2021 was a turbulent year for China’s real estate sector. Developers faced a liquidity crunch following the imposition of strict leverage limits known as the ‘three red lines’ the previous year. The overarching aim of policymakers had been to rein in the debt-fuelled expansion in the industry.
Evergrande, the world’s most heavily indebted property group, defaulted on its US dollar-denominated debt late last year. Other firms that missed payments include Fantasia Holdings and Fujian Yango. The travails seem to be continuing this year, with DaFa Properties and Yuzhou Group both recently skipping coupon payments on their bonds.
Naturally, questions abound in the minds of investors about when the troubles faced by the sector will end.
I recently undertook a six-week trip to China to assess the scenario first-hand, and to seek answers to these questions. I travelled to Shenzhen, Guangzhou and Shanghai, and met with as many as 10 developers including Country Garden, Sunac, Huzhou, CIFI, Logan, Ronshine, Shui On, Powerlong, Redsun and Yanlord. The combined value of US-dollar bonds outstanding of these companies totals $45 billion and constitutes 30% of all high-yield property bonds issued by Chinese companies. The top-five issuers by amount outstanding (non-defaulted) are all among them. I had one-to-one meetings with the management of these companies, mostly with the CFOs.
‘We are burning cash every day’ and ‘no real estate company can feel comfortable at this moment,’ were the refrains from the developers. The genesis of the problem can be traced to the ‘three red lines’ policy, following the introduction of which banks and trust companies gradually tightened lending to real estate companies. The slowdown in mortgage approvals also had a telling effect on their cash collection.
These companies’ liquidity buffers also suffered as the overheated property market that we saw in the first half of 2021 encouraged some to go on a land acquisition spree, triggering further measures to cool the market, such as mortgage rate hikes and a mortgage quota cut in the second quarter. As operating and financing cash flows plummeted, developers found themselves reeling from the effects of a liquidity crunch.
Over the course of the trip I visited shopping malls, construction sites, sales centres and project launches. I also met other stakeholders in the industry, including a property agency and a real estate consultancy.
Here is what I gathered during my visit, which included a gruelling three weeks spent in quarantine. As we hope will become clear, it is evident that widespread perceptions do not always match reality.
Myth: China’s real estate sector is systemically important for the economy, implying that the government will rescue bond-issuing developers.
Reality: Bond-issuing companies are only a small portion of the overall real estate market. A rescue may not be forthcoming.
Myth: China’s real estate sector will take a big hit following defaults by developers.
Reality: Defaults are leading to sector consolidation and helping to lower corporate leverage. State-owned enterprises (SOEs) and private-owned enterprises (POEs) may gain market share.
Myth: Defaults will hurt China’s financial system.
Reality: Concerted efforts from central and state governments have kept the fallout in check. The thinking is that it’s better to clean up now than to allow the situation to fester.
Myth: Defaults by some developers are weakening the property market.
Reality: In fact, it’s the other way around. It is weakness in the property market that is causing weak sales and hitting liquidity.
Myth: A series of defaults by developers will shut down dollar funding for Chinese corporates.
Reality: Investment grade issuers and SOEs are still warmly welcomed by the market, with many able to price their bonds near the lower end of the indicative coupon rate.
Myth: China’s top leadership is keeping quiet as they are oblivious to the current chaos among developers.
Reality: The government is fully aware of what is going on. They just have more important priorities such as US-China tensions, reviving population growth, containing Covid and deleveraging the broader economy.
In the doldrums
As a liquidity crunch envelops the sector, and given weak demand, developers are waiting for helpful signals from the government. Several companies told me it may be difficult to survive another year without some form of policy easing, or a revival in growth. Their pessimism is borne out by data: year-to-date first day sales of newly launched projects in 29 major cities registered a historical low of 40%, vs. 60% in the first half of 2021; weekly viewings of newly-launched housing projects declined to 0.45 in January 2022 vs. 1.0 in April 2021; property sales manager confidence fell back to the low last seen in Q3 2021, according to data provided by Centaline, a property agency.
My interactions with prospective buyers in sales centres showed that many of them are prepared to wait because they expect property prices to decline further still.
Meanwhile, developers are trying to prepare for the long haul. The key positive takeaway is that those developers that have stayed out of trouble still have high willingness to repay their debt.
Where are we heading?
The fundamentals of the Chinese property sector continue to deteriorate fast. For the time being, substantial property policy easing is not our base case; in particular, we see a reversal of the ‘three red line’ rule as being extremely unlikely in the near term. Against this backdrop, we expect to see further defaults and weaker performance from the sector as the liquidity crunch continues to impact on developers’ ability to repay. We believe this justifies our bearish stance towards bonds issued by property companies.
At the same time, we won’t rule out the introduction of more supportive policy over the course of time. Should that transpire, there could be significant upside risks to the portfolios we manage. While trending down, the path could well be bumpy, given the likelihood of sector valuations jumping as and when policy easing materialises.
A – a sharp and material positive shift in China government policy towards real estate
B – the situation worsens materially and quickly and contagion spreads across the whole sector and wider China economy
C – volatility continues: the liquidity crunch forces weaker companies to default. Limited easing causes occasional bouts of optimism
Source: Bloomberg data from 01.07.2021 to 27.01.2022. China HY property bond index refers to Markit iBoxx USD Asia ex-Japan China Real Estate High Yield TRI.
Among the scenarios A, B and C in the chart above, we believe that C could be the most likely to transpire, which in turn could create some attractive entry and exit points.
Despite the prevailing uncertainty, there is no doubt the sector will manage to stay afloat, and consolidation is now underway. In this context, it’s important to make a distinction between those businesses aiming for expansion and scale, and those that are focused on delivery of projects.
For example, all the new projects launched by Yanlord, a high-end property developer, in January achieved a 100% sell-through rate on their first day, compared with the investor average of 40%. Likewise, Shui On, a medium-sized and regionally focused developer, is outperforming the sector in both property sales and land banks. Both the companies are also financially sound, with minimal near-term bond maturities. We see them as potential beneficiaries of sector consolidation, and continue to view them as core holdings in the portfolios we manage; price weakness could create attractive opportunities to add to these holdings in our China real estate portfolio.
As active managers, we expect to be tactical in managing our exposure to China real estate and will seek to take advantage of periods of volatility to add value. We focus on the merits of individual companies even while keeping a close eye on the overall outlook for the sector. Our nimble and tactical approach means we stay ready to take advantage of any opportunities that may come our way.
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