Oversupply plagues ChinaÆs property market

Soho China will take advantage of an increasing supply of distressed commercial properties at cheap prices to build its project portfolio, CEO Zhang Xin says in an interview.

Oversupply is likely to be a key theme in China's property market in 2009 and will keep prices under pressure, according to Soho China's chief executive officer Zhang Xin. On the residential side, the government's plan to build almost 10 million new units of social housing over the next three years is contributing to this glut, while on the office front, numerous foreign funds that have eagerly bought properties in China's major cities over the past couple of years are now just as eager to sell as they deleverage their portfolios.

Zhang says Japanese and American funds which are holding prime location commercial properties in Beijing and Shanghai are among the sellers. "They are all deleveraging and are trying to cash out because they don't see the market coming back over the next two years. And since they need to get out as early as they can, they are really cutting prices."

Commercial asset prices have fallen 50% from their peak in 2007 and Soho China feels they are now at a level where it is ready to take advantage of this distressed trend and start buying, Zhang told FinanceAsia during a recent trip to Hong Kong to present the company's 2008 earnings.

Indeed, 2009 will be very much about acquisitions for the Beijing-based and Hong Kong-listed commercial property developer, which has identified a number of projects -- some completed and some half-built -- that meet its acquisition criteria, which means they have clear titles, are commercial large-scale and are located in Beijing or Shanghai city centres. If possible, it would like to snap up all of them.

"We will buy a lot. We have at least 10 projects that all qualify in Beijing and Shanghai. I don't know how many of those we can close in the near future, but I think quite a few of them," Zhang says. "Our strategy is basically -- in a bull market, keep very little leverage and sell as much as you can, and in a falling market, leverage up and buy as much as you can."

If Soho China were to buy all of these 10 projects, it would more than double its current inventory. The company currently has 10 projects in Beijing and also owns a 32-house development by the Great Wall and a resort development on Hainan Island, which are both managed by the Kempinski Hotels Group.

Soho China is in a net cash position and is sitting on Rmb10.7 billion ($1.6 billion) of cash following its $1.9 billion initial public offering in Hong Kong in October 2007, record pre-sales in 2008 and a conservative acquisition strategy in the past. Last year it made one large acquisition in the form of the 500,000 square metre Chaoyangmen Soho project, another half-completed property that had turned distressed after the owner ran out of money.

Soho China has recently also signed a five-year contract with Bank of China that will give it access to another Rmb20 billion of M&A loans. This puts it in a prime position to make acquisitions at a time when other developers are struggling to get financing. On Chaoyangmen, Soho China was the only one among eight interested parties that were able to come up with the Rmb5.5 billion in cash and debt that was needed to complete the purchase.

The company sells its own projects on a strata basis to individual high-net worth individuals or companies, which is a much easier sell than to get rid of an entire distressed property that costs billions of renminbi.

Acquisition opportunities aside, there is very little visibility for the property market in China this year with regard to sales and selling prices per unit, and conflicting government policies make the market nervous, according to Zhang. On the one hand, she says, the government is trying to stimulate housing prices by reducing interest rates, giving first home buyers a 30% discount on mortgage rates, lifting restrictions on second mortgages -- especially important in cities like Beijing and Shanghai where 85% of the residents already own a home -- and making it easier for foreigners to buy properties again. These are all positive developments, Zhang says, although it is unclear whether they will be enough to restore consumer confidence.

On the other hand, the decision to build 9.9 million units of social housing into a market where residential property sales dropped by 50% last year will add to the excess capacity and further squeeze the market. Over the past several months, social housing accounted for nearly 50% of the floor area sold and 30% of the turnover in Beijing, according to Soho China's earnings presentation to analysts.

"The overcapacity is not going to get digested immediately. It will take a few years. So, prices are still under tremendous pressure to go down," Zhang says, noting that the current overcapacity or oversupply is affecting not only the property market, but applies to lot of industries as well as to labour and raw materials. Unless it feeds through to an increase in consumption, the government's Rmb4 billion stimulus package will exacerbate this problem.

Sherman Chan, an economist with Moody's Economy.com, echoes these concerns in a recent report, noting that there is a potential supply glut of new units. "Construction may have already come to a standstill, but there are plenty of finished properties that are yet to be sold. This likely explains the sharper fall in prices of new units, as developers would be keen to clear them even at lower prices," Chan says.

She adds that property prices will likely continue to fall throughout 2009 as labour market conditions worsen. "Promises by the government in sustaining employment may at best prevent a deterioration in household sentiment, but will certainly fail to strengthen confidence amid this gloomy economic climate. In most parts of China, households will likely choose to hold on to their savings for the rest of the year rather than committing themselves to property purchases, especially since the recent decline in prices has been disheartening," Chan says.

So far this year, Soho China's projects have been "selling quite well" however, and Zhang doesn't see any reason for Soho China to lower prices. The sales have been supported by the relocation of a lot of ultra high-end offices to Soho China's office buildings as part of their efforts to cut costs and reduce office sizes and the company has an occupancy rate of slightly more than 90%, compared with about 70% in Beijing's central business district overall.

"If this continues for another two months we will be pretty optimistic, but if (sales volumes) drop quickly we will need to reassess the market. However, cutting prices is never the solution because it affects the earlier buyers," she says, adding: "We are not cash tight. If sales aren't that great, we hold onto the property and lease it."

Despite the industry-wide downturn, Soho China saw very strong pre-sales of Rmb7.7 billion in 2008 -- almost double the Rmb4 billion recorded in 2007. The vast majority of that, or Rmb6.9 billion, was derived from Sanlitun Soho, which it started to pre-sell in July. The mixed commercial property was the best selling project in Beijing last year and fetched an average price of Rmb49,000 per square metre. Selling prices across all of Soho China's projects increased 36% year-on-year to Rmb48,718 per sqm.

Unfortunately, it wasn't able to turn all of that into profit since the Sanlitun Soho's construction schedule was delayed due to a ban on construction in Beijing in the months before and during the Olympics. And since pre-sales revenues can only be booked once the project is completed and delivered, the company was unable to book Rmb4.3 billion worth of sales in the 2008 financial year. In terms of the impact on the bottom line, approximately Rmb1 billion of net profit that was earned in 2008 will have to be accounted for in 2009, and as a result 2008 net profit fell by 80% from the previous year to Rmb399 billion. The gross profit margin eased to 49% from 55%, partly due to a lower margin of 34% at Beijing Soho Residences -- a luxury apartment complex that is one of its few residential properties. The lower margin was largely compensated by a quick asset turnover after the acquisition and refurbishment.

Soho China's shareholders won't feel the profit drop, however, as the company decided to use some of its cash to pay an unchanged dividend of Rmb0.1 (HK$0.114) per share. In total, it will pay 130% of its net profit as dividend, and based on Friday's closing price of HK$3.10, this will result in a dividend yield of about 3.7% compared with the previous year's 1.3%.

Despite its solid performance over the past year, Soho China's share price has been dragged down with the poor sentiment for China's property sector overall, losing 59% in 2008 and 6.9% so far this year. However, according to Zhang, some institutional investors who have found it difficult to buy the stock in bulk in the market, have approached her and her husband -- the company's chairman, Pan Shiyi -- asking if they might want to sell any of their shares. So far, the couple, who control about 67% of the company, have declined due to the share price being too low. 

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