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Why the outlook is less bleak for Chinese developers

Christopher Lee, analytical manager for corporate ratings at Standard & Poor’s, answers investors’ top 10 questions about Chinese property developers.

Chinese property developers faced sliding sales and refinancing pressure at the start of 2012. But they can now see light at the end of the tunnel, as conditions have turned for the better during the past few months. Standard & Poor’s has received many investor questions about our prognosis for the real estate sector in view of the evolving and challenging environment.

What's the outlook for China's property market during the next 12 months?
The overall outlook for the sector is mixed, but we see some bright spots emerging. The residential market appears to be stabilising after a challenging period. Property sales in the second quarter of 2012 are at a healthier level, and the positive momentum is holding. However, property prices are still under some pressure due to the high amount of unsold properties. Developers are likely to continue to cut prices to clear their inventory, although at a more moderate pace. Previously, we estimated that prices would slip 10% in 2012, and they seemed on track for that after the first six months. But we now believe prices will fall by less than 5% in the second half of this year. In 2013, the supply pipeline may decline as inventory gradually clears. Real estate investments and new construction projects have already been dropping for the past 12 months.

What's behind the recovery in property sales in recent months?
Pent-up demand is spurring sales. Buyers stayed on the sidelines in 2011, but first-time buyers and upgraders are now pumping up sales. That's despite the fact that the government's restrictions on home purchases are still in force. In our view, the sales improvement stems from buyers' expectations that property prices have bottomed now that government policy is becoming less severe. Since December 2011, the central bank has increased the availability of credit by reducing the commercial banks' reserve ratios three times and cutting interest rates by 0.5%. As inflation has come under control, the government could ease credit lines more aggressively to stimulate the flagging economy.

Will the government change its restrictive housing policy as the economy slows?
We don't expect any major policy change in the next six months for the property sector. But we could see policies start to differentiate between those affecting owner-occupiers and investors. The government's policy towards the property sector has worked to a certain extent, given that prices have fallen. However, ongoing goals remain to increase the amount of public housing and control speculation. We believe that home purchase restrictions will likely stay well into 2013. On the other hand, the government will continue to ease funding and mortgage rates for first-time buyers. We don't expect the government to introduce additional measures to tighten the property market because this could increase the downside risk to the economy — unless property and land prices rise significantly.

Are local governments likely to relax the implementation of housing policy?
Not really. We believe the central government's intervention will prevent local governments from relaxing housing policy by stealth. The central government has tightened the implementation of its housing policy since 2011 by holding local government officials to account. As a result, home purchase restrictions have been better implemented than previous measures. The central government has quickly and firmly clamped down on local governments that have tried to relax its measures in recent months.

How have credit conditions changed for developers in recent months?
Credit conditions are uneven, but they have generally improved in the past few months. In general, mortgage credit lines are more relaxed than they were earlier this year. But lenders remain cautious toward the property sector. This is due to the banking regulator's concerns over risky property lending and the developers' uneven property sales performances. Large and well-established developers continue to have access to credit while small, high-risk developers still have difficulty in borrowing. Nevertheless, the offshore bond market for well-established developers has re-opened. Bond yields for developers rated 'BB-' or above have tumbled and the issuance pipeline is growing. In July 2012, Gemdale Corp issued a debut bond and raised Rmb1.2 billion despite a weak bond structure.

Will developers' renewed appetite for land acquisitions curtail cash flow improvement?
Developers' recent land acquisitions have been measured, in our view. Property sales have been good, and developers are replenishing their land reserves at deflated land prices. Players involved in aggressive land buying include Evergrande, Longfor Properties, Kaisa Group and Sunac China. Since mid-2011, many companies have scaled back their land acquisitions to preserve their cash flows. However, a repeat of the land grab in 2009-2010 at inflated prices could weaken developers' liquidity if the market recovery stalls. In our view, it will be difficult for developers to materially improve their leverage and credit ratios due to their aggressive growth appetites, including land purchases.

Will large and small developers continue to polarise?
The current downturn clearly separates strong and weak developers, with diverging property sales performances and access to funding. Large developers with geographically diverse operations (i.e. those rated 'BB-' and above) have been able to offset the impact of home purchase restrictions. These restrictions severely affected weak developers with high project and geographic concentration (i.e. those rated 'B+' or below) and those targeting the high-end segment.

We believe consolidation in the China property sector will continue as large, geographically diversified developers increase their market share. Every market downturn presents opportunities for strong and well-funded developers to expand through buying land at deflated prices in the public market or from competitors. Mergers and acquisitions will likely continue as some owners sell out to stay afloat. Recent examples include Shanghai Zendai Property, Greentown China and SPG Land.

What do improving property sales and pricing imply for rating trends?
Rating trends remain negative despite some positive rating actions in the past two months. This is because the majority of our ratings are on negative outlook, reflecting the issuers' weakened credit profiles and liquidity. Property sales may be stabilising, but lower prices will translate into weaker profitability for all developers over the next one to two years. Credit ratios for most developers will deteriorate in 2012 and 2013 as they recognise weaker property sales at lower margins for the past 12 months. A small number of positive actions may occur in the next six to 12 months. That's because some developers' property sales have been better than we expected, while some companies have eased their liquidity pressures through asset sales or refinanced large offshore maturities.

Which developers are still vulnerable?
We believe those credits that have weak liquidity and large refinancing risks remain vulnerable to financial stress despite the improvement in buyers' sentiment. Coastal Greenland and Hopson Development have weak property sales and face large refinancing risks on their offshore bonds. SPG Land may breach its bank loan covenants and depend on asset sales to stay afloat. Renhe Commercial Holdings has weak liquidity due to weak property sales and heightened receivable risks.

What's the prognosis for commercial property?
The commercial property sector has fared better than residential. In tier-one cities, particularly Beijing and Shanghai, office rents have recovered and exceeded their peak in 2008 due to strong demand. Increased new supply may moderate rents, but those for well-located properties should remain at good levels. Franshion Properties is likely to continue to benefit from high occupancy and rising rents in Beijing and Shanghai. The picture is mixed for commercial property in tier-two cities because of the large supply of new projects and untested demand. As more developers enter the commercial property space, the supply pipeline will likely increase significantly over the next three to five years.

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