China’s property market is a microcosm of China’s debt problem, with mega developers potentially becoming ‘too big to fail’. While returns have been strong and selective opportunities can still be found, investor caution is deepening as the authorities tackle systemic weakness.
7 minute read
China’s residential property sector is the backbone of the world’s second largest economy, a crucial component powering growth. It is also, unsurprisingly given the state’s influence over economic affairs, an industry in which the government has a particularly heavy influence. During times of market stress, such as the global financial crisis or the 2013 ‘taper tantrum’, policymakers stoked the economy by stimulating housing supply and demand. Such interventions were followed by a tightening cycle to prevent overheating when recovery had taken hold.
Through several cycles of easing and tightening, investors have become comfortable – some would argue too comfortable – on these government signals, dialling up risk when policies loosen and vice versa. This approach was repeated late last year, with policymakers lowering restrictions on homebuying and reducing mortgage rates among other stimulus initiatives as growth softened. Such efforts are centrally planned through agencies such as the National Development and Reform Commission, with some flexibility in the implementation by provincial and city governments, indicating the importance of the sector to China’s socio-economic stability.
Investors have benefited from such measures, as well as global macro events such as the Fed’s more dovish stance. The MSCI China Real Estate Index – which primarily tracks large- and mid-cap listed companies in the real estate sector – climbed 23 per cent in the first quarter of 2019 after retreating nine per cent in 2018. China real estate stocks easily beat the broader MSCI China Index, which advanced 18 per cent in the first quarter after having fallen 19 per cent last year, as the chart below shows.
From boom to bust?
However, as an example of the conundrum China faces in solving its debt problems, the property market is racking up a potentially unsustainable amount of borrowing, which impacts several other crucial parts of the economy. While the sector has delivered strong returns recently, it is also a source of vulnerabilities, according to a recent International Monetary Fund working paper, ‘Stabilising China’s Housing Market’.1
First, government intervention is being tempered as China looks to rebalance the economy from state-led, debt-fuelled investment towards a more consumer-driven growth model. Second, demographic factors, such as a decreasing rate of urbanisation, may slow property sales growth. Third, the law of diminishing returns suggests that as more people buy their first, second and even third homes, the potential for them to make any additional purchases falls even as conditions become more enticing. Heavy discounts are already becoming commonplace; one property developer offered a new BMW Series 3 or X1 car to buyers in Shanghai, according to Bloomberg.2
“How the government manages the transition of the real estate industry to a more stable footing – without causing a property crash – will be one of its biggest challenges in the coming years,” says William Malcolm, portfolio manager in emerging markets and Asia-Pacific equities at Aviva Investors.
“It doesn’t mean it’s not manageable, and there is a realisation at the highest level of the government of the systemic financial risks that exist in the property market,” he adds. “Nevertheless, they need to be careful to reduce stress in a gradual, controlled way.”
These structural issues are worsening just as China is experiencing a host of cyclical problems, such as slowing growth amid global trade tensions. In an industry already heavily distorted by state intervention, any misstep by policymakers could be destabilising, not only to the domestic economy but also globally given China’s growing importance. The government’s efforts to stabilise the property market could also create investment opportunities, however, at least for companies that are best able to adapt.
State of play
Relative to developed markets such as the US and the UK, China’s property market is far more intertwined to the banking system, local governments’ fiscal budgets, and private savings and debt. It accounts for up to 12 per cent of China’s total gross domestic product,3and as much as 20 per cent when secondary effects such as steel, cement and retail are factored in.
“Any decline in property could cause outsized knock-on effects to other industries. That’s why the government is so focused on managing the problems in this sector,” says Malcolm.
The Kansas City Federal Reserve Bank estimated that if current housing activity in China falls by 10 per cent, the total decline in China’s output over the next few years could be around 2.2 per cent of GDP.4 Considering China’s GDP in 2018 was 18 per cent of the world’s total when adjusted for purchasing power parity,5 a jolt to the property sector would be felt across the world. In a separate analysis, Oxford Economics estimates if China’s output falls by two per cent, world GDP growth would decline to 2.5 per cent by 2020 from a baseline forecast of 2.7 per cent.6
“The precise pattern of effects would depend to some extent on the cause of the shock,” says John Payne, economist at Oxford Economics. “A steep downturn in the Chinese property market would be expected to have a particularly large effect on commodity prices, with notable negative knock-on effects on currencies and stock markets in commodity-producing economies.”
On borrowed time
China’s property developers have relied on debt to fuel growth, but the government’s deleveraging campaign is forcing more companies to turn to riskier debt with higher coupons, either offshore or via the shadow banking system. Inadvertently, in trying to reduce risk, the government may be encouraging more.
Evergrande, one of the nation’s largest property developers, had a market capitalisation of about US$44 billion (£34 billion) and an enterprise value of about US$175 billion as of March 31, 2019, according to Oculus Research Asia, an independent real estate research company. By comparison, Simon Property Group, one of the US’s largest property developers with a market capitalisation of US$56 billion, had an enterprise value of US$80 billion. In the residential sector, the UK’s Barratt Developments has a market capitalisation of about US$7.8 billion and an enterprise value of about the same.
Since enterprise value takes into account the company’s market value of debt less any cash in addition to its market capitalisation, Evergrande – like most Chinese developers – is more heavily indebted with potentially negative cashflows relative to international peers.
Chinese developers are also issuing more offshore debt at higher yields, which carries more risk of a currency mismatch and makes issuers more fragile since a large proportion is not hedged.7 In the first quarter, for example, Chinese developers issued a record US$24.2 billion of debt, up 32 per cent year-on-year, at yields that topped 10 per cent in some cases.8
“The surge in offshore debt comes amid stronger risk appetite following a more dovish Fed stance,” says Alice Wu, fixed income analyst at Aviva Investors. “However, it’s also a reflection that onshore funding conditions remain constrained.”
The vast majority of borrowing by Chinese developers is onshore, however. But worryingly, a significant amount comes via shadow banking. Overall, shadow banking accounts for about 20 per cent of the total debt among developers tracked by S&P Global Ratings and is much higher among lower-rated property developers, as the chart below shows.
“The government’s focus on deleveraging led banks and other financial institutions to unwind off-balance-sheet exposures and bring them back onto the balance sheet last year,” says Christopher Yip, a credit analyst at S&P Global Ratings who follows real estate companies. “Property developers who have relied on shadow banking to finance aggressive growth have found it less accessible and more expensive until earlier this year. However, availability has improved in recent months, signalling a pick-up, especially for smaller developers,” Yip added.
The building boom has increased debt levels, not just among banks and developers but also households. In China, demand for property has been exacerbated by the restrictions on individuals to access other asset classes. Wealth manager Noah Holdings estimates as much as two-thirds of household wealth is tied to property, with many now buying third homes as investments. (See charts below.)
Further piling on the risk is China’s pre-sale practice, which leaves homebuyers and their mortgage providers with less protection if developers don’t deliver on completion or declare bankruptcy, says Andrew Lawrence, founder of Oculus Research Asia. The practice requires that the entire cost of the house be transferred to developers upfront before completion, but without the protection of being held in an escrow account. Developers have come to rely heavily on this to finance their growth.
“The risk today is not defaults by end-buyers but the failure of a large homebuilder,” says Lawrence. “If we were to see a default by a developer, many people who have pre-bought their homes would find the money is no longer available for completion.”
Local land complexities
Logically, a solution might be to ban or severely limit home pre-sales. However, the repercussions would reach far beyond China’s property sector. Local governments also depend on revenues from land sales to meet their fiscal needs. In some cases, as much as 50 per cent of the local government’s revenues come from land sales, according to estimates by Oculus Research Asia. And while a property tax or something similar has been trialled to give local governments an alternative source of revenues, so far no comprehensive policy has been introduced.
“Local governments are incredibly dependent on land sales,” Malcolm says. “They need to sell land every year to balance their budgets, so they need developers to buy the land. For developers, they need the upfront cash from pre-sales to buy the land. It’s all intertwined.”
For obvious reasons, homeowners oppose property taxes, which generally refers to a recurring annual tax paid to the local government. But again, in China the consequences are more complex. Due to the higher premium on brand-new properties, buyers of second or third homes are often reluctant to lease them out of fear that doing so would diminish their perceived value. So far, this strategy has been sustained partly because there is no holding cost, which a property tax would introduce.
According to research by Southwestern University of Finance and Economics, there are approximately 52 million vacant residential units in China, around 22 per cent of the total urban housing stock.9 That doesn’t take into account what Ting Lu, chief China economist at Nomura International, believes is “the true amount of properties that are under construction”. Under pressure to prop up economic growth and employment while keeping a lid on property oversupply, it can sometimes take up to 15 years to complete the construction a residential building.
“They’re basically doing the equivalent of what [John Maynard] Keynes talked about – paying people to dig holes in the ground and then fill them up,” Lu says. “It would be against their interests to finish the projects as that labour force would then technically be unemployed and there would be such a mass release of property onto the market.”
While recent returns have been strong, the longer-term structural weaknesses remain a concern, especially as government policies may become less supportive in future. Yet changes in the sector could benefit some companies.
“Subtle changes are underway that may support certain companies over others, in equities and credit. In both markets, companies that can access liquidity more easily and at a lower cost have a competitive advantage,” Malcolm says. These tend to be larger companies, or state-affiliated enterprises with stronger balance sheets.
Challenging funding conditions and policy tightening have combined with other pressure points, including industry consolidation, rising land premiums and the eventual cessation of government stimulus activities, such as the shantytown redevelopment project. The latter was a policy initiative costing 1.74 trillion yuan10 (US$256 billion) in 2018 – roughly the size of Finland’s 2018 GDP – that compensated residents with cash to buy new homes if their old one was being demolished.
“The combined effect of these factors translated to slowing sales growth, record low sell-through rates in top ten cities and declining land sales,” says Adeline Ng, head of Asia fixed income at Aviva Investors. “This carries major implications on developers’ liquidity, funding costs and profit margins. Our preference is for larger developers with better credit quality that have demonstrated repeated access to multiple funding channels.”
Developers that are doing more to reduce debt, focusing on quality over quantity and diversifying their business models may also prove attractive. Some, for example, are shifting from residential into commercial property, which is less dependent on centralised policymaking and more determined by market forces. Relative to residential property, commercial projects tend to be capital intensive but can potentially offer more sustainable returns, albeit with their own set of investment risks.
Malcolm is trying to cut through all of the noise surrounding China’s property market. “We’re looking for companies that are fit for purpose as and when China’s property market matures,” he says.
- ‘Stabilizing China’s Housing Market,’ International Monetary Fund, April 2018
- ‘Buy a house, get a free BMW! China developers are getting desperate,’ Bloomberg, September 2018
- ‘Chart: property plays bigger role in GDP than believed, study says,’ Caixin Global, June 2018.
- ‘How much would China’s GDP respond to a slowdown in housing activity?’, Federal Reserve Bank of Kansas City, September 2018
- GDP, PPP data, The World Bank, 2017
- ‘China slump could cut world growth to decade low’, Oxford Economics, 2019
- 'Mortgages, developers and property prices,’ Bank for International Settlements, March 2018
- ‘China Property Watch: The Slowdown Won’t Stifle Jostling Developers,’ S&P Global Ratings, April 2019
- ‘A fifth of China’s urban housing supply lies empty. That’s 50 million apartments,’ Bloomberg, November 2018
- ‘China spends $256 billion on shantytown redevelopment in 2018,’ Reuters, January 2019