Painful Times Ahead For China’s Property Developers

The author is Li Junheng, founder of Chinese equity research firm JL Warren Capital

In response to the bearish comments made by vice chairman of China Vanke Mao Daqing, we did some analyses to verify Mao’s comments on excess housing inventory in China.

We took a different approach from his use of home units per thousand people as a measurement of market saturation, but our conclusion is similar to his: that China’s residential property market is indeed building up excessive supply.

We estimate that supply exceeds demand in terms of gross floor area by 1.4 billion square meters in 2014.

Looking at demand and supply, the Chinese residential property market has reached the inflection point during 2013 and 2014, with or without investment driven demand.

As excess supply continues to build up in the next two to three years, a home stock surplus will accelerate. Projects built in 2012 to 2013 will launch in 2014 to 2016, while demand driven by new households and upgrades will decline, both driven by demographics.

On average, Chinese marry at around 25 years old. Since opening and reform in 1979, China’s birth rate peaked in 1987 at 23.3 million per year and declined to around 18.2 million in 1992 and 12.4 million in 2003.

Those born in 1987 on average married approximately 25 years later, around 2012. Hard demand driven by newly formed families, therefore, reached a peak around 2012, and since then has continued to decline along with new household formation.

We estimate new household formation has declined around 7% per annum since 2012.

Annual new births in China appear to have stabilized at around 12 million since the 2000s. If we assume that demand is about 35 square meters per capita, new family formation will create around 420 million square meters of demand per year beyond 2025.

We estimate upgrade demand to be from 500 to 550 million square meters per year from 2003 to 2013, assuming around one square meters per year per person.

One main myth about China’s urbanization is that it directly results in home demand in tier I and tier II cities. Our research shows that, due to the Chinese Hukou restrictions and price affordability issues, home demand does not benefit much from an inflow of migrant workers into cities.

China’s property developers operate in a highly levered business. When transaction volume dries up, an inevitable outcome of excess supply, developers will quickly cut prices to move the inventory so they have the cash flow to fulfill debt service obligations.

Declining home prices also lead to a contraction in investment-driven demand, which we estimate to be around 15% of total commercial home transactions in China, declining from the peak of 30% in 2009.

Since home start-to-completion takes on average around 2.5 years, and home starts have been rising given easy monetary policy and rising home prices over the past three years, home supply is likely to rise for the next two to three years.

As excess supply increases, price cuts will deepen.

Still, we think part of the above negative view is likely to have been priced into the market, especially in the stock prices of residential developers.

(The article has been edited for clarity)

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