Realty sector likely to remain under strain

Cash flow, struggling sales and high debt levels will continue to be the main issues facing Chinese property developers going into 2015, according to market analysts, who still fear that despite monetary easing policies by the People's Bank of China, many firms will continue to find problems raising funds.

Experts say that companies will have to significantly reduce debt and improve sales to improve valuation, given moribund market conditions being felt in second-tier cities.

Hong Kong-listed H shares of Chinese mainland property companies are trading at an average price earnings ratio of 5.7 times on prospective 2015 earnings, which is much lower than the market average PE of mainboard-listed H shares trading at 10.7 times.

A recent Barclay's report on noted that Chinese property shares remain undervalued, even after the market rally triggered by the cut in bank interest rates in late November.

"Investors' biggest concern has always been the potential cash flow problems of the many mainland property companies," said Alvin Wong, an analyst with Barclays Bank in Hong Kong.

"Of course property shares look attractive at their current prices," he said. But "we aren't sure which company will be the first to default on its loans."

However, overall, he still considers "the worst days (for mainland property developers) are over" and that "investor sentiment is beginning to turn positive", although analysts would still like to see real improvements in developers' balance sheets before publishing any re-ratings.

To be sure, interest rate cuts are going to help. The Chinese central bank is widely expected to further cut interest rates in the first half of 2015 to stimulate economic growth. But monetary easing has highlighted another problem facing property developers: poor sales.

The specter of further economic slowdown has already sent the property markets in many second-tier cities, including East China's Hangzhou, Ningbo and Wuxi, into a tailspin.

Many property developers are known to be stuck with massive stocks of unsold apartments that are putting a serious strain on cash flow.

Of course, not all mainland property stocks are being shunned by Hong Kong investors.

Many brokerages are recommending China Resource Land shares, which Wong of Barclays said is presenting a good balance sheet.

But they suggest investors should confine their bargain hunting to big-cap State-owned property developers with healthier balance sheets than the industry average because they stand a better chance of benefiting from any government monetary easing policy.

The central bank in November reduced its benchmark one-year lending rate by 40 basis points to 5.6 percent, as well as cut the one-year deposit rate by 25 basis points to 2.75 percent.

The move has been interpreted as a signal for monetary easing to avoid a sharp economic slowdown. Wong said he expects valuations on Chinese property shares to improve significantly on the Hong Kong market in coming months.

"Market consensus is that home prices and sales in the Chinese mainland will not grow as fast as several years ago. The evaluation criteria therefore has changed," Wong said, adding a company that is small in size but has higher quality housing stock has a better chance of standing out, when people are buying properties not for speculation but for lifestyle reasons.

Some recent data suggest the distressed property sector has already shown signs of warming up.

Chinese developers have raised more than $4.16 billion from rights issues and share sales since July, for instance, up from $3.06 billion between January and June and $3.07 billion in the whole of 2013, according to Dealogic.

The Shanghai Stock Exchange Property Index, which tracks 24 stocks, is also up 25 percent since Nov 21, and has risen 50 percent so far (by last Monday) this year.

However, rating institutions are less optimistic.

Su Aik Lim, an analyst with Fitch Ratings, is equally skeptical. "I do not expect any meaningful recovery of this sector. After all, a rate cut would not help if banks do not loosen lending conditions to developers," said Su.

Experts suggest that banks will be more willing to lend to big SOEs, or those that generate faster sales as they are better able to service their loans, while smaller companies focused on a few projects will continue to struggle to maintain liquidity with falling sales, especially if they are in lower-tier cities or cities facing excess housing supply.

"A company's sales-to-debt ratio is very important for us to evaluate its financial condition. The higher the ratio, the less likely the company will face liquidity problems, " Su said.

Bank lending to the property sector is declining, having dropped 23.3 percent in the third quarter from the previous three months, central bank data showed.

Moody's is predicting annual sales in 2014 are likely to fall by 5-10 percent year-on-year, although sales seemed to have been picking up in the last quarter of this year. Fitch said nationwide housing sales may continue to shrink, by up to 5 percent in 2015.