This document analyzes the residential development business in China using Michael Porter's Five Forces model. It examines the intensity of industry rivalry (neutral to favorable), threat of new entrants (neutral to unfavorable), threat of substitutes (favorable for end use, neutral for investment), bargaining power of suppliers (favorable), and bargaining power of buyers (neutral). Key factors discussed include barriers to entry, differentiation of developers' products, availability of substitutes, developers' relationships with suppliers and power in negotiations, and how buyers' power fluctuates depending on the property cycle stage.

1. Industrial Analysis February2011
Michael Porter's Five Forces Model Residential Development Business in China
By Robert Fong
June 2011
1. Intensity of Industry Rivalry (Neutral to Favorable)
Compared to many other industries, the intensity of rivalry among developers in
residential development is relatively low. The area where it is felt most is in
competition for development land. When it comes to selling end units, developers
typically try to avoid competing directly by 1) developing products in different
markets / locations; 2) launching products at different time periods; 3)
differentiating product types.
The key factor is that residential property is sufficiently differentiable and not
subject to any sort of perishibility or technological obsolescence such that
developers have much more flexibility with the timing of producing and selling
their end product.
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2. 2. Threat of new entrants (Neutral to Unfavorable)
When an industry has over 60,000 registered participants, it is hard to conclude
that barriers to entry are high. Although the number of entrants varies over time
and according to market condition, they are sufficiently low relative to other
industries that new entrants can continue to enter and eventually push above
average returns back to historical means.
Generally speaking, the potential barriers to entry to any industry fall into
several broad categories: 1) capital; 2) technology; 3) legal authorization; and 4)
expertise and know-how.
Legal authorization is necessary for certain types of industries such as telecoms
and utilities. The number of participants in these industries is limited due to the
nature of the businesses (“natural monopolies”) or the return profiles (massive
upfront investments which can only be recovered through limited operating
competition).
For most real estate development, no special legal authority is needed to enter
the industry. That is why many non-property companies find it relatively easy to
migrate into this industry as and when returns become attractive or simply out of
interest.
Furthermore, the technological and expertise/know-how component of this
industry is not particularly high. Designs, names and concepts can all be copied
as there is less ability to protect these through patents or copyright. Large value
supply chains such as agents, consultants, property managers and employees of
rivals can all be hired or co-opted.
Capital can be considered a barrier but mostly to larger scale projects. The gross
amount of capital needed to “enter” the industry is paltry compared to the likes
of steel mills or chip fabs.
In addition to the above factors, the wide range of different types and scales of
development each entail different barriers to entry. Obviously larger, more
specialized developments in top tier cities (i.e., a massive mixed use residential,
commercial development in Beijing) would have much higher barriers to entry
than a small residential project in Taiyuan.
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3. 3. Threat of substitutes (Favorable for End Use; Neutral for
Investment)
Real estate development involves different types of products – residential, office,
retail and industrial being the most common. To narrow the scope of discussion,
we will just consider private residential real estate.
Currently in China, residential real estate is in high demand both for its utilitarian
value as accommodation and also for its investment value as a stable, inflation-
proof store of wealth. As such we need to consider the substitutability on both
fronts.
As accommodation, new private housing from any firm can be replaced by 1)
competitive product from another developer; 2) existing private housing for sale
or for rent; 3) social housing either for sale or rent. Any specific developer can
lower the risk of substitution by differentiating their product offering by i)
location; ii) type and iii) quality. The more generic a developer’s product，the
more substitutable . Developers that have managed to distinguish their product
or image will fare the best.
The threat from the secondary market varies by city. In T1 and large T2 cities, a
sufficiently large stock of housing exists for the secondary market to be a viable
choice for potential homebuyers. In many T3 and T4 cities, there are either not
enough secondary units for sale or the market is simply is too illiquid.
The threat from social housing exists but not significant. Usually, those allowed
to buy or rent social housing would only be able to enter the low end of the
private housing market anyway – if at all. Moreover, resale and other restrictions
make it a far less liquid asset class. For that reason, the threat is only to the
lower end of the private housing market.
Given China’s current state of negative real interest rates and capital controls,
most individuals have limited channels for savings and investment. Real estate
has helped fill this void. If investors were given more alternatives and if other
asset classes such as equities start to perform better, investment demand for
real estate would quite likely cool.
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4. 4. Bargaining power of suppliers (Favorable)
Overall, developers are in a favorable bargaining position relative to the key
suppliers in the industry. The 3 key suppliers to any residential developer are 1)
land sellers (usually cities or other developers); 2) construction contractors; 3)
building materials and home furnishing / equipment manufacturers; 4) capital
providers. This situation is more or less reflected in that the typical cost of sales
for any developer is made up of roughly 1/3 land, 1/3 construction and 1/3
financing costs.
A typical developer’s bargaining position relative to a land seller varies according
to 1) nature of sale and 2) location of sale. Developers typically prefer to buy
land through direct bilateral negotiations with the government or 3rd party
rather than be involved in a multi-party bidding ware. Auctions are the least
desired channel for land acquisition but sometimes a necessity. For land bought
in smaller cities or newer areas of larger cities, developers wield a lot more
bargaining power. Smaller cities are generally eager to entice well known
national developers. For example, if Vanke or COLI buys into a smaller T3/4 city,
it would signal to other developers that this city is worthy of investment. In such
cases, local officials are willing to give a discount to entire desired players. This
logic is also true of newly emerging districts in T1/2 cities.
Construction companies do not command much if any pricing power and many
work on thin margins. Although developers can backward integrate and take on
construction duties themselves, this is often more for ensuring timeliness of
completion or maintaining quality standards than for cost savings. Also, the
construction materials and household furnishings that developers buy are mostly
commodity goods for which the manufacturers not only command no particular
pricing power but would also yield a discount on bulk or volume purchases.
Lastly, capital providers, be they banks, shareholders or bondholders, may have
different investment appetite for this industry at different times but whether
investors or bankers demand a specific risk premium to provide capital is more
dependent on the perceived risks at any point in the property cycle and not any
kind of structural risk premium.
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5. 5. Bargaining Power of Buyers (Neutral)
Of all the five forces, this is perhaps the most dependent on 1) the stage in the
industry cycle; 2) regulations to protect consumer interests and 3) financial state
of individual developers. Given this wide variance, it is very difficult to conclude
definitively that buyer power is always strong or always weak. The truth is buyer
power will fluctuate greatly. Thus developers that have a larger proportion of
their business in markets with weaker buyer bargaining power will obviously
realize higher returns.
Near the peak of a property cycle, the
combination of investment and end user
demand generally outstrip available supply.
This gives developers tremendous pricing
power and leads to outsized returns.
Conversely, near the bottom of the cycle,
developers are usually overstocked and
must cut prices to move units.
In the transaction of any large sized
purchases, information is the key to
knowing what a reasonable price to pay is.
Figure 1 Property Cycle In the absence of rules and regulations,
developers often maximize revenue by
trying to extract the maximum possible price for each unit. They can do this by 1)
not publishing any standard price lists and 2) not reporting critical information
such as how many units have been sold and at what price. This situation is
generally known as asymmetric information and gives the developer tremendous
power. However, in most large markets, regulators are aware of this and have
enacted laws to protect consumer interests by making information more
transparent and readily available. In general, all else being equal, consumers in
T1/2 cities or those with consumer protection laws have more bargaining power
than cities without protection.
Lastly, developers that are on solid financial footing (larger resulting from a more
prudent management of working capital) would generally have greater pricing
and operational flexibility than those that are financially overstretched heading
into a cyclical trough.
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