Thursday, December 30, 2010

Riding on western China's growth

CHINA'S property market is a hotly debated aspect of the economy. In one camp, you have renowned shorts like hedge fund manager Jim Chanos calling the Chinese property market 'Dubai times a thousand'. He cites valid concerns about the gravity-defying price increases, especially in the top-tier cities and the widening income/affordabili- ty ratio. On the other side, perennial China bull and legendary hedge fund manager Jim Rogers argues that the property market is supported by a low level of leverage, unprecedented urbanisation, and strong economic and income growth.

As with all things, only time will tell as to which side is correct. But with property being a sizeable portion of GDP growth, the Chinese government is taking no chances, and has clamped down on the market to cool it. It is no surprise then that China property-related stocks listed on Asian bourses from Shanghai to Singapore have taken a tumble from their former highs.

An interesting point to note is that talk of a bubble has always centred on the residential market, with little said about commercial space. Yet when the market takes a potshot at property-related counters, both residential and commercial developer stocks take a hit. With the current negative sentiment surrounding Chinese developers, could there be a bargain to be unearthed in the form of a relatively unknown S-chip listed on the Singapore Exchange (SGX)?

Based in Chongqing and dealing primarily in prime central business district (CBD) commercial space, Ying Li International Real Estate is a mid-cap stock that enjoyed a market capitalisation of $1.8 billion at the peak of its share price, only to see its valuation halved in a matter of months. It has remained a laggard ever since, despite the resurgence of the stock market. All this while, Ying Li has been enlarging its hold over various parts of Chongqing's CBD, winning the recent 697 million yuan (S$136 million) Wu Yi land tender and quietly securing its funding needs.

A specialist in urban renewal with 17 years' experience, Ying Li is now the largest office space developer in the Chongqing prime CBD area with the ability to build landmark projects such as the forthcoming 287-metre- high International Financial Centre (IFC), one of the tallest buildings in western China when it is completed in 2011.

Furthermore, with the media spotlight on the property action taking place along China's eastern seaboard, investors may be forgiven for overlooking the potential of western China. Some little-known facts about Chongqing are:

It is China's third largest centre of motor vehicle production and the largest for motorcycles. It is also one of the top three aluminium producers and among the top 10 steel production centres.
With a population of 32 million residents, it is the most populous city not only in China but in the entire world too. And yet, the urbanisation rate is just 50 per cent, far from the 70 per cent target set by the government.
GDP growth year-on-year (y-o-y) was a sizzling 17.1 per cent for the first three quarters of 2010, according to the Chongqing Statistics Bureau - some 6.5 per cent higher than the national average and the third highest nation- wide. The consumer goods market had sales of US$23.9 billion from January to July, an increase of 18.5 per cent y-o-y, while total investment in fixed assets attracted US$45.8 billion, a y-o-y increase of 31.1 per cent.
Furthermore, the local municipal government has earmarked 600 million yuan over the next few years to develop Chongqing's city centre in order to achieve its aim of becoming the financial centre of western China.

Chongqing: becoming a key financial centre

On June 9, the Shenzhen government announced that the minimum monthly wage will go up 10 per cent to 1,100 yuan from July. The move follows a similar change in Beijing, which has raised the minimum wage 20 per cent to 960 yuan. The rising wage demands could tempt factories, especially those catering to domestic demand, to move further inland, potentially transforming China's manufacturing landscape. In fact, with improvements to infrastructure (notably the high-speed railway network), it would make economic sense even for export-oriented businesses to move to western China, mimicking the mid-western states of the United States during the post-World War II industrial boom.

The wage increases along China's eastern coastal manufacturing cities and the much-publicised labour discontent should jolt investors into looking more closely at the western regions of China, where just about everything (especially wages and land) is much cheaper. With the central government's aim of lifting GDP in the poorer regions, promoting domestic consumption and improving infrastructure, it is just a matter of time before the inland regions become the site of the next gold rush.

One of the biggest beneficiaries of this could be the municipality of Chongqing. As one of the four directly administered municipalities (the others being Beijing, Shanghai Pudong and Tianjin) and the only such municipality in western China, Chongqing is now better known as the 'gateway of western China'. In 2010, Chongqing was selected as one of the five key 'central cities' alongside Beijing, Shanghai, Tianjin and Guangzhou. These central cities are to be nurtured as powerhouses on the economic, political, social and cultural front so as to compete on an international footing. Thus, it is easy to see the strategic and economic importance the government has placed on the growth of Chongqing.

Following in the footsteps of Shanghai's Pudong and Tianjin's Binhai, Chongqing was designated the third New Development Zone. Formally announced on June 18, the Liang Jiang New Zone will have a planned area of 1,200 square kilometres and is estimated to reach a GDP of over 600 billion yuan by 2020, accounting for over 25 per cent of Chongqing's GDP. Plans to develop the city as a logistical and distribution hub were given a boost in 2008 when the State Council approved the setting up of a tax-free bonded port, making it the first tax-free zone in China's hinterland.

With such favourable conditions and government policies, Chongqing became one of China's fastest-growing cities in 2009 with GDP growth of 14.9 per cent, far exceeding the national average of 8.7 per cent. Foreign investments topped US$4 billion. This ranked Chongqing first among western China's cities. The financial sector's contribution to Chongqing's GDP also crossed 5 per cent for the first time, making it a 'pillar' industry for the first time and moving Chongqing closer to achieving its goal of becoming a key financial centre.

Chongqing's municipal government is actively promoting the support of economic policies to encourage Fortune 500 and multinational companies such as Foxconn, Ford and Neptune Orient Lines to set up regional headquarters in Chongqing. It is also aiming to create a 400 billion yuan high-tech electronics and information technology manufacturing hub. In April, the municipal government announced a one-trillion yuan investment plan focusing on infrastructure projects to further boost Chongqing's competitiveness.

If these plans are successful, it will create a huge demand for Chongqing's commercial property market especially for Grade A office space, of which there is currently a shortage. According to a DTZ report, the Grade A office space availability ratio in Chongqing dropped to a new low of 11.58 per cent in Q3 2010. Total Grade A space in Chongqing stands at 323,280 square metres, of which 60 per cent is in the CBD district of Yuzhong.

Another stated goal of the government is to raise the urbanisation rate, currently at 50 per cent, to 70 per cent by 2020. Giving momentum to this goal, the Chongqing government announced a policy change in July that would turn some 10 million rural residents into urban city dwellers over the next 10 years. With a population of over 30 million, Chongqing's retail, residential and commercial real estate prices are on the cusp of a sustainable uptrend, according to Ying Li's chairman and CEO, Fang Ming.

Carving a competitive niche

As any property investor knows, a key tenet of success is location. Ying Li, with its presence in the CBD areas of Jiefangbei and Guanyinqiao, is positioning itself to ride on the extraordinary growth of Chongqing. (These two districts can be likened to Raffles Place and Orchard Road respectively.) About 90 per cent of the financial services sector is located within Jiefangbei while the streets of Guanyinqiao are ranked among the top 10 pedestrian streets of China.

Having grown up in Jiefangbei, Mr Fang started Ying Li in 1993. With little capital in the beginning, Ying Li had to build and sell projects rather than retain them for rental. Through the years, as the economy grew, the company saw how its previous projects appreciated by leaps and bounds, enabling the clients who bought them to reap returns over and above what Ying Li had achieved.

While Chongqing property, like elsewhere in China, has boomed in all areas, Ying Li continues to focus on developing commercial property, specifically urban renewal within the CBD - which is what Mr Fang believes plays to the competitive strength of the company.

Asked why Ying Li did not hitch a ride on the residential bandwagon, a spokesman stated frankly that residential projects attracted the big boys with deeper pockets able to outbid it. Moreover, if Ying Li were to play the same game, it could end up overstretching its balance sheet.

As to why urban renewal did not attract the same level of interest from other property developers, the spokesman pointed to the tedious task of coordinating and obtaining the prerequisite permits from the various departments such as traffic control, noise and pollution, not to mention awaiting the resettlement of existing tenants. Resettlement can be a thorny issue due to religious sites or the presence of sensitive installations of the police or military.

Ying Li's resettlement efforts for the IFC, which were completed within a year as per schedule, were uneventful despite the site belonging to the police department, the People's Liberation Army (PLA), two state-owned enterprises and a 300-year-old temple. The awarding of such sites by the local government thus demonstrates a certain degree of confidence in the developer.

Furthermore, development in the CBD requires close working ties and coordination with numerous government agencies and compliance with regulations. So it is not surprising that Ying Li counts itself as a developer specialising in urban renewal while others have left the scene for easier pickings in the residential sector.

Another reason for reduced competition in the urban renewal segment stems from the fact that most residential properties are sold off the plan, enabling a faster asset turnaround for developers. Ying Li, in contrast, has continued to focus on this niche in order to survive and prosper among the big boys.

To date, the company has completed seven projects with a total gross floor area (GFA) of close to 500,000 sq m, and its landmark building - the upcoming IFC - is set to obtain its temporary occupation permit (TOP) in early 2011. With a long-term view of rising rentals and capital values, as western China's economy grows, Ying Li has adopted the strategy of being a landlord of key sites within the core CBD and other fast-growing districts.

Rather than recycling capital by building and selling, the company beefed up its balance sheet with a series of share placements, bank loans and a convertible bond issue. Armed with the proceeds and together with its planned sales of San Ya Wan Phase 2, the residential component of Da Ping and several floors of the upcoming IFC, Ying Li is confident that it will be able to self-finance its pipeline of projects.

Opportunity and dangers ahead

The key attractions of Ying Li can be summed up as an undervalued office-cum-retail-property play with a prime land bank in one of the fastest-growing cities. Just imagine if one had the foresight to buy up prime land in the heart of Orchard Road or Raffles Place. This same scenario could well be playing out in Chongqing. Eagle-eyed investors may have noticed that Ying Li's net asset value (NAV) consists mainly of development properties. As these parcels are developed and revalued, the company's NAV will naturally rise - as will be seen soon in IFC's revaluation, which could add close to two billion yuan to Ying Li's NAV.

With an average land cost of 2,673 yuan per sq m, Yi Ling has five ongoing projects with a projected GFA of 985,802 sq m. Out of the total GFA, over two-thirds will consist of commercial space while the rest will be residential units (from the Da Ping project). At present, its completed investment properties total 145,000 sq m, of which 6,700 sq m consists of office space. Annual rental income stands at just over 40 million yuan. Typical of brand-new properties, rental income should rise after the first round of lease renewals as the property manager fine-tunes the tenant portfolio. Average occupancy stands at 84 per cent.

According to a recent CB Richard Ellis report, average prime office rentals in Chongqing are around 60 yuan per sq m per month with prime office space such as The Metropolitan commanding 80-120 yuan psm. According to the latest DTZ reports, average transacted prices for office space are around 13,000 yuan, while the top-tier Grade A space sells for 18,000-20,000 yuan.

Ying Li could sell half of its developmental property portfolio, possibly reaping upwards of over three billion yuan, while keeping the remainder - mostly super-prime CBD office space and most of its retail space - for recurring income. Conservatively assuming that Chongqing property rentals and prices flatten out, the investment properties (once completed and tenanted with an 80 per cent occupancy rate) should be able to command gross annual rentals of over 200 million yuan. If favourable winds blow through the capital markets at that time, Ying Li could well end up bundling its properties into a real estate investment trust (Reit), helping to unlock capital value for its shareholders and providing it with a vehicle to recycle much-needed cash for future projects. In fact, Ying Li could be likened to a Chongqing version of CapitaMalls Asia as it intends to retain all its retail space, mostly located in very prime areas along the main pedestrian streets, riding on the growth of consumer spending power as urbanisation continues to plough ahead.

Bright future

While the future does look bright for Ying Li, there are several things investors should watch out for. In the near term, it is essential for the company to achieve its target sales and prices for the IFC project, due to be launched by end-2010. While Ying Li may have all of its funding in place for the IFC project, the company could ideally sell several floors of the building to lessen the strain on its balance sheet. At the moment, meeting its ideal sales targets does not seem to be an issue, judging from the recent sales of a neighbouring project which was able to hit 19,000 yuan per sq m and the fact that the city is in short supply of any new commercial projects. In addition, up to 190,000 sq m of residential and office units from its integrated project at Da Ping are targeted to be sold from H2 2011 onwards in order to fund the capital needs of its other projects.

If this or the IFC project fails to hit the targets, the company's expansion plans could be impeded in the absence of fresh bank loans. And with the central government keeping a close watch on the property market, bank lending restrictions, if imposed, could throw the company's funding plans into disarray. On a brighter note, investors should be well assured by the recent US$200 million bank loan extended in August to Ying Li by Standard Chartered Bank, a top-tier international bank by any standard. Furthermore, Ying Li's pipeline of projects has so far been very well received by the banking establishment, which tends to view owners of prime CBD space more favourably as compared to non-prime and less established developers.

Investors should also note that Ying Li issued a $200 million, five-year convertible bond (CB) with the conversion price set at $0.8029 with a coupon rate of 4 per cent. While the CB issue is set to mature in March 2015, bondholders have a put option whereby they can choose to redeem part or all of the CB in March 2013 at about 108 per cent of the principal amount. It was this very clause that caused many S-chips grief during the recent financial crisis.

Lastly, if there is a massive correction in Chinese property prices, it is almost certain that Ying Li would be a casualty. Though one can argue that it is the coastal regions which suffer from severe asset price inflation, any property crash and the ensuing rush for the exit would almost certainly affect the entire China property market - be it office or residential, coastal or inland. In fact, a severe crash could spark off a domino effect around Asia, where property prices have benefited from strong capital inflows.

So in a nutshell, while Ying Li's future looks promising and could bring fortune to its shareholders, investors would have to be vigilant about the multitude of external factors that could derail its ambitious plans. But if the doomsayers' prophecies about a China property crash do not come about, shareholders of this mid-sized Chongqing developer could very well have boarded a soon-departing train to boom town!

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