Opportunities in stocks of three high-end developers

AN adage in investment circles goes: be greedy when others are fearful. Equity markets are forward-looking and when participants grow overly pessimistic about the future, share prices fall too much. This creates opportunities for cool-headed investors who focus on fundamental value, realistic forward scenarios and have sufficiently long horizons.

Today, we see these opportunities in three high-end developer stocks. While private home prices will likely correct further, we believe their share prices now reflect too-bearish expectations on the extent of the correction.

For instance, Wing Tai Holdings, developer of the Le Nouvel Ardmore and Nouvel 18 condominiums in prime district 10, is now trading at 42 per cent of its last reported book value of S$4.04 per share as at end June 2016. This is a valuation discount of S$2.35 per share or S$1.8 billion.

This discount is too big. If it was spread proportionally across Wing Tai's entire reported asset base as at end June 2016, which includes less risky assets such as cash, leased offices and retail shops in addition to its riskier unsold condominiums, we derive market-implied valuations of S$1,300 to S$1,500 per square foot (psf) for the group's Nouvel 18 and Le Nouvel Ardmore projects.

Contrast this with the S$2,300 psf price in cash for Nouvel 18 that Wing Tai subsequently sold in July 2016 to its joint venture partner City Developments, and the market's over-pessimism becomes clear.

Similar opportunities also exist for undervalued high-end developers such as Wheelock Properties, which developed Ardmore Three and the Scotts Square Condominium in Orchard, and OUE Limited, which developed OUE Twin Peaks in Orchard. These three developers, including Wing Tai, trade at deep discounts to their respective book values, ranging from 40 per cent to 58 per cent.

Their share prices all reflect expectations of housing price declines in the magnitude of 35 per cent or more, which are too steep compared to our base case forecast of a 5 per cent to 15 per cent dip over 2016-17 and a recovery in 2018. Our forecast is in turn underpinned by the two fundamental realities of demand and supply in the Singapore market.

On the demand side, buying interest from prospective home owners and investors has picked up as prices declined. Developers who have implemented reasonable discounts and differentiated sales strategies, such as deferred payment schemes, have been successful at garnering sales at previously torpid projects, as we have seen with OUE at its Twin Peaks condominium. With a high price elasticity of demand, we see a deep correction in home prices to be unlikely, barring seismic shifts in macro-economic conditions or interest rates.

While one cannot be certain about the trajectory of housing measures ahead, there is a meaningful likelihood that the worst of regulatory headwinds is behind us, now that existing curbs have successfully stabilised the market and private home prices have fallen double digit percentages from the peak. This is particularly good news for the high-end segment which - being the most dependent on foreign demand - has suffered the brunt of existing curbs, particularly the additional buyer's stamp duties (ABSD) which imposed 10 per cent and subsequently 15 per cent upfront duties on foreigner home purchases.

As a result, the premium of high-end median psf prices over the mass-market is now 64 per cent - near a 10-year low and more than one standard deviation below the average level of 87 per cent. In the event of any potential curb reversals ahead, in particular the ABSD measures, high-end home prices would outperform those in mid-tier and mass-market.

On the supply side, the elephant in the room is the high rate of physical home completions in Singapore, including public housing, which has contributed to rising vacancy rates and falling rents since 2014. This physical over-supply will continue to drive housing price corrections in 2016 and 2017, but we expect the situation to balance out in 2018 as completions fall from an average of 48,000 units per annum over 2014-2017 to 34,000 units in 2018, which will drive a recovery in private home prices.

In terms of overall unsold developer inventories, the situation appears benign. As at end-June 2016, the total inventory of unsold private homes in Singapore stands at 21,000 units, significantly below the nine-year average of 34,000 units.

Penalties under the Qualifying Certificates (QC) rules, which require all units to be sold within two years after attaining Temporary Occupation Permit (TOP) status, do pose concerns for projects which remain largely unsold, including Wing Tai's Le Nouvel Ardmore and Wheelock's Ardmore Three. These penalties will incentivise developers to sell units more quickly, but we do not foresee fire-sale scenarios due to the penalties' manageable impact on generally healthy balance sheets in the sector.

As these fundamental realities of demand and supply become visible over time, we believe the undervalued share prices of the high-end developers we highlighted - Wing Tai, Wheelock and OUE - will eventually reflect underlying assets more accurately.

These three developers also enjoy healthy balance sheets with net gearing ratios ranging from net cash to 67 per cent, which will buttress them through this down-cycle. Despite slower home sales pressuring earnings over the near to mid-term, they also find respite in recurring income from their rental properties - and for OUE Limited, in its holdings in listed real estate investment trusts, OUE Commercial Reit and OUE Hospitality Trust as well. These income streams help anchor their dividend payments, currently in the range of 1.7 per cent to 4 per cent yield, which shareholders can enjoy as they hold for long-term price appreciation.

But the nagging question remains: have these developers' share prices reached their very bottom? The fact is near-term market movements are subject to the vicissitudes of investor emotions, and timing the bottom, in our view, is often a fruitless exercise.

Ultimately, what will prove rewarding is averaging into stocks offering attractive risk-reward and a firm margin of safety in terms of fundamental value. In this regard, it is high time to start moving into these high-end developers.