Churchouse Letter
July 2009               by Peter Churchouse

Asian Market Themes

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Wow, it has certainly been a heck of a ride in global capital markets these past four months or so. Markets have responded powerfully to the greatest liquidity injections to the global economy that the world has ever witnessed. From Washington to Tokyo, London to Beijing, governments and central banks have poured what can only be described as extraordinary amounts of liquidity into the global economy. At least US$3 trillion has been conjured up out of thin air and applied to financial markets. Arthur Laffer’s interesting chart of annual percentage change in US monetary base tells the story (see Asian Wall Street Journal, June 11th 2009). In previous cycles in the US dating back to the early 1960’s, growth of monetary base has never even come close to 20% year on year growth. Money growth is currently sitting at more than 100%!

Laffer Associates Exploding Money Supply

It should not be any great surprise that this huge surge of money into the global system would find its way into financial assets of various kinds, and there have been precious few asset classes that have not risen sharply since market bottoms earlier this year and late last year – bonds, equities, commodities, even real estate in some regions.

While we have all enjoyed the party, after about 18 months of unremitting gloom, the obvious questions must be asked: 1) how long can it last and 2) does this rally really reflect immediate prospects in the global economy, corporate prospects?

The Macro Debate.

The current popular debate seems to go like this:

The Skeptics:

Skeptic 1 – the bond bears. Such massive injections of liquidity must ultimately prove inflationary, and will lead to sharp rises in interest rates. Short long dated bonds.

Skeptic 2 – the economy stupid! A downturn of the magnitude that we are witnessing cannot be over in a 12 month period based on a “V” shaped recovery that markets seem to be pricing in. Genuine recovery will take very much longer, more economic pain to come. Current market rallies are a head-fake, and genuine, lasting recovery is some way away just yet. A “W” is the more likely scenario.

The Believers:

The Bond Bulls – Inflation rising? Nonsense! There is no immediate threat of inflation, and even if there was, central banks and government treasury departments can act to sterilize the excess liquidity that has been pumped into the system through encouraging bond sales (even if it takes tax incentives and other devices to encourage us to buy them). Stay long bonds.

The Cliches – “Green Shoots of recovery” – monetary and fiscal stimulus is working, and the decline in economic output is slowing (has stopped) and growth will resume before the year is out. 2010 will see global earnings recovery, and capacity utilization back up to trend. Load up on equities.

I confess to sitting closer to the Skeptic 2 camp. As investors though, anyone sitting on the sidelines during the kind of rally we have been seeing must be almost as painful as being fully invested as the economic world fell apart a year or so ago.

Our strategy has been to add to our property stocks, but we have not been fully invested for sure. This has allowed us to participate in the liquidity driven buzz to some extent, but not fully. Within our portfolio we have continued to focus on yield based stocks, rather than the high beta property developer names.

Asian Market Themes.

Around the region Asian stock markets and property stocks in particular have enjoyed very robust bounces (Figure 1). A number of themes are touted as accounting for these rallies.

  1. Emerging market economies (particularly the ICI group of India, China and Indonesia) are likely to recover more quickly than the western world and even other emerging markets. Probably a justifiable expectation.
  2. Asian central banks and governments have grasped the stimulus wand with almost as much enthusiasm as their western counterparts. China the most notable example, India a close second.
  3. Stimulus has taken the form of interest rate cuts, huge infrastructure development funding, rapid state orchestrated growth of bank lending, assorted tax breaks and regulatory/policy easing. Again, China has probably been most aggressive on these counts – it can afford it. Bank lending is up a spectacular 175% in the period to end May vs. same period in 2008! India is less financially able to apply such economy boosting policy initiatives.
  4. The Asian consumer is believed to be able to carry local economies forward, and fill the gap left by falling exports. Wishful thinking in my view, but nonetheless a commonly held view. Nevertheless, the Asian consumer is not burdened down with massive amounts of housing debt, credit card debt, auto loans and the like, and hence does have the wherewithal to keep spending. This is clearly helping support local economies.
  5. Politics play a big part; Elections in India went way better than expected, with a huge mandate for the incumbents. China is holding out the olive branch to Taiwan. Indonesian elections look to be possibly following the Indian example.
  6. Asia does not have the exposure to exotic derivatives that are plaguing the western economies.
  7. Asia (perhaps a cynical view!) has not had enough time to get itself into financial hot water following recovery from its own financial meltdown in the late 1990’s.
  8. Asian banks have kept generally in pretty good shape – having been lectured for years by Americans and others from the west on how to manage the banking system, only to see western countries do exactly the opposite of what they sometimes condescendingly advised us in Asia!

Figure 1. EPRA-NAREIT ASIA Property Index
EPRA-NAREIT Asia Property Index 2003-2009

Asian Real Estate Themes – Not Immune from Global Trends, but Underlying Asset Class in Pretty Good Shape.

Readers might remember our earlier work which noted that supply excesses have not been the general pattern in most Asian property markets, with some exceptions. Nevertheless, demand has been an issue, and we have seen virtually every property market trend south in the past year or so, or at least trade sideways at best. In addition, the global risk aversion trend has led to rises in capitalization rates (falling prices) for real estate in most parts of the region.

Big Volume Increases in Past 3-4 months.

With all the stimulus, liquidity, and supposed “green shoots” the past 3-4 months has seen a resounding upturn in volumes of property sales, particularly in the residential sector, in virtually all markets. While we typically expect a bounce in housing markets around Chinese new year (late January/early February) as bonuses get paid, and banks begin their new year’s loan quotas, the bounce this year has been much bigger and more extended than we were expecting.

Property Stocks have Surged, justifiably, but probably too much.

As asset markets generally have surged, property stocks have gone along for the ride also in most markets, and very much so in markets like China, Hong Kong, Singapore, India (see Figures 2-7). Less so in Australia, New Zealand. And with some justification given the improving trading conditions in residential markets in particular in some of these markets.

Figure 2: China – Shanghai SE Property Subindex
China - Shanghai SE Property Subindex 2007-2009
Source: Reuters

Figure 3: Hong Kong – Hang Seng Property Index
Hong Kong - Hang Seng Property Index 2004-2009
Source: Reuters

Figure 4: Singapore – FTSE ST Real Estate Index
Singapore - FTSE ST Real Estate Index 2004-2009
Source: Reuters

Figure 5: India – BSE Realty Index
India - BSE Realty Index 2007-2009
Source: Reuters

Figure 6: Australia – S&P/ASX 200 Property Index
Australia - S&P/ASX 200 Property Index 2003-2009
Source: Bloomberg

Figure 7: New Zealand – NZSX Property Group Index
New Zealand - NZSX Property Group Index 2005-2009
Source: Reuters

Capital raising has come back with a vengeance.

Companies in some markets have been quick to raise capital in the current buoyant market – straight debt, convertibles, rights issues, placements. REITs have worked to lower gearing to avoid breaching debt covenants. Property developers have raised cash to begin land-banking again, particularly in China.

Property prices still soft, but turning.

For the most part, although sales volumes have jumped sharply, prices are still trending down in most markets, or at best flattening out along a bottom. Hong Kong is the notable exception where residential prices have jumped sharply from a January/February low (Figure 8). In parts of China prices have started to come off their downtrend also.

Figure 8: Hong Kong Residential Price Index
Hong Kong Residential Price Index 1994-2009
Source: Centaline

Downward revaluations of portfolios for 2009.

Capitalisation rates rose sharply as the global crisis unfolded, but now seem to be leveling off in most commercial markets. However, 2009 will see continued revaluations to the downside for investment properties, making for reductions in Net Asset Values (NAV) which in turn raises the pressure on loan covenants.

Rentals in most markets are also under downward pressure, and will likely to continue to be so while local economies are weak, and unemployment rising. Investment property companies and REITs will see earnings cuts and dividend cuts for the most part in 2009.

Short List of some Asian REITS Circa July 2009

So What Now? A pullback in Asian property stocks near term prospect.

My base case is that most Asian markets are likely to experience some pullback during the second half of the year – property stocks included. In our sector, stocks have run ahead of underlying property market realities in many instances and are trading on mid cycle earnings expectations, earnings that maybe a couple of years away. Valuations, while not excessive for the most part, are also at mid-cycle levels for most markets in the region. Stocks are suggesting that property markets are all back into recovery mode. That is not the case, particularly for commercial markets where rentals are still in a downtrend for most markets. There is no major market I can point to where office or retail rental trends are to the upside. Yet stocks are suggesting they are. As always, stocks are discounting a recovery in advance of it actually happening.

Residential Markets a Bit Better

On the residential side, however, conditions are slightly better. In many markets, sales volumes are up, prices have bottomed, or even into an uptrend, and developers are back into land acquisition and construction. Many companies have raised additional capital in recent months and balance sheets are a little healthier. Increased volumes have also eased cash flow fears.

NAV’s to Trend Down for Most REITs

For the region’s REITs, commercial property values have probably hit or are close to the bottom of the cycle, and revaluations will likely knock NAV’s down a bit further by year end. Rental income, particularly for office properties, will fall for at least another year or so. Spot rentals in some markets are off about 50% or so from recent highs. Given the typical three year rental cycle, this will take some time to come through in the form of lower income. With better looking balance sheets, it is possible that some REITs may actually get back into acquisition phase in the coming months. Although REIT prices are up from their recent lows, and yields are down, they are still high relative to local bond yields, particularly in Japan, as loan covenant concerns recede.

Thailand – Land of Smiles, Again…..

While most action has been in the larger, more liquid markets for property stocks, we have been taking a look at Thailand. Our trip there this month, which encompassed a great yacht regatta on the magical island of Samui in the southeast of the country, also gave us an opportunity to take stock of some trends in property markets and stocks there.

Thailand’s property markets have been pressed into subjugation by global financial and economic events, but the country also has its own particular issues, both economic but possibly more importantly political.

Politics has Added to Economic Woes.

The political impasse that grips the country is unlikely to go away soon. The scenes of red-shirts and yellow shirts demonstrating sometimes very forcefully in the streets of Bangkok make for great television, but residents of this city of around 10 million will tell you the demonstrations and apparent general mayhem are not terribly visible or evident to people in the city going about their daily lives. Closure of the airport by demonstrators a couple of months ago was a bit of an exception.

While Bangkok is not Tehran, it could be! The country is gripped in a leadership crisis that goes right to the pinnacle of control in that country. There is a lot of hope that Thailand will muddle through in its inimitable way, but foreign investors are right to be concerned about the political environment in the country.

Political conditions at best are a distraction from the core business of running and managing the economy in what is a difficult global economic and financial environment. At worst, such conditions could bubble over into a maelstrom that could drive the economy into the ground, and see foreign investment desert the country.

Foreigners Love Affair with Thailand’s Property Markets.

The country’s property markets are slightly different from many others in Asia. Thailand is a beautiful country that has attracted millions of visitors who delight in what the country has to offer, and deservedly so. I should be counted amongst them, having been a regular visitor to the country for more than 20 years. Foreign involvement in property is greater than in many other Asian nations as a result of the huge flows of foreigners to the country’s islands, beaches, and inland cities.

Large numbers of foreigners find themselves seduced by the country’s tropical paradise islands, unique and friendly culture, wonderful food (not to mention other attractions….). In the midst of a European winter, the Islands of Phuket and Samui can seem like a veritable heaven!

I know we have all done it – gone on holiday (Dordogne, Provence, Tuscany, Majorca, Sardinia, even England’s west country) and quietly imagined ourselves buying into this wonderful little part of the planet, perhaps a retirement place, and perhaps justifying it with “well the kids will enjoy it”. Thailand has done this, in spades. Locations such as Phuket, Samui, Hua Hin, Pattaya, and even Bangkok have been a magnet for foreign buyers of seductive, usually high end real estate – buying that dream.

Foreign buying has been a significant factor in the revenues of many companies. That is clearly in the doldrums right now.

Driving around Samui, one cannot help but be struck by how much real estate targeted at foreigners is for sale, and how much is still in the construction stages. The same is true for Phuket. Do some digging and the potential buyer is likely to unearth some very eager sellers in these markets. But given that most foreigners buyers do not (cannot) fund their property with debt, the levels of distress in this market are not as great as one might expect. For developers, who do have significant debt in many instances, that may be a very different story.

Toursim is a very big earner for the Thai economy, but is clearly in big trouble right now. Hotel occupancies are very low – around 20% to 30% for a great many. One major 5 star establishment in Bangkok, well known to seasoned travelers, admits to having only 2% bookings for its normally peak season of Christmas/New Year, against a booking list normally of at least 50% by this time.

My wife and I stayed this time (again…) at a delightful little boutique hotel in Bangkok, Ariyasom Villas. Owned and run by an affable Brit, David Lee and his lovely Thai wife, this little 25 room hotel is a gem. The core of the development is an old family house built in the 1940’s by the family patriarch and the recent development has added to this in total keeping with the vernacular architecture. David is no stranger to the business, having been General Manger to that hallowed institution, the Hong Kong Club in the 1980’s and involved with various hotel groups in Thailand for many years.

The point here is that these and many other very good hotels are struggling for business at present. Not only are Thailand’s property and tourism markets having to deal with the fallout of the global economic crisis, but the country is shooting itself in the foot in a big way with its political mess. Scenes of riots and demonstration, closed airports, provide what tourists there are out there, with another reason not to go spend their money in Thailand.

Dire politics have a positive side for certain types of property.

The dire politics however, are something of a positive factor strangely enough for certain types of companies. In the tussle for the hearts and minds of the working people, policies are crafted to win support for the fighting factions. A policy environment that encourages, and makes it easy for families to buy their own homes is a real vote winner. And the politicos in Bangkok have not been shy in recognizing this, with baskets of policy measures to allow greater access to lower cost housing for the masses. Housing as the opiate for the masses!

Housing with a sticker of say Bt1 million to Bt 1.5 million (roughly US$30,000 to $45,000), finds a ready market. Particularly if it is located near to Bangkok’s rapid transit stations. The city’s traffic is diabolical, making access to public transport nodes that can get one to work quickly and cheaply a definite plus in the property markets. Banks are providing ready finance for middle income families, and interest rates are low.

There are a couple of listed companies that specialize in lower end housing in Bangkok.

Preuksa (BBG: PS TB) and LPN Development (BBG: LPN TB).
Preuksa is a “street fighter” of a company – a real “roll -the-sleeves-up-and-get-stuck-in” kind of company. The company is extremely cost conscious and has developed building and construction systems that allow it to deliver product cheaply and quickly. (Figures 9 & 10)

Figure 9: Preuksa
Preuksa stock price 2006-2009

Figure 10: LPN Development
LPN Development stock 2006-2009
Source Reuters

Land and Houses (BBG: LH TB) is the gorilla in the Thai listed property camp. Its core focus however is higher up the price bracket, with its average product selling for more like Bt3.5 million per unit – around US$100,000. Its developments tend to be more landed properties as semi detached and detached houses. As such, its developments tend to be more suburban than core inner city, and it is probably fair to say that the company’s sales may have suffered a little in recent times due to being less access friendly, and at the upper end of the market. Margins in this sector have tended to be a little better however (Figure 11).

Figure 11: Land and Houses
Thailand Land and Houses stock 2006-2009
Source Reuters

China – Full steam ahead!

It was not much more than 18 months ago that China was in the grip of a tightening cycle that was desperately trying to slow the pace of fixed asset investment in the country, rampant bank lending and a rollicking property market. Every couple of days saw new policy measures, directives, exhortations aimed at curbing a runaway property market. While the policy measure took a long time to have a major effect, the global economic slowdown took its toll very quickly.

For the past 9 months, the policy makers have been frantically reversing a great many of the tightening measures that were installed in 2007 and even early 2008.

Most notably China has seen a massive surge of state directed bank lending.

And as could be expected with such an avalanche of credit, asset markets, including property markets have benefitted significantly. Transactions volumes have picked up, companies have been able to roll over existing bank debt, take on new debt, and consumers have found it easier to get that mortgage finance. Land sales have surged again, and building starts are back on the uptrend again.

Asset prices have surged in the face of this wall of liquidity. China’s stock market is up 81% year to date, the best performing major market globally (Figure 12).

China property stocks listed in Hong Kong are up approximately 130% year to date on average. Companies are reporting strong sales (a big change from last year), ahead of target in many instances, with improving average sales prices in some cases. Earnings for 2009 are being revised upwards, following aggressive downgrades in 2008.

Many companies have taken the opportunity to raise additional capital (debt or equity), and fears of credit related problems in the sector have largely receded. Companies are back on the land acquisition trail again, and thoughts are now turning to an extended period of earnings growth.

But can it all continue?

Quite frankly, I am somewhat skeptical that the current pace of lending in China, a factor that has certainly played well to the property sector, can continue. Bank lending in the first six months has significantly exceeded quotas for the entire year.

While we probably will not see an overt tightening of policy, lending will probably slow sharply from recent levels. This may well dull enthusiasm in the sector generally.

I expect volumes of transactions to slow somewhat in the second half, and property values may trade sideways. The market is not currently reflecting such an expectation.

Figure 12: Shanghai SE A Share Index
Shanghai SE A Share Index 2004-2009
Source: Reuters

Figure 13: Beijing Residential Index
Beijing Residential Index 1995-2009
Figure 14: Beijing Office Index
Beijing Office Index 1995-2009
Source: DTZ

Property Stocks not cheap, but big growth is back in the picture

China property stocks listed in Hong Kong are not now cheap, with average 2009 PE ratio around 14 times, and many trading close to, or even at a premium to Net Asset Value (NAV). A pull back in the third quarter is a distinct possibility, and should provide another entry point to the sector. Even in the good days of 2005, before the current global problems, the sector traded as a whole at single digit multiples.

China Overseas Land (0688.HK) with a market capitalization of around US$18 billion is the giant in the pack, and one of the largest property companies in the world. It has a solid longer term track record, with a massive portfolio of development in many parts of China. At around 22X 2009 estimated earnings, it is at the high end of the pricing range, and has always been so. (Figure 15)

Figure 15: China Overseas Land
China Overseas Land stock price from 2006-2009
Source: Reuters

SOHO China (0410.HK) is a relative newcomer to the listed market, and currently sports one of the lowest gearing ratios in the sector. The company focuses largely on inner city development in Beijing and should see a sharp earnings acceleration this year that gives it a 2009 PE of around 11.5X, at the low end of the sector. (Figure 16)

Figure 16: SOHO China
SOHO China stock price from 2008-2009
Source Reuters

Hong Kong. What a Bounce! Gotta cool a bit from here.

Average residential property prices fell by around 24% in the second half of 2008, from a level that was still about 25% lower than the 1997 peak experienced around the time of the handover to China sovereignty (Figure 8). But since around February, prices have rebounded by around 20% again to now stand just a little shy of the mid 2008 peak. This is one of the sharpest rebounds I have seen in my 29 years in Hong Kong where the market has been through 6 significant down-cycles in that time. (see Figure 17)

Figure 17: Hong Kong Residential Index
Hong Kong Residential Index circa 2009
Source: Jones Lang LaSalle

A number of factors can be identified as contributing to this state of affairs: Interest rates have fallen even lower than previously, and it is possible to secure a mortgage at around 2.5% (floating not fixed), and one can now get a HIBOR (Hong Kong Interbank Offered Rate) based mortgage which runs to a little over 1%. Hong Kong banks are flush with deposits, and no one wanting to borrow – loan to deposit ratios have been routinely below 60%. Hong Kong households are famously cash rich, with low consumer debt. Housing supply is tight, with new home production running at less than 50% of the average production during the 1990’s. The city has certainly benefited in some ways from the massive surge of liquidity and lending in the Chinese economy.

Rising unemployment (now about 5.5%) and an economy that will show negative growth of about 5% this year are the key negative forces out there.

The Hang Seng Property sub Index has rebounded 73% or so from its March 9th low. Property stocks are now in Goldilocks land – not too cheap, but not overly expensive. Average 2009 P/E is around 14X, about in line with longer term averages, and average discount to NAV standing at around 20%, hardly making stocks overly expensive.

Interestingly, even though it is the residential sector that has rebounded so obviously, and so strongly, there is not a lot of difference in the performance of the residential developers compared to the office/retail property focused investment property companies.

I am inclined to focus a little more on the latter right now – that is where more good news at the margin is likely in the coming months. Office vacancy rates at around 7% are probably close to a peak, and vacated space seems to be filling more quickly than one might have thought given the current economic climate. Office and retail rentals are probably now close to a trough from their bubble levels of about 15 months ago (Figure 18). Because of the typical three year rent renewal cycle, the current downturn in spot rentals takes a couple of years to reflect in gross revenues and earnings/distributions. My guess is that the shares will reflect trends in the spot markets for rentals as they recover.

Figure 18: Hong Kong Office Index
Hong Kong Office Index from 1984-2009
Source: Jones Lang LaSalle

Champion REIT (2778.HK), although not a pure office play looks cheap, with considerable upside potential as commercial office markets recover. At the current price should produce a dividend yield of around 9% in the current year. (Figure 19)

Figure 19: Champion REIT
Champion REIT stock price from 2006-2009
Source: Reuters

Prosperity REIT (808.HK) – sponsored by Hong Kong’s favourite tycoon, Li Ka Shing, is also cheap, but with a less than prime portfolio. A yield of around 10% in prospect is not to be sneezed at. (Figure 20)

Figure 20: Prosperity REIT
Prosperity REIT stock price from 2006-2009
Source: Reuters

Hong Kong Land (HKLD.SI) is the quintessential office Grade “A” office play in Hong Kong. It has long dominated the Central Business District office market – less so these days – with a well managed portfolio of prime office and retail properties. The stock has rallied along with others in the sector, but as the economy recovers, and the financial sector stabilizes, and bad news flow on jobs/vacancies/rentals ebbs, I expect HK Land shares can move back towards their recent highs again.

The Jardine parent saw fit to move all the group’s listing domiciles to Singapore in the early 1990’s, a move that saw trading in the company’s shares fall dramatically. (Figure 21)

Figure 21: Hong Kong Land
Hong Kong Land stock price from 2006-2009
Source: Reuters

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