Cooling down

The statement issued in early September by Vanke, China’s biggest property developer, was brief and to the point: "Although the company sympathizes with the early buyers for their loss, as a listed company, it is responsible to shareholders and must conduct business in the spirit of the contract."

The notice came in the wake of protests from angry homebuyers in Shenzhen, Hangzhou, Shanghai and Nanjing. In Hangzhou, homebuyers had stormed into Vanke’s office demanding payment after the developer dropped the per-square-meter price in some apartment buildings from US$2,640 to US$2,053 within months after putting the buildings on the market.

The current situation is uncomfortable for nearly everyone in China’s housing market. Developers like Vanke, after record profits last year thanks to rising sales and the stock market boom, have been forced to slash prices as their funding sources dry up. Investors in many markets have watched the value of their homes fall for the first time in 10 years. Meanwhile, the global economic crisis has added a major unknown to Beijing’s plan for a steady property cooldown.

To be sure, few experts doubt the long-term viability of China’s housing market given the country’s underlying fundamentals – strong GDP growth, rising incomes and ongoing urbanization. But in the short-term, the severity and duration of the market’s current "downturn" or "correction" – depending on whom you ask – is harder to ascertain.

"A lot of people are looking at the October holiday as a true indicator," James Macdonald, senior manager of research at Savills, told CHINA ECONOMIC REVIEW in late September. "During the October holiday, you have a lot of developers trying to push their properties … You’re going to start to see people clarifying their positions on what the market is doing."

Initial reports following the October holiday were not encouraging. The number of property transactions in major cities hit a record low for the holiday period, state media reported. In Beijing, the number of deals during the week-long period fell 72% year-on-year, while at the Shanghai Autumn Real Estate Expo, transaction volumes sank 37% from the previous year.

But record-low sales volumes in October were just the latest episode in a saga that began in earnest late last year as Beijing’s most recent round of policies to cool the market kicked in. Property prices in many areas had been driven up wildly by domestic and foreign speculators, and cash-rich developers building at breakneck speeds. While developers and second-home buyers saw windfall profits, families looking for a place to live weren’t positioned quite as well.

"We had a situation where property prices were rising at a rate significantly faster than GDP," said Anton Eilers, executive director of residential at CB Richard Ellis (CBRE). "Where that happens, we get into a difficult situation regarding affordability."

Government intervention

Beijing began by limiting developers’ access to credit, imposing bank lending quotas and raising interest rates. Yet perhaps the change that had the most immediate impact was aimed at domestic speculators. In December, the government raised the required down payment on second homes to 40% from 30% and increased mortgage rates. This dissuaded many middle-class homebuyers from investing in a second property.

The number of residential real estate transactions in markets like Shenzhen and Guangzhou, where property speculation was more prominent, dropped off following the implementation of these policies. Transaction volumes in Shenzhen for the first quarter of 2008 fell by about 76% year-on-year, according to Savills. China as a whole has seen a drop in transaction volumes this year, though not at Guangdong levels.

"You have two peak selling times throughout any year, April-May and September-October," explained Macdonald. Though sales volumes dropped in early 2008, it wasn’t until spring that developers began to worry. "[Sales] didn’t really pick up as it went into the peak season, it was just flat."

While the government’s second-home policies were the initial impetus for the drop in transaction volumes, now weakening prices are keeping investors away. In volatile markets like Shenzhen, prices have fallen 30% from their September 2007 peak, to US$1,611 per square meter. In Beijing, though, prices have held up well.

"Softening prices [in Shenzhen] have been the big anecdote the media has cornered," said Michael Klibaner, head of research in Shanghai at Jones Lang LaSalle (JLL). "But I don’t think that’s reflective of what’s happening in other parts of the country."

But perhaps the best approximation of a China-wide property market comes from statistics by the National Development and Reform Commission. According to monthly figures, property price growth across 70 major cities has slowed for seven consecutive months from a record high of 11.3% in January. Though market conditions vary widely among cities, a general market sentiment can be said to have emerged.

"Buyers are waiting for a bottom and not seeing it yet, so they’re hesitant to get into the market," said Klibaner.

This market sentiment presents a Catch-22 for developers. With limited credit and urgent cash flow needs for already-contracted new projects, developers must generate strong sales to stay afloat. When sales volumes slip, many firms – like Vanke in Hangzhou – begin offering discounts on their properties to stimulate sales. Yet, in times of larger price lulls, this reinforces the notion that prices have not yet hit bottom – keeping would-be investors on the sidelines.

Unlike a majority of consumer goods, property prices and sales volumes are positively correlated. When both begin falling, terms like "property meltdown" begin to be thrown around. A September Morgan Stanley research report advanced the "meltdown" argument.

"Our theoretical stress tests on Chinese property developers and banks paint a rather gloomy picture … The likelihood of a property sector meltdown (i.e., price and volume falling in deep scale) is high," the report reads.

Morgan Stanley researchers looked at five relatively small developers – Agile, Guangzhou R&F, Shimao, KWG and Aoyuan – and determined that all show solvency risks if forced to cut property prices by even 10%. "When the fall reaches 20%," they concluded, "the solvency risks turn serious for [both small and large developers]."

Moody’s Investors Service carried out its own stress test of 13 developers earlier in the year, evaluating their credit positions if 2008 sales drop 25% below predictions. Eight of the 13 remained "stable," three were "on review for downgrade" and two were deemed "negative."

"When there’s a liquidity crunch, smaller developers will be most severely affected," said Kavan Tsang, a Moody’s analyst and co-author of the report. Tsang notes that even developers with stressed credit positions have options to save themselves, such as slowing down construction, delaying land payments and negotiating with the government.

Doubting doomsday

Most moderates in the "cooldown vs. collapse" debate agree that smaller developers will face hard times in the coming months, but they argue that consolidation is a government priority. In years past, companies in fields unrelated to real estate got into the development game after finding themselves with access to land and loose credit. These non-specialist developers will likely be the first to go – not necessarily into bankruptcy, but back to their core businesses.

 JLL’s Klibaner also argues that China’s overall demand for housing still exceeds supply. Though falling prices endanger  poorly positioned developers, when public sentiment turns – be it through a natural price floor or more forceful government stimulation – pent-up demand is expected to start the cycle’s next upswing.

"From our perspective, what’s going on right now is a correction, not a collapse," said Klibaner. "You would see Beijing step in fairly quickly if there were a collapse. It’s too important an industry to the Chinese economy."