Land costs for Tier 2 and 3 cities in China softening

This should alleviate margin concerns.

Based on market data, it has been observed that there are indications regarding the softening of land costs in Tier 2 and 3 cities in China, although these are holding up for Tier 1 cities.

According to a research note from Maybank Kim Eng, for 300 cities in China, CREIS data show that 2Q14 avg land cost was 1,136/sq m, down 15 percent QoQ and up 13 percent YoY. The report noted that on a YoY basis, growth was 12ppt slower than in 1Q, and that this should alleviate some margin concerns amid property price cuts.

Maybank Kim Eng also said that May was already the fifth consecutive month of YoY decline in residential new start GFA for China overall since the start of the year.

If it is assumed, according to the report, that there will be an average nine-month lag from new start to project pre-sale, then residential supply in China should taper at the end of this year or early 2015, a positive for the sector.

Here's more from Maybank Kim Eng:

In terms of demand, we examined the past two downcycles for indications, although some may argue this physical correction may last longer. As of end-May, we have already experienced six months of YoY decline in commodity residential GFA sold in China.

If we look at the 4Q11-mid-2012 and the 2008/2009 downcycles, the commodity residential market underwent nine months and 11 months of YoY declines in GFA transacted, excluding a minor rebound in March 2009.

If we compare against the aforementioned corrections, we are about halfway through the duration of the decline in property transactions. Since the stock market leads the physical market (e.g., in 2012 by about six months), we expect China property stocks to outperform the broader market in 2H14.

We expect more local loosening from Tier 2 and 3 cities, after recent loosening from Hohhot and Jinan, which can serve as investment catalysts.

Our Top Picks remain COLI and KWG and we add GZ R&F to the list with our upgrade on 26 Jun. We derive our Top Picks from deploying various criteria: limited exposure to Tier 3 cities, decent margins, cheap landbank, good earnings growth and overlay with valuations.