24 November 2008 Property : Is the property market resilient?

December 1, 2008 at 8:09 am Leave a comment

Is the property market resilient?

• Looking for light at the end of the tunnel.
We recently hosted a property talk with an overwhelming turnout of more than 100 participants comprising mainly of fund managers. We invited property consultants from Regroup Associates as speakers to shed some light on whether the Malaysian property market is resilient enough to ride out the economic downturn.
• Not as bad as the Asian financial crisis.
We came away from the talk with reinforced belief that the current property down cycle is not as bad as the Asian financial crisis. We are more inclined to see a moderate property downturn similar to the dot-com
bust days in 2001. Although over-supply is evident in varying degrees in various sub-segments of the property market, indications are that the market is fairly resilient. With the exception of luxury condominiums, correction of capital values and rental of properties should be moderate.
• Property stocks passed our “crash” test.
We carried out a “crash” test and noted the following: (1) risk of declining sales is moderate and not likely to crash, especially residential properties, (2) further risk of margin erosion is minimal as building materials prices have stabilised, (3) developers are in better financial position now as leverage is half that of the 1998 Asian financial crisis, and (4) property stocks are already trading at “mini” distressed valuation last seen in 2001.
• Upgrade to NEUTRAL.
We are upgrading our call on the property sector from underweight to neutral. Although there may be more negative news in the near term, we believe most of the bad news has already been priced in. This is premised
on our belief that the current property downturn will not fall into a crash mode like the 1998 Asian financial crisis. We believe fundamentals of the economy and property market are stronger now and the current downturn should be more moderate.
More importantly, after seeing prices of property counters falling by 50% to 70% YTD, the downside risk is limited as property stocks under coverage are already trading at distressed valuation similar to the “mini
property downcycle” in 2001. However, the change in our stance is more of turning less bearish than turning bullish, as property stocks will still operate under challenging environment over the next 6 – 12 months.
Sunway City is our top pick for the sector as it has lower risks among stocks under coverage due to its more resilient earnings from property investment as well as its undemanding valuation which has more than
priced in the negatives.

Residential Market Outlook

Bubbles in luxury condominium and serviced apartment?
For the residential market, the speakers focused on the luxury condominium and serviced apartments (priced > RM350 psf) in Klang Valley which have seen lots of activities before the downturn sets in. Over the past 2 years, developers have launched massive numbers of luxury condominiums and serviced apartments as demand picked up considerably which coincides with the relaxation of Foreign Investment Committee guidelines for purchase of residential properties by foreigners (Dec 2006) and waiver of real property gain tax (Apr 2007). Besides demand by local and foreign individuals, en bloc sales to institutional investors was also the order of the day. The rise in capital values was astounding and has gone far ahead of rental growth.
Luxury condominiums and serviced apartments in city centre (particularly KLCC) seem to be most at risk of a bubble where future supply of 8,164 units dwarfed the current supply of 6,383 units. Besides competing with one another, developers also face competition from newly completed units in the secondary market. Sales rate has seen noticeable decline since June 2008.
A quick scan of properties for sale in the newspaper revealed that secondary prices of luxury condominiums in KLCC have fallen by 15% to 30% over the past 6 months.
The over-supply situation is further compounded by the lack of fundamentals on the demand side as it is more speculative and difficult to predict, unlike the landed residential properties which are mainly owner-occupied.

Developers may still make profit with lower selling price
While the over-supply situation is quite a concern, developers of luxury condominiums and serviced apartments may still be able to make a profit with a lower selling price. This is provided the land cost is not “too expensive”.

Massive supply coming on-stream
Klang Valley’s office market has had a few good years due to restriction on the construction of new office buildings in Kuala Lumpur by the City Hall after the Asian financial crisis. Back then, a 6-year building frenzy had seen supply doubled in 1999. Over the next 9 years, the over-supply situation was slowly and steadily absorbed by the market. Whilst there is no absolute shortage of office space in Klang Valley, poor maintenance of existing buildings and restriction on new office building have resulted in a supply-demand mismatch for new and/or better maintained office space. This has resulted in rising rental and capital values
for new and/or better maintained grade A office. Capitalising on these favourable conditions as well as the easing of building restriction by the City Hall, many developers jumped onto the bandwagon of developing office buildings. This has resulted in massive supply of new office space coming on-stream until 2012 which is equivalent to about 41% of existing supply. Although this number is staggering, it is still no way near the level of over-supply in the 90s when additional space added between 1994 to 1999 was equivalent to a 106% of supply in 1993!.

Is the party over?
The services sector (particularly financial institutions and oil & gas service providers) continued to drive demand for grade A office space in prime locations. As demand continues to outstrip tight supply of grade A office space in the near term, rental and occupancy rates have been rising steadily. This has attracted numerous investments in office buildings by institutional investors, particularly real estate investment trusts. Capital values have also been rising and touched a new record in 2007 when Glomac sold Menara
Glomac, a grade A office under construction, for RM1,120 psf.
The onset of a global economic slowdown, tightening credit environment as well as massive supply coming on-stream may put pressure on rental as well as capital values. In fact, capital values may have peaked as recent activities indicate some “softness” and resistance to breach last year’s record of RM1,120 psf. 2009 will be the crunch year as an anticipated 8m sq ft of new office space will be completed.

May not be as bad as the Asian financial crisis
While dark clouds are looming over the prospect of office market, we believe it may not be as bad as during the Asian financial crisis when rental plummeted and abandonment of office buildings under construction were widespread. Here’s why:

  • Although building plans may have been procured, developers are cautious in launching as most will only commence construction upon securing en bloc sales. In the event of a worse than anticipated economic downturn, some of these planned launches, which will be completed in 2011 and beyond, will be deferred. This may potentially trimmed 11.9m sq ft out of future supply of 28.2m sq ft.
  • Office occupancy cost in Kuala Lumpur is among the lowest in the region and over the past 12 months, the rise in rental has been quite measured as compared to other cities in region which may face the risk of a bubble.

Klang Valley’s retail space is saturated with current supply at 38.2m sq ft in 114 centres which is equivalent to 6.58 sq ft per capita. Over the years, the retail market has hit several saturation points. The first occurred in 1998/1999 when Suria KLCC and Mid Valley were completed, while the second occurred in 2003/2004 when One Utama (phase 2) and The Curve were completed. The most recent saturation point happened last year when Pavilion, Gardens Mid Valley, Sunway Pyramid new wing and Aeon Bukit Tinggi added a combined
3.5m sq ft of retail space to the market.
924,000 sq ft new retail space is expected to come on-stream in 2008 which is moderate.
However, the numbers in 2010/2011 is higher at 4.3m sq ft if developers continue to launch according to their plan.
Overall retail sales growth in 2007 was 7% but is expected to ease to 5% – 6% in 2008. In view of the global economic downturn, Malaysian Retail Association has recently revised its projected retail sales growth for 2009 downwards from 8% to 5%.

Retail centres are not created equal
Although the overall view of the retail market in Klang Valley is gloomy, retail centres are not homogeneous products and they are not created equal. Many other factors besides just location and demographics determine the success or failure of a particular retail centre. Out of the existing 114 centres, there are only about 20 “good ones” while another 10 are considered “average” by Regroup Associates.
Retail centres in the city seem to be more saturated with average occupancy at 88.8% as compared to 96.1% in the suburbs. Furthermore, certain suburbs such as Setapak and Cheras continued to be under-served.
On the bright side, the recent entry of institutional investors as owners of retail centres will improve the quality of the retail market in the long run as they bring in expertise in the management of a modern retail centre.

Expect correction but crash will be averted
Amid saturated supply and expected declining retail sales growth, retail occupancy rate is expected to drop going forward. No crash in rentals and capital values is expected, although yield is expected to rise going forward. Polarisation will likely to happen with better centres taking more market share.

Crash Testing
The property market is in a downturn, that’s a fact. The question is whether this down cycle is going to be a crash (like the Asian financial crisis in 1998) or just a moderate correction (like the dot-com bust year in 2001)? The answer to this question will provide us guidance on sales expectation going forward. Next, we also need to determine whether there is further downside risk to margin erosion as well as the financing risk of developers. We attempt to find the answers through some “crash test” as follows.

Is 2008 worse than the Asian financial crisis?
We examined past property bust cycles in order to gauge how severe the current downcycle going to be. Over the last 10 years, the property market has experienced a sharp downturn in 1998 and 2 minor corrections in 2001/2002 and 2005. In 1998, the country was severely impacted by the Asian financial crisis. The residential property market contracted by 35% and it took another 2 years before transaction volume
recovered to the level seen before the crisis. The commercial property market was more severely impacted as it contracted by 44% in 1998 and did not recover until 6 years later in 2004.
In 2001, the U.S. experienced an economic slowdown as a result of the dot-com bust. The Malaysian economy was not spared as it also went into a downturn. This was followed by the September 11 terrorist attack on U.S. soil and the outbreak of severe acute respiratory syndrome (SARS) in Asia in 2002. The property market went into a phase of correction with flattish growth but averted a crash.
In 2005, the Malaysian economy as well as the property sector suffered another minor blip as the government tightened its purse string to reduce budget deficits. Similar to 2001, property sales growth also declined but averted a crash.
Following a strong growth in 2007, the property market is showing signs of slowdown in 2008. Looming global economic slowdown and high inflationary pressure have dented consumer confidence as well as eroded household disposable income. After peaking in October 2007, housing loan growth is now on a downtrend.
Amid all the talk of doom and gloom, it is easy to assume that the property market is on course to crash like it did during the Asian financial crisis. However, the fundamentals of the property market in 2008 are much stronger as compared to 1998. The property crash in 1998 was accentuated by credit tightening, high interest rate, widespread mortgage defaults and foreclosure of properties. On the other hand, there is ample liquidity in the domestic banking system now as the domestic financial system has remained largely intact and pretty much shielded from the global financial crisis. Average lending rate is also at an all time low
right now at 5.96%. Although inflation is still a major concern, crude oil prices have corrected significantly since hitting more than US$140 per barrel in July. Going forward, we expect inflationary pressure to ease. As such, we believe the property market unlikely to crash like it did in 1998. Commercial properties seem to be at higher risk due to large new supply coming on-stream. On the other hand, residential properties are quite resilient as demand is underpinned by urban migration and population growth. Furthermore, residential
properties are largely owner-occupied which are less speculative. However, high-end condominiums in Kuala Lumpur which are not supported by fundamental demand are at risk of a sharper correction.

Risk of declining sales is real but moderate
There has been a massive selldown of property stocks since the beginning of 2008 as investors were spooked by concern over declining property sales and margin erosion amid political uncertainty and deteriorating global economic outlook. KLSE property index has fallen sharply by 49.7% YTD. Question is given our expectation that there will not be a crash like the 1998 Asian financial crisis, has the risk of declining property sales been priced in at current levels?
To assess the risk of declining property sales of stocks under coverage, we examine the “quality” of their revenue source. Here’s what we noted: (1) 43% of Sunway City’s revenue come from recurring sources such as property investment income while other companies rely almost entirely on property development, and (2) significant proportion of Sunrise, YNH Property and Glomac future projects are commercial developments where demand may be in doubt given the current economic conditions.
As demand for properties wane during a downturn, we like counter such as Sunway City which has significant recurring property investment earnings to cushion declining property development earnings. However, we believe demand for residential properties to be more sustainable and based on 1998’s experience, recovery of this segment is faster as compared to commercial properties. As such, we are of the view that developers with large residential landbank in diversified locations such as SP Setia will be least affected. Developers with large landbank at cheap land costs will have more flexibility in modifying their planned launches to cater to current demand during a downturn. On the whole, we are inclined to think that sales volume of residential properties will not fall by more than 35% while commercial properties will experienced a sharper fall in volume.

Further risk of margin erosion is minimal
Property developers have been facing margin erosion due to unprecedented price hike of building materials over the past 12 – 18 months, in particular diesel and steel bars. Construction costs have, on average, increased by 20% – 30% over the past 12 – 18 months. As developers have already pre-sold their properties ahead of the commencement of construction, margins have been on a downtrend.
Although still a concern, we believe further downside risk to developers’ margin is minimal. Based on our analysis, property developers which typically have EBIT margins of 20% to 35% will still generate positive EBIT after taking into account 20% – 30% increase in construction costs. Most importantly, developers’ margin seems to have fallen close to the bottom levels we anticipated.
Further downside risk to margin is also mitigated by significant drop in steel bar and diesel prices as commodities prices fall on the back of a global economic downturn. However, we do not anticipate margin to recover swiftly to previous levels as only steel bar and diesel prices have adjusted downwards while prices of other building materials such as cement, aggregates, sand etc remained unchanged. In addition, developers may also face buyers’ resistance from higher pricing to cover higher construction costs.

Developers are not highly leveraged
Property developers are in better financial position now to withstand a downturn. This is due to lower leverage now as developers exercised more financial prudence since the Asian financial crisis. Average net debt/equity ratio of developers now is around 28.1% which is half of the 58.4% level seen in 1998. Among property stocks under coverage, SP Setia has the lowest gearing at 16.5% while YNH Property has the lowest absolute level of net debt at RM212.8m.

Stocks already trading at distressed valuation in 2001
We compare the current P/E and P/BV valuations of stocks under coverage with the levels seen during the Asian financial crisis in 1998, the dot-com bust in 2001 as well as respective historical averages. We noted that, in general, current valuations of stocks under coverage are below their historical averages. Against valuations during past property downturns, these stocks are currently trading at similar valuations to 2001 but still higher than 1998. SP Setia, which currently trades above 2001 level but marginally below its
historical average, is considered high risk from a relative valuation standpoint.
However, if the property market is to crash like it did in 1998, all stocks under coverage will fall by at least 50% based on relative valuation.

What’s the worst case scenario?
Although property stocks under coverage are already trading at distressed valuation based on our existing or base case earnings estimate, would the valuation holds if earnings fall below our expectations? We carried out a “crash” test on our earnings estimates and noted that Sunrise, Sunway City and Glomac are trading below distressed P/E valuation in 2001 even with our “worst case scenario” for their earnings prospect in FY2009. However, SP Setia and YNH Property do not fare that well as both companies will trade just marginally lower than their respective historical average P/E but higher than distressed P/E in 2001.

Upgrade to NEUTRAL
We are upgrading our call on the property sector from underweight to neutral. Although there may be more negative news in the near term, we believe most of the bad news has already been priced in. This is premised on our belief that the current property downturn will not fall into a crash mode like the 1998 Asian financial crisis. We believe fundamentals of the economy and property market are stronger than 1998 and the current property market downturn should be more moderate. We further concur with Regroup Associates’ view that
the property market shows some signs of resilience, except for high-end condominiums which faces risk of oversupply. Correction of capital values and rentals of properties should, in general, be moderate.
More importantly, after seeing prices of property counters falling by 50% to 70% YTD, the downside risk is limited as property stocks under coverage are already trading at distressed valuation level in 2001. However, the change in our stance is more of turning less bearish than turning bullish, as property stocks will still operate under challenging environment over the next 6 – 12 months. We will be keeping tab of activities on the ground very closely for signs of further deterioration or improvement in the months to come.
Going into stocks specifics, based on our “crash” tests, we have tabulated the risk profile of each property company under coverage in terms of risk of declining sales, margin erosion, leverage and relative valuation (vs distressed level in 2001). Overall, we believe Sunway City to have lower risks among stocks under coverage due to its more resilient earnings from property investment as well as its undemanding valuation which has more than priced the negatives. That forms the basis of our recommendation for Sunway City as our top pick for the sector.
We reiterate our calls on individual stock with no changes to target price.


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24 November 2008 Newz Bits November 24, 2008 Daily Highlights

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