we highlighted from our visit to Changsha, demand remains robust and supply is relatively tight as younger Chinese head towards the mega cities. However, our preferred way to gain exposure to this investment theme isn’t through the developers themselves, but to the home appliance manufacturers furnishing them. As we can see from the image on page 6, the level of finish on these upgrade developments is high and that should translate into sales of high-end appliances at attractive pricing points.
Another related trend is the upgrade demand potential for home appliances from existing households. Following an initial COVID lockdown spending spree in 2020, Chinese households have experienced the benefits of having quality home appliances and we have seen an uptick in this upgrading trend through 2023. As we approach the four-year mark since peak COVID lockdown spending on home appliances, it is reasonable to assume that there is further upgrade potential, especially as consumer sentiment continues to improve and general consumer spending increases.
A key factor in determining the potential in future spending centres around disposable income and concerns over the impact the property market slump has had on average household debt levels. Conventional economic theory would suggest that substantial falls in property prices should lead to a negative wealth effect, but that doesn’t seem to be the case. Disposable income levels among urban and rural residents have proved resilient and on an upward trend, which gives us confidence in the future potential upgrade demand.
Figure 4: Urban resident average disposable income per capita
Source: NBS, April 2024.
Figure 5: Rural resident average disposable income per capita
Source: NBS, April 2024.
Companies we like
Two names we like in the home appliances space are Midea Group and Hisense Home Appliances***.
- Midea is the market leader in the Chinese appliance market. It has done a good job in reorganising its product lines, reducing costs, introducing new innovative products and has become more shareholder friendly. This has translated into market share gains, higher margins and improving return on equity. It has quietly transformed from a mass market home appliance producer targeting its domestic market into a global brand and a fast-growing B2B business, leveraging its strong technology and distribution platform. We believe the market is currently attributing very little value to this structural shift.
- Hisense Home Appliances is the fourth largest white goods manufacturer in China and has undergone SOE reform since 2019, which resulted in extensive leadership changes, mixed-ownership reforms, overseas expansion and supply chain optimisation. As a result, it has outperformed its main competitors in both domestic and foreign markets, thus increasing its market share.
*Estimates can vary - some commentators put this as high as 30-40% when 2nd order/indirect effects are taken into account.
**A mega city generally refers to a city with a population of greater than 10 million people.
***These stocks are held in 4Factor portfolios. This is not a buy, sell or hold recommendation for any particular security. For further information on specific portfolio names, please see the Important information section.
General risks. The value of investments, and any income generated from them, can fall as well as rise. Costs and charges will reduce the current and future value of investments. Past performance does not predict future returns. Investment objectives may not necessarily be achieved; losses may be made. Target returns are hypothetical returns and do not represent actual performance. Actual returns may differ significantly. Environmental, social or governance related risk events or factors, if they occur, could cause a negative impact on the value of investments.
Specific risks. Geographic/Sector: Emerging market (inc. China): These markets carry a higher risk of financial loss than more developed markets as they may have less developed legal, political, economic or other systems.
