A recent Deutsche Bank report on June 13 said the fundamentals of China’s Hong Kong-listed homebuilders were the best in three years. Investors might be tempted to buy but some peculiar accounting rules allow developers to book profits by marking up the value of their properties.

Here is an excerpt from last weekend Barron’s article on the subject:

“Companies like Evergrande Real Estate Group capitalize all their interest expense so it doesn’t dent their income statements. Hong Kong’s rules make it a more attractive bourse for developers than Shanghai because these payments can be treated as part of an investment in a project.

Income statements can show profits even though most of the developers run deeply negative free cash flows because of their highly leveraged investments in new land and construction. When Chinese home prices stop rising, these companies’ appraisers won’t be able to justify the mark-to-market profits that have supplied half of recent pretax income.

At year-end 2011, Evergrande’s debt level was about 160% of its shareholders’ equity. Greentown China Holdings, a builder of high-end residences, had staggering debt of about 240% of equity at the end of 2011 (table below). In addition to the debt on their balance sheets, most of the Hong Kong-listed developers also have billions of renminbi worth of contingent liabilities for things like mortgage guarantees that they’ve furnished to partners and customers.

After signs emerged that that China’s overall growth was moderating, the nation’s central bank enacted its first rate cut since December 2008… Deutsche Bank responded to these positive signs by urging investors back into large names like China Overseas Land, CR Land and Longfor Properties. But … average selling prices remain flat… developers simply have too much inventory.

Speculation on residential-real estate has been one of the few high-return investments available to China’s savers. The largest speculators, of course, are the developers themselves. Hong Kong accounting rules have enabled them to be more aggressive than they could be elsewhere. But when times aren’t so good… some of their investors will be hard pressed to find shelter.”

Source: Barron’s

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