China Overseas Property (2669 HK)

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China’s property market is in the midst of a downturn. However, one segment of the market has not only survived but flourished — the niche of state-owned property management companies.

The topic of today’s discussion will be state-owned property manager China Overseas Property (“COPL”) (2669 HK － US$2.0 billion), an affiliate of property developer China Overseas Land & Investment (“COLI”) (688 HK － US$17 billion).

COPL takes care of properties after they’ve been completed. It offers basic services such as security personnel, cleaning, repairs and maintenance, gardening, etc. It’s also moving into value-added services like helping owners rent out their flats.

Most property managers are affiliated with specific property developers. For example, China Resources Mixc Life is affiliated with China Resources Land, Country Garden Services is associated with Country Garden, and COPL is affiliated with developer COLI.

After COLI completes a project, COPL typically takes over its day-to-day management. After the initial contract runs out, properties typically end up in the hands of so-called “property owners’ associations,” which represent the interests of individual apartment owners. These associations typically meet every two or three years to decide whether to renew their contracts with COPL.

The business’s attractive features include its stability, high cash flow, and high return on reinvested capital.

Today, COPL earns a return on equity of 37%. One explanation is that it’s a service business that doesn’t require much capital. Another is that the switching costs are high. Since majority votes are needed to replace property managers, it almost never happens. My impression is that the industry-wide churn has been less than 2%.

So what’s the catch?

In late 2020, the Chinese government introduced its three-red lines policy, which limited the amount of debt developers could take on. The companies that exceeded the limits had to deleverage. And being cut off from credit from China’s state banks, they started defaulting on the offshore bonds en masse, leading to a wholesale restructuring of the industry.

While the property management industry remains stable, it was also affected by the government crackdown. Companies like Shimao Services and Jinke Services engaged in related party transactions to funnel money out of their property management companies to save their affiliated property developers—to no avail.

But my point is this: every single developer that’s gone bankrupt is a private enterprise. COPL’s affiliated developer, COLI, is doing just fine. In fact, the state-owned developers are benefitting from the current crisis, being able to acquire assets from their private sector counterparts on the cheap.

If you go through the numbers, it becomes clear that COPL is managed just like any other state-owned enterprise. The dilution in the share count has been exactly zero since the spin-off in 2015. They chose a spin-off over an equity carve-out since they didn’t think COPL needed more capital. And its related party transactions are few and far between.

COPL’s financial track record has been decent, too. It’s been compounding revenues at a 26% annual rate in the past five years. Its earnings per share have grown at a 27% annual rate. State-owned property managers such as COPL are winning, most likely benefitting at the expense of their private sector counterparts. That’s fundamentally positive for COPL’s longer-term growth prospects.

While it is true that sister company COLI has seen its contract sales drop ~30%, that drop only reduces the growth in total gross floor area managed, not the total amount. Plus, the majority of the total gross floor area managed now comes from third parties, so the net impact of the property downturn on COPL’s growth remains minimal.

In fact, COPL is guiding for an almost 20% increase in GFA in 2024. Based on this number, I project a P/E ratio of 9.1x for 2024e and 8.3x for 2025e, far below the historical level of 21x.

Some investors worried about a related party transaction in 2023. But it was eventually cancelled. The truth is that most Chinese state-owned enterprises, including say CNOOC and Shanghai International Airport, have had related party transactions in the past. But they’re usually done on favorable terms. In COPL’s case, I don’t see much to worry about.

There’s been a slight drop in non-resident value-added services earlier this year due to a drop in completions. However, that revenue drops in the ocean compared to COPL’s main business, which is basic property management services. So, from what I can tell, COPL’s outlook actually remains rather positive.

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