Supply-side Structural Reform of China’s Real Estate Industry

Over the past two years, China’s real estate industry has experienced unprecedented changes in both supply and demand. This is due to a combination of factors including industry trends, government policies, and the COVID-19 pandemic, which have inadvertently led to a "supply-side reform" in the real estate sector.

Since the end of 2021, as real estate policies relaxed, there have been significant changes in the supply structure of the real estate industry. First, second-hand housing has gradually become stronger than new housing. The overall sales of new homes are largely on par with last year, but second-hand homes sales have significantly outpaced new homes in some cities with a year-on-year increase of 50-100%. Second, state-owned enterprises and mixed-ownership developers have emerged as major players as many private enterprises significantly scaled back or even exited the market. Among the top 100 developers, the market share of state-owned and mixed-ownership developers has increased from just over 30% in 2018-2019 to nearly 60% today.

At the sector level, players who have exited or downsized may represent over 40% of the market share previously. Therefore even if demand has stepped down, the remaining players still has a very significant pie to share, and we may even expect to see some temporary shortage of supply.

More people have come to share this view recently, and the highly divergent performance of companies within this space also confirms this point. If we compare this round of "supply-side reform" in real estate to industries such as steel and coal in China that experienced significant excess supply between 2015 and 2016, there are indeed many similarities, such as suppressed supply in a weak demand, high inventory, and overall tightened policy environment.

We also agree with the logic of this round of "supply-side reform". However, we think this process is still in its early stages and, compared to previous real estate cycles with stronger beta performance, alpha opportunities at the sector and company level will be the biggest source of investment returns in this cycle.

In terms of supply structure, even though developers have undergone significant consolidation, the industry landscape may continue to change, leading to more alpha opportunities to be discovered. On the one hand, the scale of the real estate market will remain significant, but market share will further consolidate. Using Japan as a more extreme example, 80-90% of the land reserves of top developers are concentrated in Tokyo. China's market is much larger and can accommodate 15-20 such large markets and several small markets in the long term. On the other hand, the issue of abandoned buildings has attracted serious attention from the government, leading to a continued reform of the pre-sale system. Regardless of which developed country we use as reference, the business model and cash flow of real estate developers will see further changes. It is not unforeseeable that as the pre-sale model slowly evolves, real estate players will experience further reshuffling.

In terms of business model, the shift from land appreciation (driven by monetary policies) to property appreciation (service operation) is still in the early stages. With a growing housing market and a focus on value and quality, the real estate management and servicing sectors have large potential for growth. Factors like location remain important, but with an embrace of the popular view "houses are for living, not for speculation," and against a backdrop of high price-to-income ratio, and limited room for leverage, the growth of land prices will inevitably slow down and start to diverge. Housing on the other hand, can still achieve appreciation through superior maintenance, operation, and management. This is also one of the important changes in the valuation of real estate in Japan after the bursting of the land speculation bubble. The leading real estate companies in developed economies either derive most of their profits from the rental and service sector, or lead the competition in terms of construction/development efficiency. China has a large and growing housing market, which provides room for the property management and servicing sector to thrive. As the standardization of service-related policies and the expansion of the C-REITs market continues, these industries will see further growth and evolution.

Of course, in addition to the supply-side reform, the rebound of the overall real estate sector also needs demand support. Housing demand experienced a decline last year and another cooldown following a temporary rebound in February to early March this year. The key would be to figure out where the equilibrium lies.

Inelastic demand is the backbone of housing demand, but the first-time homebuyers driven by factors such as urbanization and downsizing of families account for only a small portion of the current transaction volume and are likely to decrease in the long term. The bulk of the transactions is driven instead by demand for home upgrades, a.k.a. "per capita living area growth”, and even investment needs. In the long run, the natural depreciation of housing will trigger a release of further home improvement demand, so the total demand will likely remain high in the medium to long term. In the short to medium term, the recovery of this type of demand will depend on various factors including economic growth, liquidity, and housing price expectations.

In fact, before the lockdown of Shanghai last year, we briefly saw the return of home improvement demand in some core cities: the average transaction area of second-hand housing increased (through an increased proportion of medium-to-large apartment transactions). Overall housing prices and projections also showed signs of recovery. However, due to subsequent events, the return of such demand was not obvious until the recent mini-boom. But we remain optimistic for a moderate recovery, which will take time following two turbulent years in the sector. On the macro level, aside from remaining uncertainties in demand recovery, other factors such as economic growth, liquidity, and policy environment have all improved considerably since last year. At the same time, recent official surveys and medium-to-long-term loans have also pointed to a positive change in attitude towards real estate.

Overall, real estate supply remains sufficient in the short run and demand will likely stabilize after the recent pressure release. Looking forward, the industry’s supply dynamic will continue to evolve, and although total demand may soften further, the industry’s overall size remains very significant. In summary, real estate’s beta opportunity will weaken but still exist, while the alpha logic in real estate development and services still has a long runway.