Developers stand by for earnings cap

PUBLISHED : Monday, 16 May, 2011, 12:00am
UPDATED : Monday, 16 May, 2011, 12:00am


Property investments now rank as one of the mainland's biggest wealth creators, thanks to the massive tide of people that has flowed from rural areas to big cities such as Shanghai.

But a change may be due as the central government eyes a cap on the earnings of property developers in a bid to curb soaring property prices.

'The era of fat profits in the property industry has ended after a string of austerity measures aimed at cooling the overheated market,' said Shimao Property Holdings chief finance officer Lawrence Hui. 'Net margins in the industry have already come down significantly from the 30 per cent levels that players used to achieve three years ago.'

The central government's declared intention to curb what it has called 'excessive profits' being earned on property projects is not the only issue that has upset developers. By targeting their profits, the government is effectively saying developers are responsible for creating a bubble in the property market and is accusing them of amassing profits at the expense of helpless homebuyers, they complain.

So now they are fighting back, saying the government is aiming at the wrong target. It is focused on gross profit margins, they say, and instead should be looking at net margins and earnings.

For instance, the gross profit margin reported last year by Shimao was 37 per cent, which was much lower than the average gross margin of 55.72 per cent polled by the Chinese Academy of Social Sciences when it released its 2011 Housing Blue Paper in December last year, said Hui.

'The industry's profitability would also become much clearer if it were examined at the level of net margins,' he added.

In Shimao's case, after deducting all expenses such as 564 million yuan (HK$674.3 million) in sales and marketing costs; 1.08 billion yuan in administrative expenses; and three billion yuan in income tax, the developer earned four billion yuan from its core business operations last year, which represented a net margin of 18 per cent.

Hui said net profit margins of 15 per cent to 20 per cent - which vary with land costs - were the industry norm. 'It is the same as their counterparts in Hong Kong,' he said.

Lee Wee Liat, regional head of property at Samsung Securities, said net margins in Hong Kong's property market were about 15 per cent. On the mainland, gross margins were 35 per cent to 40 per cent while net margins were about 15 per cent to 20 per cent.

'But moving forwards, net margins should start to decline as developers increase their exposure to smaller third- or fourth-tier, regional cities. Net margins for projects built on land acquired in the past two years will slowly trend lower as land costs have risen,' he said.

Also, confronted with the government's intention to curb the gains to reduce the risk of a property bubble, developers were likely to be more cautious with their pricing, he added.

On April 27, the National Development and Reform Commission, the mainland's price regulator, said it was studying property firm costs and profitability and planned to apply a 1995 regulation that sought to cut 'excessive profits' on commodities and services that have a major impact on the economy or people's livelihoods. Prices deemed 'unreasonable' could be adjusted by the NDRC.

Hui said the biggest cost component for property development was land which accounted for a third of the total development cost, while construction took up another third.

Under pressure to contain rising inflation, it appeared that the central government was attempting to control possible price increases ranging from commodities, consumer goods and more importantly, properties, analysts said.

On May 7, the government fined global consumer products giant Unilever two million yuan for talking to the media about expected price rises in detergent and soap products, comments which were blamed for triggering panic buying amid inflation fears.

After more than a year of launching nationwide austerity measures to dampen demand in the housing market, home sales and prices fell sharply last month. The government introduced a series of measures to suppress demand including limits on the purchase of homes, and raising down payments to 60 per cent from 50 per cent when buying a second home.

The value of residential properties sold nationwide fell 21.44 per cent to 324.9 billion yuan last month from March and the total area of residential properties sold dropped 24.17 per cent to 64.96 million square metres.

Evergrande Real Estate Group urged the NDRC to clarify the definition of 'excessive profit' before taking action.

'What is high or not? It is hard to say in the absence of a definition of excessive profit,' said Parry Tse Wai-wah, chief financial officer at Evergrande, which claims to have the largest land bank on the mainland. Tse said the gross profit margin in the manufacturing sector was 11 to 12 per cent, while internet firms could generate net returns of as high as 70 to 80 per cent, he said.

The issue has sparked heated debate in mainland newspapers and online forums.

'Property is the most profitable industry in China with average profit margins 5 per cent higher than other sectors. Some projects even earn more than 100 per cent profit,' wrote one poster on an internet forum.

'According to Hurun Report's rich list between 1999 and 2009, developers accounted for more than a third of the nation's richest citizens,' it added.

Alan Chiang Sheung-lai, head of residential at property consultant DTZ on the mainland, cast doubt on the implementation of rules to limit profit growth. 'It's easier said than done. At present, the land appreciation tax has served to cap developers' profit to keep prices at a reasonable level. But the rule has not been strictly enforced,' Chiang said.

To stabilise property prices, the central government in May last year began enforcing the tax which ranged from 30 per cent to 60 per cent on capital gains on developers' projects. He said most listed developers would set aside a sum for the tax but not every non-listed property firm would do so.

Many municipal governments were reluctant to strictly enforce tax since the proceeds would be transferred to the central government's coffers and not their own.

'There is no reason for local governments to ruin the relationship with developers by pressuring them to pay the tax,' Chiang said.

Lee said a developer was required to pay a higher land appreciation tax if projects achieved higher average selling prices, which meant that 50 per cent of the gains would go to the government tax.

'The mechanism [to rein-in excessive gains] is already in place. It is a matter of enforcement,' he said.

No fat profits

The value, in yuan, of residential properties sold nationwide last month: 324.9b yuan

Shimao's earnings, in yuan, from its core business operations last year: 4b yuan

The starting level of a land appreciation tax on capital gains : 30%