By Thomas Streater

That China's real estate market might be weakening isn't exactly breaking news. But as investors browse for bargains among beaten-down property stocks, which ones should they avoid?

Performance of Hong Kong-listed property stocks have differed wildly this year: China South City's shares ( 1668.HK), for example, are up a whopping 70%, while Agile Property's ( 3383.HK) have lost half their value. Generally, however, the larger developers have outperformed their smaller peers - thanks to a widely-held perception that the bigger developers have better operations and stronger balance sheets.

Yet bigger isn't always better. Some large developers -- whose stocks tend to be more widely-held by global investors - are increasingly at risk if capital flows out of Hong Kong and China index benchmarked funds were to pick up. And such an exodus of funds could well occur if China's economy slows, or if the U.S. Federal Reserve withdrew its monetary support more quickly than expected, driving investors to more defensive stocks with lower debt levels.

New World Development ( 17.HK) and China Resources Land ( 1109.HK) are two of the household names whose stock-market returns have been lackluster this year. Of the top Hong Kong listed developers, they appear to be most at risk from macro scares or capital flight.

For a start, both have less stellar balance sheets compared to top-tier peers and, as such, are more vulnerable should interest rates rise. The ratio of total debt to total assets is 33.2% for New World Development and 25.9% for China Resources Land -- compared to 19.1% for the Hang Seng Index's property average, or other top-tier Hong Kong-listed property peers.

On top of that, New World Development trades at a 49% discount to its net asset value, and China Resources Land is at a 27% discount, using Barclay's calculations. Both have been discounted less by the market than this year's unloved underperformers, many of which are suffering discounts of roughly 60% to their net asset values. As such, both stocks could have further selling pressure.

Of course, the case for investing in Chinese property stocks is well-known, and there are ways in which China's housing sector is different from the U.S.'s housing bubble of 2006, as Goldman Sachs recently pointed out. First, a rise in the number of urban households and the push to move up to better residences is still apparent and much needed. The construction boom of the last 15 years was due to the privatization of housing and real demand, not the "irrational exuberance, " seen in bubbly markets. Second, given the lack of investment opportunities in China, owning property is a surrogate for savings. Finally, generally low household leverage dampens the potential damage of negative equity seen during the U.S. subprime crisis. The Peterson Institute for International Economics believes the property market downturn should "prove to be merely cyclical" so long as appropriate policies are adopted.

Yet low household leverage will provide scant comfort to investors in the more highly-leveraged property firms. Bears argue that rising property prices in the past decade have been a kind of self-fulfilling prophecy: Price increases spurred potential home owners and investors to buy property as soon as possible - before prices got away from them. Now that the trend has finally turned, the opposite may be true. When China Overseas Land & Investment ( 688.HK) reported earnings yesterday, it made a rueful point that summed up the current sentiment: "Relaxation in the tightening measures toward the China property market continued, but improvement in both the transaction volume and home prices has yet to be seen."

This matters to stock-market investors because developers face pressure to cut prices or hold back inventory, or risk taking write-downs on balance sheet assets.

Email: thomas.streater@barrons.com

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