Despite the general unease towards China’s real estate industry, an unease that centered on speculation that the rising property prices and sustained building boom in China were contributing to the creation of a burgeoning property bubble within the country, international investors in the past few years have zealously poured money into the Chinese real estate market. Drawn by the high yield bonds issued by Chinese developers and the impressive earnings of these companies, international money managers were more-than-willing buyers for the property bonds issued by Chinese companies looking to borrow large sums in short-term debt in order to purchase land and build projects as quickly as possible to take advantage of skyrocketing property prices.

While China experienced its decade-long boom in the real estate sector, this risky business model paid off handsomely for both parties due to strong property sales. Especially when compared to the low returns available in developed markets during the past few years after the financial crisis, higher returns in Asia have attracted many international investors. Even when housing prices began to stagnate in 2013, Chinese property bonds still outperformed most of their peers in 2013 and 2014. While many people have pointed to China’s low urbanization rate (just 54% in 2013) and population of 1.357 billion (which could possibly see growth in the future as the government’s infamous “one-child policy” becomes more relaxed) to rationalize the building boom, there’s no denying that the Chinese real estate industry has been off to a rough start this year due to oversupply, and a weakness in China’s real estate industry has greater implications for the already-beleaguered Chinese economy, which is currently growing at its slowest rate in over two decades.

The government’s official February figures released on March 17 by the National Bureau of Statistics reported that housing prices in 70 of China’s major cities decreased 5.7% compared to a year earlier, making this the sixth consecutive month of declining real estate prices. This is not the first time that property values in China have experienced a significant decrease—property values had fallen earlier in 2011 and again in 2012 but were quick to recover soon afterwards. However, this protracted period of falling property prices has taken its toll this year on highly-leveraged Chinese developers, the most notable casualties being Kaisa Group Holdings Ltd (1638:HK) and Evergrande Real Estate Group Ltd (3333:HK).

Kaisa successfully weathered 2011’s housing price declines (caused mainly by the government’s efforts to rein in booming housing prices by ordering banks to tighten credit), and when the government reversed its policies in 2012, its high-yield bonds (promising yields of 10.25%) were snapped up by investors, who made $3.9 billion of offers for the $250 million in offerings by the company. Kaisa’s debt rating was even upgraded at the time. In the first half of 2014, Kaisa by all appearances seemed to be a successful company—it had a BB rating and was the top-rated residential property-sales firm in Shenzhen with, by its own reports, over $1.5 billion in cash. However, when the company ran into to trouble with the local government and had its permits frozen in October, things quickly spiraled out of control. It was revealed that Kaisa had mislead investors and had a significantly larger debt burden than it had disclosed—65 billion yuan ($10.5 billion) compared to the 30 billion yuan ($4.8 billion) it had reported. In the months since, Kaisa has been downgraded to a D rating and defaulted on a $128 million interest payment on $500 million of debt to foreign investors, missed two coupon payments worth a total of $52 million, and is currently subject to a planned buyout by Sunac China Holdings Limited (1918:HK) that is dependent on acceptance by Kaisa’s offshore creditors, who would receive only 50% of the value of their holdings if they agree to Sunac’s offer.

While Kaisa’s was a local, medium-sized company, its debt problems were not unique. Evergrande, China’s second largest developer by revenue, received a $16 billion (100 billion yuan) bailout on March 17 from China’s state-owned banks (in comparison, Bank of America spent $4.1 billion on Countrywide Financial in 2008) after essentially being deemed “too big to fail” by the Chinese government. Evergrande’s debt as a proportion to equity was 287% in 2014.

More generally, the business model used by both Kaisa and Evergrande is the same one that has been repeated across the board by Chinese developers (and Chinese companies in other industries as well), and due to the large stock of unsold inventory, small developers have defaulted on loans whereas larger developers have reported weaker-than-expected earnings as their margins narrow due to slow sales. As a result, foreign investors are approaching these highly-leveraged companies with circumspection and are bearish on China’s housing market. To add further to the problems facing Chinese real estate industry, in addition to internal demand problems, the US rate increase will also have an adverse effect on China’s housing market as investors pull money from developing markets.

Real estate has been vital to the development of China’s economy, making up 33% of China’s economic activity, and local governments rely heavily on land sales to drive revenue. With land-sale proceeds projected to decrease 20% in 2015, China’s already low projected growth numbers could take another hit. China’s housing bubble has been subject to frequent comparisons to the US housing bubble, and while it should be noted that China is not subject to the same risks—new homebuyers in China must pay at least a 30% down payment in cash (compared to the 2% cash down payment median applied to homebuyers in the US in 2006) and China, for the most part, does not have sub-prime mortgages, CDOs, or CLOs—the massive oversupply of housing (nearly 1 in 5 completed homes in the country are empty) is a serious cause for worry. With wealthy Chinese investors, who had traditionally been enthusiastic buyers of new properties, increasingly turning to wealth-management products and foreign properties due to laxer government restrictions on where they can invest their money, real estate developers are having a harder time selling their properties. Because government restrictions on Chinese investors have traditionally pushed households to put the majority of their net worth into properties, falling housing prices have a direct effect on ordinary households. With a price-to-income ratio for houses that peaked at 8.1 in 2009, the high housing prices meant that buyers were often buying properties that would take 20 years to pay off.

China’s central bank has recently cut its benchmark interest rates (the second rate cut in four months) and the government has eased its housing tax and lending rules, and while it is too early to draw any conclusions given the mercurial nature of Chinese housing prices and the uncertainty regarding China’s policy response, the outcome of this fiasco could be an indicator of whether the world’s “slowing giant” can transition into sustainable and stable growth.

Please reach out to Grace Chang at gc4@princeton.edu for any questions, comments, or concerns.

Written by thefinancier

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