Wednesday, April 05, 2006
The Signs Are There For Shanghai
Real Estate Bubble Almost Ending
It is wonderful to see how Shanghai has evolved over the last 10 years. However, the property prices have gone way past what is rational. The trouble is, predicting when the bubble would deflate is like catching falling swords - it may kill you, and even if you manage to catch them, you may be seriously injured yourself. (No, I am not financially independent enough to own any Shanghai property). The trouble with a rising asset class, no matter what asset class - it could Shanghai property or Sydney property, or San Fran property, or London property, or Indian stocks, Nasdaq techs, etc... - is that the ones who profited will get back into the same asset class with an an even bigger exposure. Say, you have this HK speculator who has bought and sold ten Shanghai properties over the last 10 years. He has turned his HK$10 million capital into HK$80 million. Chances are high that he will have at least HK$50 million as down payment for a few geared Shanghai new developments with an actual exposure of at least HK$400 million. By staying put in the same asset class, we are basically saying to the gods, "Please, I really want to make sure that I will get caught really bad when the market comes crashing down". A decent sized correction of just 25% over a 6 month period for Shanghai property will wipe out HK$100 million from the speculator's net worth - which means he will now have a negative net worth of negative HK$20 million. As in any good profitable markets, the need to diversify must be heeded, and always watch for signs to pare down your exposure because every dog has its day.
The one sign that I came across which could start deflating the Shanghai property bubble was the surprising rating given by Standard & Poor / Moody's on Shanghai Real Estate's (SRE) bond issue. SRE is a leading developer in Shanghai's financial hub, and has proposed a US$150 million (HK$1.17 billion) bonds. It was rated as non-investment, or junk status, as rating agencies were concerned about the company's narrow focus and limited cashflow. Standard & Poor's assigned a "BB-" long-term corporate credit rating to the seven-year bonds, three notches below the investment grade, while Moody's Investors Service assigned a similar "Ba3" rating. The ratings reflect the key challenges faced by Shanghai Real Estate, including its lumpy operating cash flow, resulting from its single business focus on property development.
The significant geographic concentration on Shanghai alone did not help and the company's rising leverage was a big concern. Leverage is not just an option in Shanghai for property developers. Leverage is a necessary toll to compete. Developers there have to get the biggest projects and complete them the fastest, and try to sell them all yesterday. To enable the retail side to buy, many developers have innovative financing schemes to help the buyers/speculators - hence leverage is not an option in Shanghai property market.
SRE said last month its 2005 profit surged 234% to HK$301 million, from HK$90 million a year earlier. The company plans to use the net proceeds from the proposed bond sale to replenish its land bank, rating agencies said. It has a land bank of 1.4 million square meter gross floor area in Shanghai, which the company estimates will be sufficient for its development for the next four to five years. However, S&P did say that SRE's low cost of land bank, good locations of its developing properties, and expertise in the industry are offset by its high concentration risk, small- scale operations, and lack of stable recurring income. After the bond sale, SRE's EBIT will fall to about 3x interest expense in 2007 from 10x in 2005. The thing is, cases like SRE are being replicated many times over all across Shanghai - when your earnings starts coming down from 10x of interest expense to just 3x, its a worry. There is not sufficient cushion for even a minor blip.
Owing to the small size of the bond issue and SRE's relatively small size as well, this piece of news will be brushed aside by many. To me, this is an important sign. If you have made a lot of money from China properties, to tell you to get out would be fruitless, just gear down. If you normal gearing is 8x, bring it down to 3x - you have already made your money, let someone else make theirs. Keeping what you made is the most difficult thing.