China Property:A closer look at developers’onshore debt

There are structural improvements in the China property sector, driven bymultiple forces, including inventory improvements in tier-1 and top tier-2cities, improved supply/demand, lower development costs and funding coststhat should drive an increase in margins, etc. Among all, the opening of theonshore bond market is a key change for developers, as it gives them acheaper, more stable and better risk-matched source of funding; it is a healthydevelopment for the longer-term China property market, in our view. Againstsuch a backdrop, the value of developers with good execution ability will beable to emerge more quickly, and with higher certainty than before, hencedifferentials among developers will also increase down the road, in our view.

    Highly leveraged names may not benefit as much: Intuitively, thelowering of funding costs may look to benefit the highly levered, lowerquality developers more, but we do not agree. We think cheaper financingmay only benefit developers with plans to restructure debt and de-gear, butnot for expansion. Developers with not-as-good landbanking strategies andexecution ability may just continue with their lower ROE reinvestment usingthe newly raised money, and this will cause continuous underperformance.

    Lower funding costs cannot result in them outperforming. Moreover,cheaper public offering bond is subject to a cap of 40% NAV, hence theycannot refinance all of their debt.

    Key beneficiaries from the opening of the onshore market: We thinkLongfor and Country Garden are the biggest beneficiaries; Shimao is onthe edge, depending on its upcoming landbanking strategy. While for COLIand CR Land, their funding cost is already quite low, so they may not beable to benefit too much. R&F’s onshore bond issuance results in themslowing down sales, and is more a negative rather than positive, in our view.

    Direct impact to developers: Interest usually accounts for 5-8% of ASP.

    With a decrease in interest rates, developers should see an uptake in margin.

    Developers’ funding costs have come down from an average of 7.1% p.a. in2014 to 5.8% p.a. in 2015, driven mainly by the increase in onshoreissuance, from 30% to 73%. The 124 bps interest savings will result in a 131bps increase in post-LAT gross margin, or a 5.6% increase in gross profit, onour estimates. With the lowering of the onshore risk-free-rate, we expectthere could be another 50 bps decrease in interest cost over the next 12months, and expect more positive impact on margins.

    Longer-term impact on developers: Apart from the direct impact ondevelopers, the opening of the onshore bond market can also cause afundamental change in developers’ strategy, in our view. While this isdifficult to quantify for now, the benefits should be gradually released overthe next year, via more gradually improving margin and ROE. Historically,uncertainty of the offshore fund raising market has resulted in short-termcash flow planning and strategy for developers. With a more stable fundingsource, we expect more developers will develop their own long-termstrategy, which is healthy for them and should reduce volatility in the sector.