James May submits:
Xinyuan Real Estate ( XIN ) 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 business.
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 developers.
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 growth.
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 effectively manage.
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 more.
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 properties.
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 future.
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 around 15X.
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.
Disclosure: Long XIN
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