Xinyuan Real Estate (
) is probably the most undervalued stock on the NYSE. The company
develops middle income residential properties in tier II and tier
III cities in China. The stock currently trades at 2.61 X 2011
estimates and less than .4X book value. The company has beat
estimates in each of the past 5 quarters, counts the likes of Sam
Zell and John Griffin as stakeholders, and is audited by
PricewaterhouseCoopers. Xinyuan is a legitimate and well managed
The question is whether or not book value, and thus earnings power,
will significantly decline. China real estate bears including Jim
Chanos and Andy Xie argue that a severe decline in property prices
is imminent and inevitable. It is worth considering the rationale
behind the the two most prominent China property bears and putting
it into context. The following is a list of bearish points made by
Chanos and Xie followed by a response informed by many analysts and
industry participants who have a long term bullish view on China
Jim Chanos appeared on Charlie Rose on April 12th 2010, and on
CNBC on September 21st 2010 making the following points:
Chanos: There is a real estate bubble in China because people
are financing the purchase of property on which the rental yield
will not cover the mortgage.
My Response: Currently the rental yield in tier I cities stands
around 4%. The rental yield in tier II and tier III cities is
generally significantly higher. Most analysts consider a rental
yield of 5% to be a reasonable target in the current monetary
environment. Assuming a down payment of 30-50% (current policy), a
4% yield will cover the mortgage.
Chanos: Many investment properties are unfurnished boxes
designed only to be held as a commodity.
Response: This type of speculation has been strongly
disproportionate to the luxury market in tier I cities.
Chanos: Speculative building projects like a replica of Times
Square and an indoor ski hill demonstrate a bubble.
Response: An unintelligent allocation of capital by certain
investors in some cities is not indicative of the value of all
development projects across a country experiencing robust
Chanos: China is on a treadmill to hell because 50-60 percent of
GDP is construction.
Response: Most analysts determine development to account for
25-30 percent of the Chinese economy if underground economic
activity is included.
Chanos: Real estate development (and speculation) is the only
thing keeping China from experiencing negative GDP growth.
Response: With mortgages on third properties now completely
banned, no analyst is predicting negative GDP growth for China.
Chanos: The average Chinese person can't afford to carry the
average Chinese apartment.
Response: With 30-50% down payments and 33-40% of home purchases
being made entirely with cash, the people who are buying real
estate can afford to carry it even in a market decline.
Chanos: State and local governments have speculative interests
in real estate that will lead to defaults.
Response: Government backed entities are not active in many
markets. The central government has taken steps to shut down the
real estate divisions of many state owned companies, and continues
to enforce measures reducing government exposure to the property
market. Government backed entities are not actively developing
property in any of Xinyuan's markets.
Chanos: The problem is too big for the Chinese government to
Response: The PRC government has taken many steps specifically
targeting speculation to prevent a widespread property bubble, and
to effectively manage the overvaluation in the tier I luxury
market. The government has demonstrated its ability to swiftly
implement necessary policy changes on many occasions.
Chanos: Slowing transaction volumes over the summer are a
precursor to price declines.
Response: Property sales volumes were anemic over the summer
because there were virtually no loans made in many parts of the
country, and Ag Bank stopped lending completely. Many developers
experienced record sales in September 2010.
Andy Xie has recently expressed his opinion on China real estate
writing for Bloomberg and appearing on CNBC Asia
Xie: Rental yields are now less than 3% and must rise to 5% or
Response: Most estimates put rental yields around 4% in tier I
and well above that in most tier II and tier III markets.
Xie: Property prices will decline gradually over the next five
years, while China GDP experiences robust growth.
Response: Unlike Chanos, Xie estimates development accounts for
only a small fraction of China GDP, allowing for a property market
collapse and robust economic growth. Xie appears to be alone in his
projection for long term gradual sustained price declines across
most markets in a robust economy.
Xie: There is already enough housing for everyone in China.
Response: The PRC government plans to demolish 50% of urban
dwellings over the next 10 years, and double the pace of property
development over the next 5 years. The government and nearly all
analysts agree that there is strong and growing demand for middle
class apartments throughout China.
It is important to consider that rent yields in tier I were over
14% in 2003 when tier I property began its 900% run up, and that
development has disproportionately been concentrated in the luxury
space. Considering the average price of a $1,000,000 home and two
$100,000 homes is $400,000, average sales prices are significantly
higher than median sales prices.
This favors the view that an inevitable decline in tier I will
be a measured if significant pullback in a long term secular bull
market. Tighter monetary policy, including a new property tax in
certain markets, 30% down payments for first homes, and the
exclusion of all mortgages to owners of two or more properties will
likely accelerate an inevitable drop in certain markets. The
consensus appears to be that tier I luxury will drop 40-60%, tier I
non luxury is likely to drop 20-30%, while tier II and tier III
will likely see a decline of 0-15%. Following these declines, most
analysts project long term and sustained growth for all sectors of
China's property market.
Purchasers of Xinyuan units pay 5.5-6.5X annual income for an
apartment. By global standards, this is very reasonable for urban
Assuming an immediate 15% decline in property value from Q2 2010
(ASPs have probably increased 5-8% in Q3), Xinyuan's book value
would stand at $4.56, and the company's earnings power would come
in at $.84-$1.08 based on net margin of 10-13%, and moderate growth
in operating leverage consistent with company plans. The company is
likely to benefit from recent 10-20% declines in land auction
prices, and is poised for 20% growth for the foreseeable
Modeling $.84 EPS, 10% growth and a 12X multiple, the stock
would be worth $16.23 in five years.
Modeling $.92 EPS, 15% growth and a 12X multiple, the stock
would be worth $22.21 in five years.
Modeling $1.00 EPS, 20% growth and a 15X multiple, the stock
would be worth $37.32 in five years.
The hypothetical multiples listed above were determined by the
current multiples of Hong Kong listed developers which trade at
At current levels, Xinyuan Real Estate offers limited long term
downside short of an Armageddon scenario in tier II, and tremendous
long term upside potential if likely events play out.
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