SURVIVAL OF THE FITTEST
How mainland Chinese property firms are plotting to survive—and thrive—in a real
estate bubble that Beijing is determined to deflate.
By Cesar Bacani

After six years as CFO at mainland Chinese property developer Top Spring Group, David Lee has learned the cardinal rule for doing business in the People’s Republic. “Whatever you do, never embarrass the government,” says the 42-year-old Hong Kong CPA and management accountant. “Accommodate the requests of local officials because property development is a long-term relationship.” Over the years, Top Spring has agreed to hold off demolition of houses, increased compensation offers, fast-tracked hotel construction so city mandarins could host People’s Congress meetings, and rebuilt the roof of a new shopping mall because city officials thought
it clashed with its surroundings (see “Bubble Trouble”).

The strategy has worked like a charm. Top Spring has completed high-end villas and residential complexes in Beijing and Shenzhen, built and invested in department stores in Guangdong, and is midway through the construction of the US$863 million Top Spring Waterflowers—a mixed-use development in the third-tier city of Changzhou, in Jiangsu province. Scarborough International, a joint venture with UK property tycoon Kevin McCabe, has just inaugurated Scarborough Landmark in Hangzhou, a US$53 million shopping mall with Wal-Mart as its anchor tenant. Lee is also CFO at Scarborough, which was formed in 2005.

But storm clouds are gathering. Last year, property companies met a financing roadblock. The People’s Bank of China reportedly ordered financial institutions to stop property lending as Beijing intensified a drive to deflate China’s real estate bubble.

Lee and others in the industry are bracing for more restrictions. “The government will remain hostile to property in the next four to five years,” predicts Joe Zhang, chief operating officer at Shenzhen Investment, another property company. This could spell trouble for small companies and the larger but overextended firms that bought land at very high prices and spent lavishly on projects. At the same time, it could present stronger and more agile firms with acquisition opportunities.

It will be a trial for the finance function. Real estate is a capital-intensive enterprise that runs on borrowed money and advance payments from pre-sales to end-users, investors, and speculators. Companies that recently went public, among them Country Garden, Shimao Properties Holdings, Greentown China, and Soho China, may still have pots of cash. But those counting on an IPO this year may be out of luck, since stock markets are likely to remain volatile. CFOs like Lee are under pressure to think up novel ways of helping their companies survive—and thrive—in an environment that is growing more challenging by the day.

The Big and the Small

At Shenzhen Investment, the immediate agenda is clear. Prodded mainly by Zhang, an outspoken former UBS analyst, the developer has sold stakes in non-core assets, including a power plant and cable TV station, and is now hawking its interests in Jingdong Expressway and Shengang Transport for up to US$195 million. “It may seem counter-intuitive to dispose of our infrastructure businesses [which generate steady income] in these uncertain times,” Zhang concedes. “But our core competency is property development.” By monetizing most non-core assets—Shenzhen Investment is keeping its 27 percent stake in Road King, which operates 18 toll roads and has 6.63 million square meters in landholdings—the company has been able to trim net gearing from 71.6 percent to 35.5 percent. The Hong Kong-listed company has also amassed cash reserves of US$551 million, which Zhang believes is bigger than the war chest of any other property company in China except Country Garden. “The real estate sector is on the verge of a shakeout,” he says. “The safest course is to keep your powder dry. And if somebody gets in trouble, you can buy on the cheap.”

Top Spring, a private company that does not publicly disclose its financial results, has a less orthodox approach. In December, it announced a plan to add a fund and asset management arm to Scarborough International. McCabe’s flagship company, Scarborough Group, has US$8.5 billion in assets under management. The idea is to leverage McCabe’s expertise and connections to raise money abroad to finance Scarborough International’s projects. The funds may also invest in Top Spring and other developments in the form of real estate investment trusts (REITs).

“We can first complete a project and make a profit as the developer and manager of the property,” explains Lee. “Then we can sell stakes in the completed project to the investment funds and make another profit.” The CFO says one potential partner, a well-known Australian asset management company, is currently conducting due diligence. McCabe is also trying to persuade two European banks to invest in Scarborough International. “We think we can make use of their borrowing facilities in the future,” says Lee.

It’s instructive to compare and contrast the two Shenzhen-based companies, whose circumstances and strategies mirror those of many other Chinese property firms. Shenzhen Investment, which listed in Hong Kong as a red chip in 1997, is owned 45.6 percent by the Shenzhen city government, giving it clout in getting bank loans and making land acquisitions. Top Spring is a private-sector company owned by mainland-born C. H. Wong, who was a property developer in Hong Kong before founding Top Spring in 1993. Shenzhen Investment is currently developing more than 25 properties and has a land bank totaling 11 million square meters, not including Road King’s own land bank. Top Spring and Scarborough are working on just four projects.

In short, Top Spring would seem to be one of the smaller property developers that could well end up being forced to sell itself or its best assets to bigger and well-connected players like Shenzhen Investment.

Riding the Dragon

But Lee is confident that Top Spring and Scarborough have the depth of experience and financing sources to ride out the crackdown. He sees a powerful advantage in the combination of Top Spring’s intimate knowledge of Chinese real estate and McCabe’s international fund management expertise. The partners are committed to inject other assets into the joint venture, including 40 percent of Top Spring’s Waterflowers project in Changzhou and 100 percent of McCabe’s US$116 million Sheffield Icon mixed-use project in Chengdu in Sichuan province.

On its own, Top Spring has recurring income from its 44 percent stake in Shenzhen Rainbow Department Store, which owns and operates 27 department stores and supermarkets across Guangdong province. A state-owned enterprise owns the remaining 46 percent. “Since 2001, they have been making profits in the nine digits,” says Lee, adding that earnings in 2006 topped 270 million renminbi. Rainbow is waiting for approval to list in China’s A-share market in the second quarter of 2008.

Lee says Top Spring’s stake, for which it paid only US$974,000, could be worth more than US$139 million. “Other retail companies are currently trading at a P/E of 50 to 60 times earnings, although new IPOs are limited to a top price of 30 times earnings,” he notes. Top Spring can use the extra cash. The government is forcing developers to dig deeper into their own pockets. “Previously, you needed to inject 35 percent of the total project value as your registered capital to get the approval of the Ministry of Commerce,” says Lee. “But they have changed the rules. You now need to inject 50 percent as equity.”

The other half in project costs can be funded by borrowings. “It’s actually not difficult to borrow from domestic banks in China,” says Lee. “They are even more aggressive than banks in Hong Kong in lending.” The problem is the actual disbursement of the money. In 2007, the People’s Bank of China is said to have directed financial institutions to stop lending until the end of the year. The central bank denies doing so, but loan releases indeed dried up in the last quarter of the year.

Until recently, many companies have been borrowing in Hong Kong. “It was practically free money,” says Lee. “You could get a loan with interest rates of 3 to 4 percent, and that could be covered by the 2 to 3 percent appreciation of the renminbi.” He had wanted to borrow in Hong Kong dollars too, but Top Spring did not have a strong enough credit history in the territory. In any case, Chinese regulators are now sitting on applications to convert foreign currency inflows into renminbi, particularly for property development, so this route is slowly being closed off.

Counting on Finance

But the financing challenges, declares Lee, are not insurmountable. CFOs can devise workarounds with regard to bank lending and foreign exchange issues. “It depends on the relationships you have cultivated and your knowledge of how things work in China,” he says. “The government may have told banks to stop lending to property developers, but the banks must still find ways to put their deposits to work. How will they be able to pay interest to their depositors?” China’s banks are awash in cash, given a national savings rate that now tops 40 percent.

Lee is rejigging Top Spring’s financial management to prepare for the possibility that its three banks may have to temporarily stop honoring the credit facilities they had granted. He is front-loading drawdowns in the first half of the year, for example. That’s because government planners make the judgment on whether the economy is overheating or cooling near the end of the year, so the fourth quarter is usually the time new directives are sent down. “Credit is usually very loose in the first quarter of the new year,” says Lee. “The banks think that if they don’t lend now, they may not be able to do so later on.”

The CFO is also intensifying cash conservation efforts. “You have to be prudent because you may not get more money later,” he cautions. “Don’t get drunk [and spend too much today].” One initiative is to centralize purchasing. Top Spring and Scarborough have signed one master contract for the supply of escalators and lifts. “You gain bargaining power,” says Lee. “Secondly, you can avoid some under-the-table dealings, which might happen if project managers negotiate by themselves.”

Depending on your relationship with your bankers, it is possible to delay loan repayments by a few months. “In the West, when you don’t pay, you default,” says Lee. “In China, you can negotiate.” But whatever you do, never delay payments to your subcontractors. “You need to have the money to pay them,” says Lee. “If construction companies cannot pay their workers, they won’t have the money to go back to their villages for Chinese New Year, and they will protest in front of City Hall.” As a result, the property company will end up in the bad books of local officials.

Cardinal Rule

That is a place a property firm should never, ever be in China, where all land belongs to the state. When developers say they have a big land bank, what they mean is that they own the land-use rights for 70 years if they build residences on the land, and 40 years for commercial use. These long-term leases are granted by the Land Bureau, but local officials typically have a big say. New rules from Beijing now require that raw land be auctioned in a public bidding. Developers can still negotiate to buy land-use rights on farms and property with structures, but local authorities must justify why they have decided against an auction.

It used to be much simpler. Local governments that wanted to build houses and commercial buildings created companies whose main assets were land-use certificates. These state-owned enterprises then partnered with property developers. “You put the land-use certificate into the project company as your share of the capital,” says Lee. “The developer uses his own money to build the structures, which is his share of the capital. Then we split the profits. Finished.” As the pickings grew richer, however, disputes arose with the peasants and other users of the land, who were quite rightly incensed that a few well-connected individuals were prospering at their expense.

New rules mandating auctions and fair compensation to current land users are meant to avoid these frictions and the resulting social disharmony. Lee says local governments and developers have become very sensitive to the issue. In 2003, Top Spring was awarded a land-use certificate on 100,000 square meters of land in Changzhou after negotiations with local officials. The property had some 1,600 houses, whose occupiers were to be compensated by Top Spring. The company allocated around US$49 million in total costs for the land-use acquisition, including a land premium to the local government of around US$14 million.

Then a farmer from Anhui province tried to burn himself in Tiananmen Square to protest what he said was the local government’s forced relocation of his family so his farm and the surrounding land could be turned over to a property firm. In response, Prime Minister Wen Jiabao issued a brief statement urging adequate compensation in property development. The news filtered to Changzhou. “Suddenly, the people we already paid came back and asked for more money,” Lee recalls. “The amount some were demanding was really unreasonable,” at least from Top Spring’s perspective.

Top Spring refused and the tension escalated. When its site office was vandalized, the company wanted to call the police, but fearing more disturbances, local officials asked it to hold off. They also prevailed on Top Spring to observe a moratorium on the demolition. After a year, the company finally succeeded in taking over the property, but its costs had ballooned to nearly US$83 million. The pain was eased by the sharp appreciation in the property’s value. Changzhou, a city of 3.5 million people, sits at the heart of the Yangtze River Delta, near enough to booming Suzhou and Wuxi to benefit from spillover development.

Top Spring also acquired allies within Changzhou’s officialdom. The goodwill resulted not only in things like the local government building bus stops and a train station near the development, but also in testimonials to other local governments that have plots of land Top Spring is interested in. Such recommendations are not legally required, but a good word from local officials helps a developer get a favorable hearing. For example, Top Spring recently arranged for officials in Guangzhou to meet their counterparts in Changzhou to hear first hand how the developer went about the Waterflowers project. Top Spring is angling to redevelop a piece of riverside land in Liwan district into a similar mixed-use development called Guangzhou Eye, which will feature a giant observation wheel patterned after the London Eye.

“We’re trying to persuade the Guangzhou government not to put the property on auction because it will be hard for us to compete with wealthy developers from Hong Kong,” says Lee. “Our friends in Changzhou have told them how well we handled the demolition program in their city, saying we have been zero trouble to them. They also said the [Waterflowers] development is very good.” Top Spring has signed a letter of intent with Guangzhou, although Lee says the agreement is very preliminary. The officials could well decide to hold an auction, which could bring in the most money, but run the risk of disruptions if the winning bidder bungles the demolition work.

Money Talks

In the end, though, it all comes down to how much cash a company can deploy, which is why McCabe’s deep pockets, the planned fund and asset management business, and Rainbow Department Store’s IPO are so crucial to Top Spring’s future. It is also explains Shenzhen Investment’s determination to pile up more and more cash. In July of last year, the company flipped land-use rights to a property in Shenzhen that it acquired just eight months earlier. “The price had gone up 40 percent in such a short period of time and so when someone came knocking, we sold,” says Joe Zhang.

That buyer may now be ruing the purchase. In a report, analysts at investment bank Merrill Lynch noted many cases last year of developers paying more for land than the price of existing completed units in the area. “For a while, it seemed all that developers needed to do was to keep buying more land to fuel a seemingly endless surge in equity prices,” the analysts wrote. “By the end of 2007, that sentiment has cooled. In 2008, it now appears that the government will be taking a much sterner course in trying to contain the rise in property prices.”

“Regulators are likely to continue imposing tighter restrictions on mortgage loans and property lending,” agrees Matthew Kong, who is associate director at Fitch Ratings. “We also expect the central government will seek to end land hoarding.” To discourage land developers from buying land and just waiting for prices to appreciate, instead of building on it, the State Council directed in January that land that has been idle for more than two years after it was approved for development should be taken back. Developers that have not developed a property for more than a year will be levied a non-usage fee equivalent to the value of the land.

As is often the case with central-government directives in China, however, enforcement may break down at the local level. “Would fencing or leveling of land be considered usage already?” wonders Raymond Ho, who is head of China operations at real estate services company Vigers. He points out that many local officials have not been collecting value-added tax from developers, which could have cooled the real estate frenzy in their area and deprived the city or province of the larger income from the boom. In December, the Guangzhou Municipal Local Taxation Bureau raised the value-added tax rates to 1 percent of the value of residential projects, and to 2 percent for all other projects. “If implemented, this will pressure developers’ cash flow,” says Ho.

Which companies will emerge the winners? Merrill Lynch is looking at the strength and severity of credit controls over mortgage and construction loans, ability to manage inventories and pre-sell apartments to avoid cashflow difficulties, and execution of growth strategies. Moody’s Investors Service points to diversification of land banks and operations, a track record in managing the challenges of rapid growth, and financial discipline. “Those rated Baa3 tend to exhibit such characteristics,” its analysts say in a report. Shimao and China Overseas Land and Investment currently carry this Moody’s rating. Over at Fitch, companies it has rated BB or higher are seen as well positioned, and these are Shimao, Greentown, Agile Property Holdings, and Hopson Development. Not having issued any bonds, neither Shenzhen Investment nor Top Spring has a credit rating.

Top Spring’s Lee says that there is real demand for property in China, although the developers may be moving too fast. “But everything in China moves fast,” he notes. Lee is convinced that the sheer number of Chinese looking to buy their first homes is on the developers’ side. Maybe so, but they are also discovering that there are speed bumps in China after all.

Cesar Bacani is a contributing editor for CFO Asia.