Attempts have been made to cool the Chinese residential market, but have investment opportunities been damaged? James Buckley reports

In the aftermath of the global financial crisis, the Chinese government, concerned about the knock-on effects of an external demand recession undertook a policy of quantitative easing. This took the form of an injection of Rmb9.6trn (€1trn) from state-owned banks. This was more than double the amount in 2008 and equivalent to about 29% of GDP. The share of new bank lending to households, notably mortgages, increased from 14% in 2008 to 26% in 2009 and resulted in rapidly increasing property prices. This has raised concerns about affordability of homes and the possibility of a property bubble.

In this article, we seek to highlight what policies have been implemented by the government to combat price growth and examine whether these have been successful and whether the current environment is still attractive to investment.

Government policies
Recent government policies have followed four broad objectives:

1. Dampen domestic demand
• Aggressive mortgage tightening which began in April 2010 has resulted in the minimum down-payment for first home mortgages rising from 20% to at least 30%. The minimum down payment on second-home mortgages has also increased to 60% versus the 40% previously. The cash outlay for second-home buyers has increased 50% (by requiring an extra 20% on the original 40% down payment) which is the highest level seen in China.
• Interest rates rising. Interest rates for new and existing mortgages have increased over the past year. The Bank of China raised prices for existing mortgages from 0.8x the benchmark to 1.0x for first homes and 1.1x for second homes. Further monetary tightening is expected as the government tries to tackle inflation.
• Home purchase restriction. In an attempt to dampen demand from investors/speculators, about 23 cities have placed a restriction on local residents preventing them from owning more than two homes. In addition, people who have not paid local taxes for a period of one to five years depending on the city, are banned from entering the property market.
• Implementation of a property tax. A property tax was implemented on a trial basis during January 2011 in Shanghai and Chongqing, although the effective tax rates are low. It is too early to measure how effective this new tax will be in regulating the two cities' respective property markets and how they will affect their local economies and local government fiscal revenue. The central government is likely to roll out the property tax throughout China on a gradual basis which should help to rationalise home buying behaviour, and make local governments less dependent on land sales for their tax revenue which has been an incentive for them to promote real estate development.

2. Increasing new supply
• A sharp increase in land supply, particularly for social housing. The construction of social housing has been a top priority in the 12th five-year plan. Between 2011 and 2015, the government plans to build 36 million social housing units. This large release of social housing is expected to affect residential prices at the lower end of the market as prices for social housing will have a competitive advantage. However, the impact on the mid- to high-end market is likely to be limited as there is no direct competition from social housing and less prime land supply. The limitation of trading social housing within five years should help to maintain its affordability for the lower income group.

3. Tighten development activity
• Land hoarding. In an effort to deter land hoarding, developers that have not started construction more than a year after acquiring a site are banned from making bids in other auctions. In some instances developers have been threatened with having land repossessed by the local government.
• Tighter control on use of pre-sales proceeds. Beijing, Chengdu and Zhejiang province have announced stricter rules to monitor pre-sales proceeds, which are now required to be deposited in an escrow account and can only be utilised to fund the construction cost of that project. This measure aims to encourage developers to expedite the construction and delivery of projects in order to recycle the cash proceeds into other projects.

4. Restrict investment demand from foreigners
• Home purchase restriction. This is not new, but merely a reiteration of a policy introduced four years ago that prohibits a foreign resident owning more than one house, where that house can only be used as a private residence. In addition, a foreign institution with a branch or representative office is only permitted to purchase a non-residential house for business use in the city where its office is registered.
• Stricter approval process for foreign invested real estate projects. The government requested a closer review and supervision of foreign-invested property projects, not only to ensure the complete qualifications of foreign investors, but also to restrain speculative investments for Rmb appreciation. This could result in a longer time to get wholly owned foreign enterprises (WFOEs) approved. Offshore funds partnered with local developers and possessing a long-term track record and commitment in China are unlikely to feel the impact of this rule.

Impact on the residential market
Since the most recent policies were announced at the beginning of 2011, overall transaction volumes have declined across China to varying degrees, but the price correction has been mild so far. In general, the listed developers met their 2010 sales targets which have alleviated the pressure to cut prices. There is an expectation that property prices should start to soften towards this summer as weaker property sales start to stretch developers' balance sheets. This will be particularly prevalent for the small-to-medium-sized developers, who cannot access the capital markets easily and perhaps expanded their land bank aggressively in 2008/09, fuelled by abundant bank lending. We believe that the central government will implement further tightening measures if it remains unsatisfied that prices are continuing to rise too quickly relative to income growth.

There does seem to be a divergence in price and transaction volumes between cities with and without home purchase restrictions. Third-tier cities without the purchase limit policy saw sales volumes increase 8% year on year in March and cities such as Guiyang that have home purchase restrictions enjoyed sales volumes increasing 22% year on year in March, implying a significant part of demand is from first-time homebuyers and upgraders who are not affected by the purchase limit.

Sector remains attractive
Despite short-term blips, China's housing market is on a long term growth trajectory underpinned by strong secular trends. China's population is expected to grow by 9.5% over the next 20 years. This is at a time when the populations of other major developed countries will be shrinking (UN projections, 2009). The age structure of the Chinese population is favourable, as a large part of the population is concentrated in the low and middle age groups, which are likely to consume more and have increased demand for housing. People over 60 represent just 14% of the Chinese population, with this number expected to increase to 21% by 2025, compared with 31% in the world's more developed countries.

According to the 2009 revision of the World urbanisation prospects report by the UN (March 2010), China surpassed other countries with its rapid urbanisation in the past three decades and 25% of cities with at least half a million inhabitants worldwide are in China. In 1980 there were only 51 Chinese cities with more than 500,000 people; since then that number has more than quadrupled to 236, and by 2025, China is expected to add another 107 cities of that size to that group. A report on China's urbanisation trends by the McKinsey Global Institute (MGI) argues that if current trends continue 350 million will be added to China's urban population by 2025 - more than the current US population, with increased numbers of ‘midsized and small cities' (with population over 500,000 people). This should generate demand for an additional 125 million residential units.

Rapid urbanisation trends coupled with declining household sizes will generate increasing demand for residential units for the new city dwellers, and rising urban incomes will continue to feed upgrading demand for better and bigger apartments.

Investor considerations
The current policy environment, while posing certain additional hurdles for foreign investment, is likely to generate attractive residential development investment opportunities, including special situation transactions. Given the tightening measures highlighted above, we expect to see some developers under pressure towards the middle and end of 2011 and consequently land prices in the short term will become more reasonable.

Many small-to-medium-sized developers are likely to experience financial distress as they struggle to access the capital markets, and to meet sales targets as demand is curbed by the impact of the tightening measures. From the third to the fourth quarter of this year, we believe that there will be the opportunity to secure land, or partially completed projects, at an attractive discount to current market pricing. We expect the window for such types of ‘distressed' transactions to be small, lasting no longer than 18-22 months, as pent-up demand rebounds when price cuts become marked. The government will adjust regulations according to market movements, avoiding the threat of widespread crisis among the smaller developers, and relaxing their policies once the market has cooled sufficiently.

China is not just one market, but thousands of markets that are constantly evolving in very different ways. It is extremely important for investors to take a bottom-up approach, and closely monitor sub-markets, in order to identify the right city to target for residential investment.

Investors should seek to invest in underdeveloped areas with strong growth potential accelerated by improving infrastructure (eg, Tianjin, Nanjing, Jinan, Kunshan and Suzhou - cities along the high-speed railway line that will become operational in July 2011 between Beijing and Shanghai).

Underwriting of residential development opportunities should reflect weaker short-term sale volumes and softer pricing, with prices in the medium term trending income growth.

James Buckley is executive director, TAN-EU Capital