Credit Suisse warns of 'value trap' for developers in second-tier cities

PUBLISHED : Thursday, 10 March, 2011, 12:00am
UPDATED : Thursday, 10 March, 2011, 12:00am

The conventional wisdom that developers are smart to build in second-tier mainland cities is wrong because many of these areas suffer from oversupply and low development margins, according to Credit Suisse.

Last year, land with a potential gross floor area of 410 million square metres was purchased on the mainland for building private housing, up 28 per cent from 2009.

Of the 30 first- and second-tier cities it monitored, Credit Suisse identified Hefei, Chongqing and Changsha as the top-three cities with the lowest property development margins. Wuhan, Taiyuan, Tianjin and Dalian will face severe oversupply that will take more than seven years to absorb.

'Most developers tend to buy in second- and third-tier cities with the rationale that land is generally cheaper in such cities compared with first-tier cities and the potential for growth in tier-two cities is huge,' said Du Jinsong, an analyst at Credit Suisse.

As a result of growing developer interest in second-tier cities, land prices in key areas increased by an average of 23 per cent last year, compared with a drop of 2 per cent in first-tier cities, he said. In fact, the pace of growth in land prices there was much faster than residential prices last year, he said.

Land prices in Haikou, Hainan, rose 93 per cent last year compared with a 45 per cent increase in residential prices. Wuhan land prices grew 28 per cent compared with a meagre 7 per cent gain in residential prices.

In terms of profitability, Chongqing is ranked as the second-worst performer with an estimated gross margin of 6 per cent. This was based on the city's average selling price of 5,151 yuan per square metre against a total development cost of 4,842 yuan per square metre.

Second-tier cities previously had a key advantage. Beijing's policies to cool property markets generally did not apply to them. But that will disappear this year.

The State Council in January ordered 36 cities to implement home-purchase limits, including Beijing, Shanghai, Tianjin, Chongqing, Dalian, Qingdao, Ningbo, Xiamen, Shenzhen and 27 provincial capital cities. Local residents are barred from buying if they own more than two houses.

In light of these new restrictions on home purchases, Du also ranked each city on the severity of potential oversupply. The top-10 cities to avoid: Wuhan, Shenyang, Jinan, Changchun, Taiyuan, Hefei, Changsha, Haikou, Chongqing and Tianjin.

He listed CC Land, Guangzhou R&F, China Overseas Land and Investment, Longfor Properties and Shui On Land as having the most significant exposure to what he called these 'value traps'. More than 40 per cent of their land banks were located in such cities.

Xu Tonghui, manager of Chongqing-based developer Longfor Group's customer and corporate branding department admitted that Chongqing's profit margin was relatively low compared with other secondary cities.

'But the city's housing demand is growing much faster than others and will be a stable source of revenue,' he said. 'It will continue be an important part of the group's investment.'

Forty-five per cent of Longfor's land bank is located in what Credit Suisse is calling these 'value-trap' cities with 8.24 million square metres in Chongqing or 33 per cent of its total land reserve.

'Prices in second-tier cities will likely come under pressure as demand is constrained by the home-purchase limits,' Du said.

Margins squeezed

Developers' margins are falling in second-tier cities as land prices rise

Land prices fell 2 per cent in first-tier cities last year but rose in second-tier cities by: 23%