The woes of China’s real estate market could be attributed to the hoarding of assets by leading property companies, according to one analysis by a prominent Chinese economist.
Evergrande files for bankruptcy
The debt woes of China’s property sector have most recently culminated in a bankruptcy filing by one of the country’s biggest real estate concerns.
On 17 August, China Evergrande Group filed for Chapter 15 bankruptcy protection at a court in New York. The filing permits the protection of Evergrande’s US assets as it continues to restructure its debts and negotiate with creditors.
The move comes in the wake of protracted challenges for Evergrande during the Covid pandemic, including its suspension from trading in 2021. On 17 July, Evergrande released its performance results for 2021 and 2022, revealing losses of 686.219 billion yuan and 125.814 billion yuan respectively, for year-on-year declines of 235.02% and 26.63%.
Evergrande is far from the only Chinese property giant left imperilled by its highly leveraged business model. Country Garden recently announced that it could sustain losses of as much as US$7.6 billion for the first half of 2023.
Given the outsize role that the property sector plays in the Chinese economy, these disruptions to its leading players could have major implications for its overall health.
In an opinion piece that gained traction on social media platform Sina, economic pundit Chen Guanglei (陈广垒) said that as of 2020 the real estate sector’s contribution ratio vis-a-vis China’s national economy was 7.34%, while also accounting for a 13.5% share of the tertiary sector, putting it behind only the retail sector and finance.
Evergrande’s downfall spurred by excessive leverage
Excessive debt has played a pivotal role in the undoing of Evergrande. Chen Guanglei writes that Evergrande is the “representative of a growth model involving high debt, high leverage and high turnover.”
“As a classic example of high-turnover development, since 2016 Evergrande saw a surge in assets and liabilities, becoming a Chinese real estate enterprise with a super-large balance sheet,” Chen writes.
According to Chen, Evergrande’s 2022 results indicate that as of December 31, 2022, the balance of China Evergrande’s interest-bearing debts was 612.391 billion yuan, accounting for 25.12% of total liabilities.
Short-term interest-bearing debts accounted for 24.08%, a decrease of 14.53% from the end of 2020. Cash, however, was only 14.305 billion yuan (including restricted cash), in a clear sign that Evergrande Real Estate was unable to repay its debts in 2021-2022.
Evergrande’s long-term liabilities consisted primarily of bonds and (US dollar) senior notes. Total interest-bear debt denominated in the renminbi and US dollar accounted for 75.95% and 21.23% respectively of these long-term liabilities, incurring considerable exchange rate risk. In 2022, Evergrande saw 9.59 billion yuan in exchange rate losses as a result of the appreciation of the US dollar.
China’s real estate developers severely indebted by international standards
Evergrande isn’t alone in the Chinese real estate sector in its use of a highly leveraged business model. Zhang Bin (张斌), senior researcher with the China Finance 40 Forum, points out that the Chinese property sector as a whole is highly indebted by global standards.
“From the perspective of industry comparison and international comparison, the debt level of China’s real estate sector is extremely high, and this cannot be explained by inherent industry traits,” Zhang wrote in a collaborative research piece published on 17 August.
Zhang’s research found that the Chinese real estate sector’s debt-asset ratio was 79.3% in 2020, higher the Japan by 10.6 percentage points, the US by 22.7 percentage points, Germany by 24.9 percentage points, France by 41.0 percentage points and the UK by 42.0 percentage points.
Excessive debt caused by “asset hoarding”
Zhang points out that since the start of last decade, Chinese developers have increasingly adopted a business model consisting of high turnover driven by the pre-sale of properties.
According to his data, during the period from 2008 to 2021, off-the-plan housing’s share of total commercial housing sales in China rose from 64.5% to 87.0%. At the same time, the share of real estate development funds derived from advance receipts rose from 24.6% to 36.8%.
This high turnover model consists of developers accelerating the schedule for building starts to make a rapid grab for pre-sale funds, before using advance receipt from home buyers for subsequent land acquisitions and construction.
In theory, this should help reduce the debt dependence of real estate developers by giving them ready access to cash.
A popular view in China, however, is that high turnover has been one of the chief causes of high debt, given that the rise in debt levels since 2010 has coincided with the adoption of the high turnover business model.
“From a financial point of view, high turnover does not necessarily lead to high debt, but should help reduce dependence on debt,” Zhang writes.
“The core of ‘high turnover’ is the high turnover of funds, which is the pursuit of positive cash flow as soon as possible. The result should be an acceleration in asset turnover and income realisation for real estate companies, which should correspond to a decrease in dependence on debt.
“The reality, however, has been quite the opposite.”
Zhang points out that in the case of the Chinese real estate sector, there has been low asset turnover due to “asset hoarding” by companies that anticipate further gains from appreciation in property prices.
His researchers looked at the annual report data of mainland real estate companies listed in Shanghai, Shenzhen and Hong Kong. They discover that their asset turnover rate dropped from 26.4% in 2010 to 22.0% in 2020, for a decline of 4.4 percentage points. This decline in the overall asset efficiency should not coincide with a “high turnover” model.
“While real estate adopts a high turnover model in the development and sale of commercial housing, a considerable part of the asset turnover rate is very low, and ultimately lowers the overall asset turnover rate of real estate companies,” Zhang writes.
“Based on this, we can infer that when accumulating assets, the real estate industry has formed a large-scale base of ‘accumulation assets’ that are difficult to cover via sales revenue and operating income.”
According to Zhang, there are two main reasons that real estate companies have accumulated a huge volume of these assets that lack cash flow coverage.
“Firstly, during a period of rapid housing price rises, real estate companies hope to hoard more land and build inventory. Secondly, a considerable part of these hoarded lands and buildings fail to obtain their expected cash flow after being held and developed.”
Consequently, this asset hoarding and its attendant cash flow problems further compound the debt woes of highly leveraged developers.
“High debts are basically brought about by the accumulation of assets that are difficult to sell or rent out,” Zhang writes.
“Under the prevailing market conditions, it is difficult for these assets to generate sufficient cash flow. However, the debt and interest payments are still there, so the cash flow of real estate companies continues to be depleted.”
Is Chinese property in bubble territory?
The price-to-income ratio for Chinese housing remains extremely high, especially in big cities.
In 2020, the house price-to-income ratio in China’s top 50 cities reached 12.3, including 20.3 for first-tier cities, 11.4 for second-tier cities and 11.3 for third-tier cities.
China’s top five cities in terms of house price-to-income ratios were Shenzhen (33.9), Shanghai (26.6), Sanya (24.6), Beijing (23.4) and Xiamen (19.2).
“Although China’s per capita income has just crossed the US$10,000 per capita level, housing prices in China’s first-tier cities are already comparable to housing prices in the major cities of economies with a per capita income of US$40,000 or more,” Zhang writes.
“A 2019 comparison of housing prices in the central urban areas of the world’s core cities found that the first-tier Chinese cities such as Beijing, Shanghai, and Shenzhen ranked in the top ten, and their housing prices were comparable to those of world-renowned cities such as New York, San Francisco, and Paris.”
Zhang attributes the exorbitant price of Chinese housing to “lack of flexibility in the supply of residential land in big cities,” alongside a disconnect between the supply of affordable housing and domestic population flows as well as market development lags.
Despite the high price-income ratio of Chinese homes, Zhang does not believe the property market is in bubble territory or will eventually see a precipitous drop in values.
“High property prices are not necessarily equal to property bubbles,” Zhang writes. “The pain caused by housing bubbles may not burst as quickly as bubbles, and could last for a long time.”
Zhang points specifically to the high interest coverage ratio of Chinese households as the chief reason that home prices are unlikely to plunge in the near term.
The interest coverage ratio measures the ability of households to repay their mortgages based on their debt, savings and interest levels.
Research from Vanke’s Tan Huajie (谭华杰) found that the interest coverage ratio was a more reliable predictor of home price declines than the price-income ratio.
An interest coverage ratio of under 1.5 frequently portends a sharp decline in housing prices, as was the case for households in the US (1.46) in 2007, Japan (1.49) in 1989 and Finland (0.73) in 1989.
According to Zhang, the interest coverage ratio of Chinese households currently stands at around 8, indicating that their ability to pay off their mortgages remains high.
“From the perspective of international experience, there is very little chance that real estate prices will fall sharply in the near term and cause systemic risk.”
Chinese property needs to change its business model
Given the affordability challenges of urban housing in China as well as the debt woes of leading developers, both Chen Guanglei and Zhang Bin highlight the need for the property sector as a whole to make deep-seated changes to its business model.
“The ‘high debt, high leverage, and high turnover’ development model represented by China Evergrande depends on certain preconditions, including a rapid increase in the urbanization rate, loose credit policies, and local government support for ‘land finance’ under the tax-sharing system,” Chen wrote.”
Zhang Bin points to three changes in particular that make the current business models of the property sector unviable.
- China’s rapid urbanization phase has passed, and the urbanization rate may be approaching an inflection point after breaching 63.9%.
- Most cities in China have completed their urban renewal programs, and the demand for urban renewal across the country will drop significantly in the future.
- Chinese society is ageing, and the number of new homebuyers will continue to decrease in future.
Zhang advocates two means for resolving the debt burden of the real estate sector.
- Promote the marketization of mortgage interest rates, ease the debt repayment burden of the household sector, and stabilize the housing demand of the household sector. “At present, China’s housing mortgage interest rate is based on the 5-year loan prime rate (LPR). The average interest rate of personal home loans in the fourth quarter of 2021 was 5.63%. The average yield to maturity of 5-year treasury bonds for the same period was 2.75%, and the interest rate difference between the two was 2.88 percentage points. In the fourth quarter of 2021, the scale of personal housing loans is 38.3 trillion. Given the average interest rate spread of 1.5 percentage points in developed countries, there is room for a 1.3-1.6 percentage point decline in home loan interest rate, while corresponding mortgage interest payments can be reduced by 500-600 billion yuan per year. The reduction in interest expenses brought about by the decline in mortgage interest rates will not only ease the debt repayment burden of the household sector and improve its cash flow, but also stabilize the housing demand of the household sector.”
- Adopt the “subsidised interest + REITs” model to invigorate accumulated assets and increase the housing supply for low- and middle-income groups, while defusing the debt risks of real estate companies. “The core idea of the ‘subsidised interest discount + REITs’ model is to use the financial market to transform part of the accumulated assets of real estate companies into public housing with quasi-public asset attributes by means of asset securitization. This will not only alleviate the debt pressure faced by real estate companies to a considerable extent, it will also increase the public housing supply of local governments.”