Rated Chinese property developers will endure, says S&P

Standard and Poor's forecasts a difficult year for many Chinese real estate developers, but says most companies it rates look relatively strong.
A new report released by Standard and PoorÆs forecasts a difficult year for many Chinese real estate developers as the governmentÆs anti-speculation measures begin to take effect and access to funding becomes increasingly restrictive.

However, property developers with strong cash flows, well-diversified geographic and product portfolios, financial flexibility, disciplined financial management and established recurring income will consolidate and eventually thrive, continues the report.

The majority of the 13-rated property developers listed on the Hong Kong stock exchange have good funding channels as well as established market positions in their home regions. They also have stronger balance sheets than their unrated peers with a reasonable amount of cash holdings (having been rated in the last two years) and are expected to consolidate smaller and weaker players, although mergers among rated companies are less likely.

With sound financial management and discipline, these developers should have enough short-term resources to weather difficult market conditions as long as they focus on their core competencies rather than expanding aggressively. Most of them have land reserves for between three to five years of development.

Based on ratings and outlooks, the strongest companies, in descending order are: China Overseas Land and Investment (BBB-), Country Garden Holdings (BBB-), Shimao Property Holdings (BB+), Agile Property Holdings (BB), Hopson Development Holdings (BB), Road King Infrastructure (BB), Greentown China Holdings (BB-), SRE Group (BB-), Coastal Greenland (B+), Lai Fung Holdings (B+), Shanghai Zendai Property (B+) , China Properties(B+), and Neo-China Land (B+).

S&P doesnÆt expect any negative surprises overall from the companiesÆ 2007 financial results, since the first three-quarters of the year were strong. Most of them generated strong cash flow through sales and presales, and enjoyed easy access to funding, allowing aggressive growth.

However, restrictions on mortgage lending to second-home buyers, stricter regulations on bank credit for property development and land bank holdings, as well as more initiatives for affordable housing by the government have contributed to weaker sales and lower access to funding in the last quarter of 2007 and so far this year.

As well as weaker market sentiment, funding channels have tightened or closed. Due to diminishing sales, internal funding from presale and sale proceeds can no longer fund the acquisition of new projects. Meanwhile further controls over the banking system û potentially demanding closer supervision of the use of presale accounts û will make it increasingly hard for companies to rely on presale proceeds for expansion.

Moreover, companies cannot rely on domestic equity issues since the government has reportedly delayed the approval process for listing in the domestic A-share markets to help cool investment activities, focusing particularly on real estate listings.

Furthermore, developers are not allowed to pay for land premiums through domestic bank borrowings. Credit lines have become harder to obtain for development loans and the cost of funding has increased. As a result of tightened policies, banks will only lend to companies with strong credit profiles.

In terms of offshore funding, equity and bond market investors have become cautious, making new listings and bond issues challenging. Moreover, transferring the money onshore again has become more difficult due to increasing regulations.

As a result, convertible bonds (Country Garden paved the way in February) and offshore loans could prove an alternative funding avenue while investor appetite for straight bond and equity issues remains low. Nonetheless, funding costs have clearly soared, a trend that is likely to continue for the rest of the year, says the agency. Furthermore, offshore banks are also beginning to offer credit facilities to mainland real estate developers, with longer tenors than domestic credit lines and at more attractive rates.

Risks to the sector, according to S&P include a price war, which could substantially erode companiesÆ margins and cashflows. Moreover, a shift in the demand/supply equation could lead to oversupply, pressuring both volume and selling prices. A drop in economic growth would affect affordability levels, while negative buyer sentiment could also weigh heavily on the sector.

Companies likely to be the most affected by a potential price war are Greentown and Neo-China, while China Overseas Land and Investment will be the least affected versus its rated peers. China Overseas will also withstand tighter liquidity better, with Greentown and Lai Fung the most vulnerable.

Investors should consider constant regulatory changes, and examine the degree of financial discipline inherent in each company, and bear in mind that competition will increase as strong players from overseas seek to enter the market. The governmentÆs aim to provide affordable housing to low-income buyers will also intensify competition. Moreover, corporate governance will have to be watched since many of the rated companies need to establish more structural management styles or corporate governance practices. Ongoing related-party concerns, such as those by Shanghai Zendai and Hopson Development, are a particular concern. Rapid expansion due to the fast accumulation of funds can create challenges, with Neo-China being placed on negative credit watch, in part because of its weak internal controls.

The report is positive given that many high-yield Chinese property bonds are trading at distressed levels. In the credit default swap market, Shimao, Hopson, Greentown, and Agile trade at imputed five-year default rates of 45% to 55%, according to a Deutsche Bank report. "We believe these dramatic levels for CDS bonds, and to a lesser extent cash bonds, largely reflect unique technical considerations and do not incorporate the inherent asset valuation and burgeoning cash flow potential we project for the industry," concurs Deutsche.
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