Churchouse Letter
August 2009           by Peter Churchouse

“Bubble, Bubble, Toil and Trouble” with apologies to William Shakespeare

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Deflation in the West While Talk of Bubbles Surface in Asia

While western markets are still battling with recessionary forces, struggling banking systems, massive and rising loan defaults, collapsing asset prices, talk in Asia is emerging of asset bubbles. China and Hong Kong are the focus of such talk, and with some reason. China has pumped more than US$1.1 trillion of new loans into the economy in the first six months of the year, not to mention piles of hard cash into infrastructure and other investments. Much of the borrowed money has found its way into stock markets and real estate – surprise, surprise! Transaction volumes in China’s property markets have accelerated sharply, and residential prices which were in retreat in some cities in 2008 have reversed, or at least bottomed.

Developers who, 12 months ago, were suffering dreadfully from slow sales, falling prices, cash flow problems associated with high gearing, have once again charged back into land grabbing mode, using all that lovely cheap money being provided courtesy of government directed banks. From worrying about companies’ cash flows and ability to service existing debts, investors are now turning to figuring what earnings growth is now likely to be. Models are being revised at a rapid clip, from earnings estimates that were looking likely to tank, to now looking likely to grow by 30% plus in many instances.

Most companies are at least hitting sales targets, and many are exceeding their 2009 targets, and with rising prices as well. Margin expansion is back on the cards again – all within the space of a few months.


Noteworthy:
“Ms Lin was among the more than 480,000 investors who opened new brokerage accounts last week” – imagine the logistical implications of opening 480,000 brokerage accounts IN A WEEK!
“At present a total of 129 million accounts are held by retail investors on the Shanghai and Shenzhen stock exchanges” South China Morning Post, 24, July 2009


Across the border in Hong Kong the picture is similar. Hong Kong is well known for its volatile property market. It is a town where real estate can take on the status of a religion, sometimes almost a mania. A town where your taxi driver can often quote the average selling prices of flats in various housing estates accurately to within a few dollars per square foot. Residential prices that fell precipitously in the second half of 2008, by close to 25%, suddenly did one of their about turns in February of this year, putting on around 20% plus up to July. Property transaction volumes that run at around 6,000 – 9,000 per month in “normal” times have leapfrogged to 12,000 to 15,000 per month.

Even in the Lion City of Singapore, property transactions activity has taken off again, though prices have proved a little slower to come off their lows.


Across Asia property sales activity has picked up sharply in the past six months, sometimes doubling, in response to domestic monetary and fiscal stimulus. Easy, cheap money. Property shares have more than reflected this turn of events.


The driver of all of this activity is of course liquidity – coupled with a view that Asian economies are on a recovery path. The punters are buying the domestic demand recovery Kool Aid! And not without some reason. The monetary and fiscal stimulus is working in China. Economic growth looks set to hit close to 8% this year, with many economists now revising forecasts upwards from their targets set earlier in the year. The consumer in China is still spending, and although consumer spending has fallen from its peaks of around 20% to around 15% currently, those levels are still extremely high. Western countries would die for figures one third of these.

Latest numbers from Singapore show equally impressive turnaround in that economy, with latest quarterly GDP running at around 20% on an annualised basis.

The “Bubble” Word is Making a Reappearance.

With all of this activity in asset markets in China, Hong Kong and even Singapore, the “bubble” word is starting to emerge in official circles as well as in markets generally. Officials from the Peoples’ Bank of China (PBOC) have sounded initial warning signals showing concerns that some of the recent lending may be inefficiently used (to coin a euphemism), giving rise to concerns of future none performing loan problems once again – just as the authorities are getting on top of the last cycle of NPL’s. PBOC officials have been quick to assert that these concerns do not signal a tightening of monetary policy. Nevertheless it is almost inconceivable that lending will continue at the same pace as the first half’s clip of Rmb7.4 trillion (approx. US$1.1trn). July’s loan advances slowed sharply to around Rmb500bn it seems, consistent possibly with a full year figure of perhaps around Rmb10 trillion (approx. US$1.47 trn).

So what does it mean for China’s economy and property markets? Here is my read:

  • Despite a slowdown in lending and money supply growth, the lending and investment in infrastructure that has taken place in H1 will be applied to development projects of various kinds in H2, underpinning overall demand in the economy. So no marked slowdown in the economy generally.
  • In addition, China’s exporters are likely to see some benefit from restocking in its core export markets.
  • Lending to home buyers will slow and tightening of lending standards and conditions will become de-rigeur. Other tax and administrative measures to cool property markets may also be re-introduced.
  • Residential property transactions volumes will slow somewhat from H1.
  • The pick-up in residential price appreciation will slow or even stall in some markets in face of tighter lending criteria. Don’t expect a crash in residential prices.
  • Housing production by the larger listed developers will continue to grow based on capital raising that has already taken place in H1, but land acquisition will slow again.
  • Many listed developers are ahead of sales targets by the halfway mark of 2009, and are likely to meet earnings targets for the year given pick-up in volumes, prices and margins so far.

However, the blush of enthusiasm that has given rise to 100% plus rise in China’s developer share prices will fade as slower lending and liquidity conditions become apparent over the coming months. The sector is hardly cheap on an earnings basis relative to its history right now, with average PE ratio for the HK listed China property developers running at 15 times 2009 expected earnings.

In the past month or so some somewhat confusing signals are emerging from some of the bigwigs of China’s monetary rulers.


“Excessive lending and money supply could cause inflation and asset prices may balloon to form bubbles”
– Wu Xiaoling, deputy director, finance committee, People’s Congress, former vice governor of People’s Bank of China. SCMP, 24 July 2009.

People’s Bank of China statement confirms the bank will maintain a “moderately loose monetary policy”, and use “market means” to ensure stability of loan growth rather than administrative “scale controls”.
– Su Ning, vice governor, People’s Bank of China. SCMP, 31 July 2009.


Despite apparent confusion, we should not be in any doubt that bank lending is slowing in the second half. July lending numbers are down by more than half from previous levels, and may be expected to slow even further in the coming months.

With this will come a slowdown in residential mortgage growth and a slowing of sales and purchase activity.

Further weakness in China property stocks can be expected near term. This will provide a cheaper entry point for an industry that is fundamentally likely to see strong earnings growth in the coming year or so, with the sector likely to grow at close to 25 % – 30% in 2010.

Net Profit Growth Forecast for the Major Developers: FY08-09 China 77.8%, Singapore -6.3%, Hong Kong 21%; FY09-10 China 40.3%, Singapore 21.3%, Hong Kong 10.1%

Talking of Bubbles……

Hong Kong’s property markets are in a slightly different place. And it is all about real interest rates, and the pegged currency. Already there is considerable muttering of a bubble developing in Hong Kong property markets.

Definition of what constitutes a bubble is unclear, and is a somewhat emotive term. Often we recognize it after the fact. A bubble can be defined as occurring when prices of an asset are rising to levels that cannot be justified on the basis of economic fundamentals. For property, in my book, that can be when indicators such as affordability get out of whack, and by out of whack, I mean when the indicator is at one or two standard deviations outside the long term “normal” range.

This indicator proved a pretty good guide in the recent property bubbles in USA and UK. In the UK, at the height of the recent bubble, average house prices were running at close to 6 times average household income, compared to a long term average of more like 3.5 – 4 times. In the US, average house price at the recent peak was around 5 times average income, compared with a long term average of around 3.3 – 3.5 times. Low interest rates may justify some ratio above the long term norms, but certainly not to the extent that markets traded to.

Hong Kong Affordability Excellent – no Bubble…….Yet!

In Hong Kong, my affordability index looks at the movement in cost of servicing a mortgage for an entry level apartment at the low end of the market in relation to changes in household income. The numerator here is calculated with reference to movements in flat prices and mortgage rates. (See Figure 2) Mortgage rates in Hong Kong are at all-time lows, and are almost all adjustable rate mortgages. A typical mortgage is around 2.5% (prime rate minus approx 2.5%). In recent months some banks have been providing mortgage finance based on the local Hong Kong interbank rate (HIBOR), which equates to a mortgage rate of around 1% or so. Some 35% – 40% of recent mortgages have been granted on this basis. I suspect that this is a temporary phenomenon. My affordability index uses the more conventional “prime minus” formula.

Despite the big pick-up in prices that has occurred in Hong Kong’s residential markets since the January low (up about 20%+), the affordability index is very much at the “good” end of the scale, and a very long way from even the average over the last 35 years. NO BUBBLE – at least yet! Even if residential prices rise say 20% from here, and interest rates rise by 250 basis points, affordability worsens significantly from the current levels, but is still well within long term normal ranges.

Hong Kong Affordability Index from 1973-2009 (Affordability = Change in Cost of Housing / Change in Household Income)

Hong Kong is Hostage to Fed Policy. Property Prices to Climb 25% – Painting a Reasonable Scenario.

Hong Kong is hostage to the Fed’s monetary policy given its currency peg to the US dollar. Interest rates in Hong Kong cannot diverge far from US rates under the pegged currency regime. This destines Hong Kong to sometimes live with a monetary policy which is out of step with domestic economic fundamentals.

For example, in the early 1990’s, when the US was in recession, recovering from recession, and the Fed was adopting loose monetary policy in face of low inflation, Hong Kong was in the grip of a China export boom, and experiencing inflation rates of 7% – 9% and higher.

Hong Kong Residential Price Index from Jan 94-Aug 09

Hong Kong Real Interest Rate VS Residential Price Index from 1982-2009

REAL interest rates –not NOMINAL rates the key.

This produced a long period of negative real interest rates in Hong Kong and a period of very substantial increases in property prices. A bubble. Our affordability index breached the 1 standard deviation level. Administrative measures were used to rein in the bubble conditions, only for a new bubble to form in the lead-up to the handover to China sovereignty in June of 1997.


Could a Property Bubble Emerge Again in Hong Kong in the coming 1 – 2 years? I believe YES!
Here is the scenario:

  1. China’s economy (and Hong Kong) is likely to have seen bottom already, buoyed to some extent by domestic monetary and fiscal stimulus, strong domestic demand, and likelihood of a pick-up in traded goods sector.
  2. China’s consumer price index is showing signs of picking up, and Hong Kong’s CPI along with it.
  3. The big question is whether Mr. Bernanke and his merry men at the Fed raise interest rates any time soon.
  4. With US unemployment likely to remain at 9% or thereabouts for some time, it seems unlikely that a rise in rates in the US is imminent.
  5. Under this scenario, Hong Kong could experience modestly rising inflation at a time when interest rates will stay low for an extended time, possibly leading to a period of negative real interest rates in Hong Kong.
  6. Under such conditions in the past, Hong Kong’s property markets have gone into overdrive, putting on 20% per annum or more. (See Figure 4).
  7. Hong Kong is currently producing around 12,000 private residential units per year – this is about half of the average annual supply during the 1990’s. Supply is, and likely will remain generally pretty tight.
  8. Hong Kong property remains a destination for newly minted wealth from China, and although perhaps only around 10% of new properties are being sold to Mainland based buyers, this is still significant at the margin.

Under this scenario it would not be inconceivable to see average residential prices pick up around 25% – 30% in the coming year or so. It has happened numerous times before.

Already the head of the Hong Kong Monetary Authority (Hong Kong’s Ben Bernanke – and substantially better paid than “helicopter Ben”!) has used the “B” word with reference to property markets. Given that it was excesses in real estate lending and real estate markets that got the world in the financial pickle it is now in, it will not be surprising to see central and commercial bankers looking very carefully at anything that remotely looks like a bubble in the property asset class in the coming year couple of years.

But markets like Hong Kong and Singapore are far from bubble territory right now. However, another 20% rise in Hong Kong residential prices might see banks starting to take some measures to curtail lending – there are plenty of tools at their disposal to cool markets, not to mention some threatening “guidance” from the central bankers.


On Bubbles and Balloons.
The fate of a bubble is inevitable – it is a fragile entity, that will certainly burst, and disappear. Applied to human endeavour and material assets the bubble analogy may not be a strictly accurate likeness. Perhaps a balloon is the more appropriate analogy. The outcomes are more varied with balloons and man made asset inflations.

  1. One can take a deliberate initiative to prick a balloon, immediate deflation, and we are left hold a tattered, destroyed asset.
  2. One can allow the balloon to continue being blown up until it bursts of its own accord.
  3. One can let the air out of the balloon slowly, perhaps to a point where the balloon is in no risk of bursting of its own pressure – a sustainable end state.

Western policy makers and central bankers seemed to follow option 2 in the recent housing/property led bubbles in their respective markets.



Singapore’s residential markets have enjoyed a similar bounce in property sales transaction both in the second hand and new properties, but an across the board uptick in average prices is much less evident there. Singapore is experiencing a substantial increase in supply of new homes which may also keep a lid on price appreciation to some extent. Hence there is even less reason to expect anti-bubble behaviour by authorities and banks in Singapore in the short term.

Singapore Monthly Residential Sales from Jan 2006-Aug 2009

Hong Kong Monthly Private Residential Sales from Sept 1995-Aug 2009

But where does this leave us on property stocks?

In just about all markets in the region property stocks, and particularly property developers (whose main business is building housing for sale), stock prices have run very hard since market bottoms in the February/March period. China’s property stocks have been the best performers in the region.


We should not be surprised to see a pullback in the higher octane residential developer stocks in the region in the coming few months. Share prices have run ahead of underlying industry fundamentals, but those fundamentals are increasingly sound for the most part.


Hence, I would expect a correction, but not a collapse. Companies generally sport good balance sheets, with prospects of good residential sales on the back of low interest rates and improving economic and job prospects. Bank liquidity is generally good, with low loan to deposit ratios supportive of mortgage lending.

However valuations are reflecting mid, to late cycle valuations for many markets. Although the valuation ranges within individual markets can be wide, stocks are generally trading at the high end of their P/E ranges and in many cases are trading at or above their net assets values (NAV).

The stock markets have to a considerable extent already reflected the increase in values that I think is likely in the coming year or so.

I would not be adding to property developer stocks in HK/China right now. A correction has been happening in China property stocks listed in HK, and I expect one to occur for HK property developers also. In both markets I would consider adding bellweather stocks once a decent correction has taken place – Sun Hung Kai Properties Ltd (16:HK) in HK and China Overseas Land & Investment Ltd (688:HK) in China. For higher beta names, Sino Land Co Ltd (83:HK) and New World Development Ltd (17:HK) in HK and Soho China Ltd (410:HK) and Agile Property Holdings Ltd (3383:HK) in China should offer decent upside.

Hong Kong Office Rentals from March 1984-August 2009

Singapore Office Rentals from 1977-2009

Commercial Property- Negative take-up a reality.

Office markets in the region have been genuinely hit by the global financial tsunami. Previous economic downturns have hit other sectors more (transport, entertainment, tourism, manufacturing, restaurants) but this one has hit the financial sector and all the ancillary service industries that hang off it – legal, accounting, headhunting, advertising. These are all big office space users. Headcount reductions and closures of many businesses has led to a sharp drop in takeup of office space, so much so that net take-up of office space in Hong Kong and Singapore may in fact be negative in the past year.

There is little doubt that the office markets of these two cities could well be defined as bubbles in the 3 – 4 years leading up to mid 2008. Rentals for prime office space in Hong Kong’s Central District rose by about 7 times, and in Singapore by about 4 times. In both instances values hugely exceeded the last cycle peak in the late 1990’s.

Office rentals have come off sharply in most regional markets but particularly in Hong Kong and Singapore. My guess is that they will both bottom out around 50% down from their 2008 highs on average. Also, I suspect they are probably pretty close to a bottom right now. Financial sector companies have stopped firing, and anecdotally at least, some net hiring is taking place again. Space hand-backs have probably pretty much ended. Hong Kong’s office market is fairly tight, with little new supply coming on stream in core office districts, though Singapore’s supply pipeline is a bit more aggressive in the coming 2 years.

The downturn has taken a significant toll on office prices and with it the book values of major holders of commercial space. The past year has seen substantial downward revisions of property values in the accounts of major investment property companies, but earnings downturns have been less sharp given the typical 3 year rental cycle.

Increased risk aversion has pushed capitalisation rates up by 100 – 150 basis points (more in Australia). Our table here (Figure 9) shows the impact of rising capitalization rates along with falling rentals.

Office Property Valuation Matrix - Change in Property Value vs Yierd/Rent Change

For example, assuming a prime office building might have been priced on a cap rate of say 4% at the peak of the market a year or so ago, and cap rates rise by 100bp to 5%, and average rental income falls by 20%, the value of the building falls by around 36%. Although spot rentals may have fallen by more than 20%, average total rental income would likely have fallen much less due to the three year lease terms of most tenants.

The significance of this decline is not simply a decline in NAV of the company and a dent in earnings, but more importantly the impacts for loan covenants of one kind or other.

Possible Breaches to Loan Covenants has Dogged Property Investment Companies.

Falls of this magnitude have raised the spectre of companies breaching loan covenants. This has been less of a problem in HK, though there are one or to instances companies coming a bit close. In Singapore, where gearing does tend to be a bit higher, some companies have been at risk, but have largely been able to raise additional equity capital, sell assets or otherwise reduce the risk of serious problems. Investor concerns of companies breaching loan covenants due to downward property revaluations has been a major factor on the downside movement of share prices of investment property companies (and REITs) in key markets. While the risks are not high for such companies in Hong Kong and Singapore, they have still been a concern.

Japan is an altogether different story, and many medium sized and smaller companies have run into major problems, in some cases leading to bankruptcy. Again, though, larger companies with strong sponsors have been able to avoid these issues very largely.


Size matters, and it is a case sometimes more of who you are, who you know, than what you know in Japan.


As rentals bottom out, and some renewed buying activity is screeping back into markets, we are also seeing cap rates stabilize, and in markets like Hong Kong are coming back down again, with positive impacts for valuations.

I suspect we will see then end of downward revaluations of commercial property by the end of this year in Hong Kong and possibly also Singapore, with Japan to follow not too far behind.

The stage is set for a gradual resumption of a new upcycle in office rentals and prices in these markets in the coming year.

Companies such as HongKong Land Holdings Ltd (HKL:SP), Great Eagle Holdings Ltd (41:HK), and Champion REIT (2778:HK) in Hong Kong, and CapitaCommercial Trust (CCT:SP) in Singapore will be the big beneficiaries of this trend.

China - Shanghai SE Property Subindex from August 2008-2009

Hong Kong - Hang Seng Property Index from August 2008-2009

Singapore - FTSE ST Real Estate Index from August 2008-2009

India - BSE Realty Index from August 2008-2009

Australia - S&P/ASX 200 Property Index from August 2008-2009

New Zealand - NZSX Property Group Index from August 2008-2009

EPRA-NAREIT ASIA Property Index from 2008-2009

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