Most Hongkongers are aware there is an acute concentration of economic power in the hands of a few families in their home city. But in the 1960s – before the rise of the likes of Li Ka-shing’s Cheung Kong and the Kwok’s Sun Hung Kai – the man known as “the godfather of real estate” was Henry Fok Ying-tung.
Having made his first fortune getting supplies into China during the Korean War, the businessman made a new name for himself with financial innovation: Fok was the first man to sell apartments before they were finished, allowing buyers to pay by instalments.
These ‘presale’ arrangements turned out to be an efficient way of turning over capital in a city that needed more housing for a rapidly growing population.
The real estate market took off and Fok’s biography claims he controlled close to 70% of Hong Kong’s residential market at one point.
He began to retreat from Hong Kong’s real estate after 1967, when the city was roiled in anti-colonial riots. But the presale system that Fok pioneered laid the foundations for some of the world’s biggest real estate conglomerates and in 1995 the same practice was officially approved by China’s lawmakers to help jumpstart its fledgling market in private housing.
More recently the concept has come into question, however. In news that surprised the market last month, the Chinese government indicated that it was reconsidering the merits of presales and that it might ban them.
What’s brought this about?
It’s not an entirely new debate. The National Development and Reform Commission (NDRC) published a research paper as long ago as 2007 advising against the sale of off-plan properties. A group of lawmakers from Guangdong also called publicly for presales to be scrapped in 2005, on the tenth anniversary of their introduction in China.
But when the news filtered through on September 21 that the housing ministry was rethinking the presale rules, it soon spooked the market. The shares of nearly all property firms fell. Country Garden, a Guangdong-based developer with a business based on maximising cashflows from presales (see WiC416), dropped more than 6% in a single trading session.
Guangdong was the first province to feel the impact of the news after the Guangzhou Daily reported that a state-backed industry body and the provincial government were collecting feedback on how to reform presales.
Citing housing ministry documents from late September, Reuters reported that five other provinces – Hubei, Sichuan, Jiangsu, Henan and Liaoning – have been instructed to reconsider a system that provides vital financing to many developers.
The local housing bureaus in these provinces should conduct a detailed study of the existing set-up, the ministry said, setting out their reasons on what to do next.
There seemed to be a steer in the instructions, too. “If the advice is that presale permits should be maintained, or that the requirements for presale permits need to be raised, thorough arguments supporting [the system’s] legitimacy and necessity should be given,” the document said.
The housing ministry later clarified that there is no immediate plan to impose any changes. But the consultation exercise has shown that a policy shift is now firmly on agenda, the Hong Kong Economic Journal reckons.
How does the system work?
Developers can start selling the unfinished units of residential projects once they obtain the appropriate permit from the local authority. This is a nationwide policy although practices vary across different localities.
According to 21CN Business Herald, developers are typically required to erect the foundations of a new building or as much as a third of each residential block before they can apply to sell units in it.
In regions where the local government is keener to attract investment, real estate bosses can get permits more immediately, however, sometimes simply by presenting a construction plan.
Homebuyers are effectively investing in an option that’s exchangeable into an apartment after construction is completed. They are left with fairly material risk, most notably if the developer can’t finish construction (although this financial exposure is often shared with bank lenders through mortgage financing).
Developers then deploy the presale proceeds as working capital for the remaining construction work: useful in cases in which the real estate firms may be new to the sector or short of capital – such as with Hong Kong in the 1950s and mainland China 50 years later.
Tighter rules on how (and if) presale is permitted will hurt the bottom line by increasing interest expenses for the real estate firms, which typically pay at least 6% interest a year for loans.
However, after more than two decades of rapid development, the Chinese real estate market has grown to such a size that policy planners are rethinking whether this financing tool is still needed.
Gunning for Guangdong…
According to information from the housing ministry, Chinese developers had already raised Rmb3.5 trillion ($509.5 billion) from preselling apartments in the first eight months of the year, a 15% increase from the same period last year.
Such strong growth has been underpinned by much faster expansion from some of the Guangdong-based developers.
Most of the top property tycoons in Hong Kong originally hailed from Guangdong and these shared roots help them to ally with one another to compete with the previously dominant British business interests in the colony in the 1970s (see WiC342). Rather coincidentally, some of the fastest-growing property firms in mainland China are also based in Guangdong. The largest three – Evergrande, Vanke and Country Garden – are all headquartered in the southern province.
The trio led nationally in residential sales last year, each selling more than Rmb500 billion of homes.
Tianjin-based Sunac, which more than doubled its own revenues last year, came in at fourth place with Rmb360 billion.
The bulk of the business from these heavyweights comes from contracts for uncompleted units. We reported earlier this year how Country Garden is the leading light in mastering presales in smaller cities, for instance, rolling out projects, preselling them quickly and then moving on to grow its land bank further. The business model has paid off, at least in the short run. Annual contracted sales at Country Garden grew more than tenfold from Rmb43 billion in 2010 to Rmb551 billion last year.
However, growth at this kind of pace often means a highly leveraged business and the largest developers have needed to sell shares or raise debt almost every year.
Again Country Garden is a telling example. It had more than Rmb1,000 billion in total assets by the end of 2017 but it is sitting on Rmb933 billion in liabilities (gearing of nearly 90%). As a consequence, it needs sentiment in the property sector to stay bullish. A sharp or prolonged correction in home prices would lead to a dwindling in buying, putting pressure on its capacity to repay its debts.
Presales on steroids?
The fundamental problem for the property market, according to the China Times, is that some of the developers have grown to such a size that they are now ‘too big to fail’. Many are overly dependent on the presales model too.
Selling off-plan properties is a common practice elsewhere in the world. But China also stands out in the way that homebuyers need to pay much higher amounts upfront, more often than not financed by bank mortgages.
Because the largest developers are getting bigger by growing their businesses in this way, they will start to pose a systemic risk to the banking sector as a result of all this mortgage financing, the China Times predicts.
Thus the current policy consultation process aligns with directives from the central government to deleverage the financial system.
Moreover, the rights of homebuyers are coming more into consideration by policymakers. Apart from a major correction in real estate prices, one of the biggest risks for homebuyers is that they buy an apartment that isn’t finished on time or to the standard that the developer has promised.
According to 21CN Business Herald, the residential market has been plagued by a slew of “quality issues”.
“A potential switch to selling completed apartments will pressure developers to improve the quality of their building works,” it suggests.
A rising number of construction accidents (as developers rush to finish apartment blocks) is another key reason why the housing ministry wants to tighten the presale rules, the newspaper says.
Following a series of construction deaths this year, Country Garden said in a press conference in August that it would strengthen its safety controls (see WiC420). Previously taking pride in needing less than 10 months to get a residential project to breakeven, the company has also indicated that it would slow down the pace of its expansion.
What’s likely to change?
Some local government have already taken steps to curb presales. In 2016, Shenzhen sold a parcel of residential land with a special clause in the contract that stipulated that only completed units could be sold.
Zhongshan and Jiangmen, two more cities in Guangdong, have been trialling similar arrangements since June on a project-by-project basis.
Time Weekly, a Guangdong-based newspaper, thinks that it is premature to predict that the province will ban presales outright, but it sees the market gradually transitioning to a situation in which properties have to be finished before they can be sold.
Cracking down on presales would also chime with one of Chinese leader Xi Jinping’s policy commands last year that “homes are not for speculation”, Bloomberg has reported.
“Now is the time to start wide trials to cancel presales, or at least to establish new rules putting buyer funds in trust,” Chen Jie, a professor at the Shanghai University of Finance and Economics, told the news agency.
“Buyers’ money should no longer be used as ammunition for developers to buy pricey land and expand in full swing.”
Recognising the policy headwinds, some of the leading developers are rethinking their growth plans. Vanke had targeted sales of Rmb630 billion this year but it admitted last month that it has completed less than half of that figure so far.
But in the meantime, the real estate sector is hoping that there won’t be too much upheaval in their business models. After all, the housing ministry has already scotched the speculation that presales could disappear overnight, noting that any changes would need to be approved by the National Peoples’ Congress first.
Current projects are likely to be grandfathered when the new rules start to apply as well, protecting developers for the foreseeable future.
All the same, the largest developers will want more certainty on how the rules could be changing, especially when the industry is facing a record $23 billion in loan maturities in the first quarter of next year. The authorities have also been slowing approvals for new bond sales from developers and trying to restrict borrowing from shadow banks.
Both the deleveraging process and the scrapping of presales could spur a shake-up in the property industry too. “The introduction of such a new rule will hurt small and medium-sized developers more, especially those with less financial resources, leading to another round of industry consolidation,” the Hong Kong Economic Journal has predicted.
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