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Worst is yet to come for Chinese developers

Refinancing risks contribute to the negative outlook on China's property sector, while across Asia, small and mid-sized developers may find it harder to compete as the economic outlook weakens and lenders and investors turn cautious.
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Construction of commercial buildings in China’s Nantong city (Imaginechina)</div>
<div style="text-align: left;"> Construction of commercial buildings in China’s Nantong city (Imaginechina)</div>

Among Asia's real estate companies, Chinese developers appear closest to their pain thresholds. Stiff competition and tightening regulations in China have contributed to unsold inventory, stifled profits, and strained liquidity over the past few months. While the government may somewhat relax its reins this year, cash-strapped companies will still struggle. One significant problem is the rising refinancing risks.

In view of the harsh conditions, Standard & Poor’s Ratings Services stands by its negative outlook for China's property sector. We believe Chinese companies will likely face more downgrades over the next six months. Developers elsewhere in the region will also find the going tough to varying degrees. Macro-economic and industry factors in each Asian market will support or undermine rating performances.

China: Negative outlook
Over the next few months, we're likely to fine-tune our base-case and stress scenarios for the China market. For now, the assumptions outlined below are unchanged.

More price cuts are likely, even for top developers
We expect property prices to decline by 10% between June 2011 and June 2012. According to the National Statistics Bureau, average selling prices fell by 3.5% across the country from July to December 2011. Sales volume is likely to remain flat or slip in full-year 2012. Discounting is becoming increasingly common, even among leading developers. For some developers and in some cities, prices have already slumped — particularly for new launches.

Modest price discounting may not stimulate sales significantly while policies to restrict home purchases remain in place in many Chinese cities and mortgage rates are much higher than a year or two ago. Overall, we believe profit margins are likely to decline from 2011 levels as the price cuts start to bite.

Fine-tuning of regulations will continue
The central government isn't likely to reverse its policy direction in 2012, but it could relax some of its tightened measures for the property sector. A positive policy surprise could appear in the second half of 2012 to ease the pain if: (1) the domestic economy is weaker than expected, due in part to the crisis in Europe and weak export demand; or (2) inflationary pressure continues to ease.

Ahead of a political leadership change this year, the central government is likely to maintain its goal to control inflation, cool property prices and complete its "social housing" programme, in other words to provide more affordable accommodation. Inflation and property prices have shown signs of easing in recent months. In response, early signs are emerging that the government is prepared to loosen the leash. Some banks have lowered the mortgage rates for first-time home buyers, and the central bank has urged lending to this segment. Recently, the central bank lowered the required reserve ratio — the amount of deposits banks must hold in cash — for commercial banks. This move may signal that the tight credit conditions could have bottomed.

Refinancing risks will grow
For Chinese developers, we expect heightened refinancing risks due to weaker property sales, high funding costs and tighter liquidity. Property sales have continued to drop sharply in the first quarter of this year and the fourth quarter of 2011. Smaller developers with high geographic and project concentration will be more vulnerable to policy risks than geographically diversified players, which are cushioned against the uneven implementation of policy across China.

In the offshore market, developers face materially higher borrowing costs in the bank loan market and the high-yield bond market than a year ago. Most Chinese property bonds have yields above 12%, apart from those issued by companies with an established reputation that we rate from BB+ to BB- or at investment grades. In addition, developers' appetite for equity issuance remains limited. Overall, share prices remain low compared with the historical peak and controlling shareholders have resisted diluting their holdings.

Negative rating actions are in the cards
The negative credit trends could lead to more downgrades and outlook revisions this year. Continued tight regulations, growing refinancing risks and a deepening market correction will take their toll on developers. In support of ratings, many companies have adopted less-aggressive strategies and maintain better cash positions than during the last big downturn in 2008.

Indicators that could make us materially lower our base case
The following indicators could revise our prognosis for the sector:

  • prices decline by more than 20% for six to 12 months and show no signs of recovery;
  • the economy weakens more than we expect, i.e. real GDP is less than our forecast of about 8%;
  • the government introduces further tightening measures on bank lending and other financing, as well as administrative controls to further control inflation; and
  • share prices decline materially, which may accelerate loan repayments if companies have pledged shares as collateral.

Hong Kong: Stable outlook, but a negative bias is emerging
On the other side of the mainland China border, Hong Kong's property market is likely to remain relatively stable in 2012. Some negative trends are emerging, however, that we continue to factor into our base case.

Demand is weakening
We expect property sales volume to decline by 10% to 20% in 2012 because of the impact of the Hong Kong government's market-cooling policies and a moderate rise in mortgage rates. In addition, demand will likely fall due to deflated expectations about property price appreciation and a correction in other asset classes, for example equity, which will weaken investors' sentiment.

Economic growth may slow
Standard & Poor's expects interest rates to remain low because the Hong Kong dollar is pegged to the greenback. We also expect Hong Kong's real GDP to be weak in 2012, at 3%, which will further subdue sales. We don't expect the acceleration in the government's supply of land for auction to have any immediate impact on sales because the completed properties will only be made available in two to three years' time due to development cycles.

Rental income will fall for offices, but the retail segment is sound
We estimate that the sector's average income from rents for office space will decline by 10% to 20% in 2012, after peaking last year. Rental rates for 'grade A' offices (the top tier) have risen by more than 35% since bottoming out in mid-2009. We expect demand for office spaces to moderate this year, given slowing corporate expansion. Occupancy rates will remain high due to the limited new supply despite weaker demand.

Average retail rents are likely to improve modestly, with many property investors continuing to benefit from near full occupancy. Tourist arrival numbers from China, a major driver of spending in the retail sector, are likely to remain resilient despite an economic slowdown and this will continue to support rental income for property investors.

Indicators that could make us lower our base case
We could turn more negative on the sector if the following conditions materialise for a sustainable period:

  • equity prices decline sharply and buyers' sentiment is weaker than expected;
  • interest rates and mortgage rates rise sharply; and
  • external demand shrinks rapidly, especially if the Chinese economy experiences a hard landing scenario (such as GDP growth falling to less than 5%).

Southeast Asia: Outlooks range from stable to negative
Markets in Southeast Asia have a fairly mixed prognosis. Our base case remains intact, with the key assumptions outlined below.

Singapore: Stable with slight negative bias
Singapore's property market is vulnerable to negative macro-economic conditions. Real GDP growth is likely to be weak in 2012; Standard & Poor's forecasts 2.5%. Interest rates are also likely to remain low. More positively, domestic liquidity is abundant and there are no signs that mortgage rates will increase sharply.

An oversupply of residential properties is constraining sales, and we expect prices in this segment to decline moderately. Office rents are likely to be flat or fall marginally. Large new supply in the office space may destabilise rents if tenants cancel pre-commitment agreements.

Indonesia: Stable outlook
We stand by our stable outlook for the Indonesian market, based on the industry's good demand. In our view, low mortgage rates, increasing urbanisation and growing prosperity will keep sales buoyant. We also expect prices to be stable and sales resilient. The credit profiles of rated property developers are improving due to the industry's good fundamentals. But companies' aggressive growth appetites and execution risks temper the potential upside to the ratings.

Vietnam: Negative outlook
Vietnam is another battling market. Hyper inflation, high interest rates, currency depreciation and government policies have all subdued demand. We have not altered our negative outlook.

Support for Asia in 2012
Developers are bracing for tougher property market conditions as the economic outlook weakens. Unlike in the sharp downturn in 2008, most companies that we rate have improved their financial management and flexibility. These companies stand in good stead to weather the market correction that we expect, particularly in China. Nevertheless, the polarisation of the property market will continue. On the one hand, large and well-capitalised developers will continue to grow by acquiring land at now deflated land prices and accessing funding. On the other, smaller and some mid-sized companies may find it increasingly hard to maintain their competitive positions when lenders and investors turn cautious on higher-risk credits.

An audio podcast on this topic is available on Standard & Poor’s website, to listen please click here.

Bei Fu, the author of this article, is director of corporate ratings at Standard & Poor's.

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