China's Unhealthy Scramble for Land

There's little to celebrate as dwindling margins drive debt-fueled takeovers.

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. 

Speculative Boost

Shares of property companies listed in Shanghai have soared in the past three days amid expectations the industry is undergoing a round of consolidation

Source: Bloomberg

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. 

Dwindling Returns

The amount the 69 listed Chinese property companies make on every dollar they sell has dropped from 86 cents to 15 in only five years

Source: Bloomberg

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.

Costly Plot

In June, one square meter of land in Shenzhen was going for 10 times more than at the end of 2010

Source: Bloomberg Intelligence

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. 

Property Buying

Chinese real estate companies engaged in record combinations, by value, in the second quarter

Source: Bloomberg

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.

Acquiring Debt

China's 69 listed real estate companies have more than doubled their total debt since December 2011

Source: Bloomberg

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.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

    To contact the author of this story:
    Christopher Langner in Singapore at clangner@bloomberg.net

    To contact the editor responsible for this story:
    Paul Sillitoe at psillitoe@bloomberg.net

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