Investment Perspective | China’s property sector: more pain to come

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    China’s property sector: more pain to come
    China’s property sector: more pain to come
    10 November 2021

     

    More Pain To Come

    The regulatory upheaval in China’s property sector has forced many developers into a cash crunch. But investors hoping for a quick resolution may be disappointed

     

    Developers are struggling

    In towns and cities across China, there are signs of abandoned real estate projects. Evergrande, one of the country’s most embattled property developers, did its best last week to reassure customers that it will honour its existing contracts. The company noted that it had in fact completed over 57,000 homes since July and would continue to do so.

    However, the writing is on the wall. While Evergrande may have staved off a default so far, several large payments are due soon. Meanwhile other highly leveraged Chinese developers have already defaulted or are at risk of doing so, including Fantasia, China Fortune Land, Kaisa, Modern Land, Sinic Holdings, China Property Group, Shimao and Yango.

    In response, markets are continuing to punish Chinese property developers. Bond spreads for Chinese high yield bonds have widened considerably this year, led by the property sector. More worryingly, this poor sentiment is seeping into the sector’s investment grade bonds, with some issues widening by as much as 150 bps. Many property developers have also seen their stock prices weaken considerably over the past few days.

    Figure 1: JP Morgan Asia Credit Index (JACI) by sector

    JP Morgan Asia Credit Index (JACI) by sector

    Source: Bloomberg/ UOBAM

     

    “Not for speculation”

    Investors have shifted from hope to gloom amid a dawning realisation that China’s property sector is in the early stages of a multi-year structural realignment, rather than just a short-term adjustment. This realignment has begun to flow through into the sector’s fundamentals. In September, residential sales fell by 17 percent and new home prices registered a decline, for the first time in six years, of 0.8 percent. A review of overall sales across China’s top developers show that 11 out of 13 saw drops ranging from 10 to 90 percent.

    As we have noted previously, the Chinese government appears willing to bite the bullet in order to address two inter-related and long-standing economic concerns – the housing bubble and property sector leverage. According to Statista.com, in 2008, first time buyers comprised 70 percent of home purchases. But in the following decade, a RMB4 trillion stimulus package topped up by significant borrowings led to a burgeoning of real estate projects, much of it directed at investors.

    This worried the authorities enough for President Xi Jinping to remark in 2017 that “houses are for living in, not for speculation”. But despite measures designed to cool the market, this comment went largely unheeded. By 2018, first time buyers had dropped to just 31 percent of home purchases. The remaining 69 percent were made by buyers who already owned two or three dwellings. Notably in the same period, home prices nearly doubled.

    Figure 2: China home prices vs wage growth

    China home prices vs wage growth

    Source: Bloomberg/ UOBAM

     

    Sector shake-up

    Some of the tightening measures introduced in 2018 were directed at banks, aimed at limiting lending to property developers. To plug the gap, developers resorted instead to issuing bonds. The volume of property sector bonds issuances jumped in 2019 and have continued to rise ever since, except during the height of the Covid pandemic. As of end-October 2021, ratings agency Moody’s estimates that US$33.1 billion of China-listed property sector onshore bonds, and US$43.8 billion of offshore dollar-denominated bonds will be due in the coming 12 months.

    Faced with this debt upsurge, a set of stringent “three red lines” policies were introduced earlier this year to accelerate property sector deleveraging. Whether foreseen or not, these policies have exposed unsustainable debt levels among some private sector developers. Fears of more hidden debt have spilled over into the wider real estate sector.

    It remains unclear to what extent the Chinese government will allow the crisis to persist. However there is now little doubt that the policies are intended to change the name of the game, with an alternate focus on young, aspiring and less wealthy individuals looking to enter the property market. Property developers and banks are urged to offer first time subsidies and mortgages, but without resorting to “malicious price cuts” that could badly hurt existing owners.

    Turnover woes

    This radical shift can be expected to hit developers hard, even those that are not overly leveraged. Over the years, many developers have come to rely on ambitious multi-project roll-outs and high sales turnover. But in an environment of less speculative buying of luxury projects, inventories will likely take longer to clear.

    Already as at the end of September 2021, according to the statistics bureau, unsold inventories of homes in China stood at 224.2 million square metres - about a third the land area of Singapore. Should property sales continue to shrink as was seen in September, this unsold inventory could grow at an alarming pace. We estimate that for China’s top developers, a 30 percent fall in sales could take them over three years to clear existing inventories.

    Where borrowings are involved, this high turnover model is further exacerbated and can result in a double whammy. Evergrande’s case demonstrates this clearly and is not atypical among big property developers. A quick turnover helps developers like Evergrande fund new projects and maintain a good cashflow. But once this turnover starts to lag, developers can no longer rely on fresh fund flows, while at the same time are unable to service their loans.

    Figure 3: Evergrande Sales vs Debt

    Evergrande Sales vs Debt

    Source: UOB/Bloomberg

     

    End not yet in sight

    It is this double whammy that can be expected to play out among China high yield property bond issuers in the weeks and months to come. Regardless of any new surprises on developers’ balance sheets, even a relatively limited weakening of the property market is likely to have a magnified impact on developer cash flows. Nor is a lifeline readily available. Given the strong “common prosperity” imperative driving current government policies, there appears to be a willingness to stomach more disruption within the sector.

    This leads us to take the view that the Chinese property high yield bond market is not yet out of the woods. We would expect to see several more high profile defaulters and as such would prefer to focus on credits rated double-B or above within the property sector.

    This aside, a significant spillover into the financial sector seems unlikely. Most Chinese banks still retain strong reserves and the ability to absorb losses arising from their mortgage and property loans. However we are sensitive to the increased risks within the Chinese financial sector, and are taking a more selective stance.

     

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