China's Unhealthy Scramble for Land
Something Chinese investors love even more than property is rumors. For once, the current bout of speculation could make sense -- but the underlying reasons are no cause for celebration.
A recent buying spree by the developer Evergrande prompted investors to bet that another wave of consolidation is around the corner and pushed the Shanghai property subindex up as much as 12.8 percent in three days.
Putting aside Evergrande itself, which in a week spent a few billion yuan amassing a large position in its biggest rival, China Vanke, and said it plans to acquire outright Langfang Development, the whole sector could use some mergers and acquisitions.
But not necessarily for a healthy reason: net income margins are under pressure. Five years ago, Chinese developers were among the most profitable in the world. That's no longer the case.
Evergrande is an exemplar, with the amount it makes from every dollar of sales dropping to 11.7 cents, from 18.3 cents at the end of 2011. One way to counter that profitability plunge is to gain scale, and the easiest way to do so may be through mergers.
The cost of land has soared over the past five years, far outstripping increases in prices of finished apartments and seriously hampering developers.
Sunac China Holdings is a good example of the industry's response. According to Bloomberg Intelligence analysts Kristy Hung and Patrick Wong, the Nankai-based company has shifted to sourcing land through the purchase of stakes in companies, avoiding escalating prices at open auctions. It's not alone. Merger and acquisition activity among real estate firms in China reached a record in the second quarter.
The key downside is how this consolidation is being financed. Chinese companies seldom use stock for acquisitions, which leaves cash earned from selling homes or raised through debt. The latter tends to be the preference. As a result, total borrowings of the publicly traded developers have more than doubled since the end of 2011, to $320 billion.
Before cheering the weeding-out of competitors in Chinese real estate, investors should examine what's driving the trend and how it's being executed. Thinner margins and growing indebtedness are no cause for optimism.
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