The residential property market is slowing in China and some  developers are facing a winter of discontent, writes Thomas Lam

Unlike in other parts of the world, real estate developers operating in China are on a roller-coaster ride. While the majority of them surpassed their sales target by at least 10% by the end of 2010, only a few of them could reach their targets in 2011. This phenomenon raised an interesting question: what are the typical risks facing developers in China?

While some believe that the three most important things for real estate development are location, location and location, the three major risks for real estate players in China are policy, policy and policy.

The central government has exercised and continues to impose significant influence over China's economy. The state adjusts its monetary and administrative policies from time to time to prevent or curb the overheating of the economy. Any action by the central government concerning the economy, in particular the real estate industry, could have a material and adverse effect on developers' financial condition and sales performances.

Since January 2010, the State Council issued a series of policies that require the regulation and control of the rapid growth of housing prices. The People's Bank Of China (PBOC) has also raised the required reserve ratio several times, which reached 21.5% in mid-2011, drawing a huge amount of money supply out of the market. These policies no doubt limit the amount of funds available for lending to real estate developers.

China's economy differs from those in other parts of the world in many ways, including the degree of government intervention in the economy - such as price control, government control of foreign exchange and allocation of resources. Compared with many developed countries, the mainland authorities possess many more policy tools that could limit developers' access to capital resources, reduce market demand and increase their operating costs. The current policy environment is clearly taking its toll on the developers, which is reflected in the relatively poor property sales performance in recent months - and we see few signs of policy easing in the near future.

Funding pressure
Apart from heavy monetary control, the yet-to-mature domestic financial market in China further increases developers' financial risk. Real estate is a capital-intensive business, so having enough funds is critical, particularly for Chinese property firms, many of which concentrate on residential development.

However, their cash flow is relatively fragile. Bank loans, the primary source of funding for mainland developers, are tightened under the current cooling measures. Apart from bank loans, other sources of funding are limited. Initial public offering (IPO) is heavily regulated, while real estate investment trusts (REITs) are in their infancy.

The financing prospects for Chinese developers is unlikely to improve much in the short term, and a number of them could face a hand-to-mouth existence.

Intense market competition
While China's market has huge growth potential, it is also one of the most fiercely competitive markets. In recent years, a large number of property developers have appeared in China. It is estimated that there are around 60,000 real estate developers fighting for market share.

In addition, a number of international property managers have expanded their operations in China, including a number of leading Hong Kong and Singapore real estate development and investment groups.

Competition is intense and may result in oversupply of commercial properties in certain parts of China, a decrease in occupancy rates, and a difficulty in hiring high-quality managers and qualified employees. Any such consequences may adversely affect a real estate developer's business. In addition, the rapidly changing real estate market makes real estate business operations more challenging.

Renminbi fluctuations
China has stepped up efforts to speed up its market-based currency exchange reform. This will mean more fluctuations in the value of renminbi and in turn might adversely effect a developer's financial position, as well as its financial results.

While most of Chinese developers' turnover is denominated in renminbi, a certain portion of their bank balances and debt obligations are denominated in Hong Kong and US dollars. Hence developers are exposed to fluctuations in exchange markets. In April 2012, The PBOC announced it would widen the renminbi trading band against the US dollar from 0.5% to 1%.

The move would surely mean risks stemming from exchange-rate fluctuations for developers. If the value of the renminbi depreciates significantly it will have a material and adverse effect on their financial positions. The widened trading band is not expected to have too significant an impact on the market, but developers might have to pay attention to the negative effects as the renminbi moves towards full convertibility.
It is likely that Chinese developers will be expected to extend these price-cutting campaigns in the second half of 2012 as the banking sector continues to squeeze lending channels to developers following central government's restrictions on loans. Little foreign capital, meanwhile, is available amid the current euro-zone debt crisis. Other tightening policies also restrict sources of funding for developers.

While developers are facing a difficult winter under heavy policy pressure and pessimistic market sentiment, some developers are not suffering quite as much. The net gearing of some developers, such as Greentown, are now at an alarming level, but a number of market players, such as China Overseas and Evergrande, remain relatively financially healthy compared with 2008.

Having learned their lesson from the previous market downturn, those developers have controlled cash flow better, as well as the scheduling of project developments, and thus do not need to count themselves victims of the government's cooling policies.

Some are also shifting their focus to the commercial property market, which usually provides steady rental income. One example is SOHO China, which acquired commercial and office properties in Shanghai in 2011 and 2012.

Last but not least, China's residential property market is not expected to rebound during the second half of 2012 and inventory levels are likely to stay high. Developers will continue to face huge funding pressure this year.

We expect the residential property market to make a soft landing later this year or next year. However, we also expect to see more mergers and acquisitions among small and medium-sized developers during the second half of the year. Some poorly managed developers may go bankrupt, liquidate or cease business.

Meanwhile, a property tax may be introduced on a trial basis in more cities to help achieve a tighter control on the market.

The government's policy on the real estate market is unlikely to undergo any major relaxation until the leadership handover of central government is complete later this year, unless there are significant changes in the external economic environment.

Thomas Lam is a director and head of research for Greater China at Knight Frank