China’s Real Estate: Debt Crisis and Developer Challenges

In past years, local governments, aiming for infrastructure development, struck deals with developers allowing them to obtain land at lower prices. The catch was that developers would help the local governments with infrastructure like building bridges, roads, schools, hospitals, and shopping centers. After completion, developers would also assist in attracting investment. For a time, this symbiotic relationship blossomed in a mutual honeymoon phase.

However, as local economies began to improve, many local governments seemed to turn on their developer partners, suggesting they complete infrastructure projects before discussing land approvals. Unfortunately, after the developers fulfilled their end, land approvals were sometimes denied for various reasons, leaving many developers aggrieved but mostly silent.

The construction industry inherently has a long capital turnover cycle, sometimes taking 5-6 years for full repayment. Meanwhile, expenses for labor, materials, and sales persist, creating significant financial pressure. A strategy devised by developers was to mortgage their constructed properties to banks. Once the property was sold, homeowners would repay the bank. Interestingly, many homeowners financed their purchases with bank loans, meaning the bank technically owned the property throughout the process.

Developers realized under this scheme they didn’t have to worry about sales — they simply had to mortgage properties to gain funds. With house prices continuously rising, developers could keep building, ensuring a steady cash flow, and then invest these funds in high-return ventures.

There were even incidents where developers hired actors to create a façade of booming sales at property sites, aiming to convince both potential buyers and banks of the property’s attractiveness.

With house prices skyrocketing across China, even in third and fourth-tier cities, property prices often surpassed local incomes. The phenomenon of “locals can’t afford local homes” became widely discussed.

The decree “Houses are for living in, not for speculation” signaled the start of real estate regulation, with various measures introduced to control property prices and loans. The market soon responded with a cooldown. Local governments tightened land approval processes, from a “villa restriction order” to an outright “villa ban”, followed by restrictions on high-rise plots, all aiming to curb the wild and chaotic expansion of real estate.

Soon after, the central bank and the Ministry of Housing and Urban-Rural Development issued financing policies for developers, effective from January 1, 2021. These were the so-called “three red lines”:

  1. An asset-liability ratio greater than 70% after deducting advance receipts.
  2. A net debt ratio exceeding 100%.
  3. A cash-to-short-term debt ratio below 1.

By mid-2023, the 12 pilot real estate companies had to meet all these “three red line” standards, with all companies expected to comply by the end of 2023.

Evergrande hit all these red lines, making debt reduction its top priority. Various measures were taken, from asset sales, divestments in cultural sectors, debt-to-equity swaps, to other forms of financing. But these actions only exposed the colossal financial black hole, a shocking $300 billion debt, which alarmed the global community given its potential to trigger a worldwide financial crisis. Yet, there was an unusual consensus among foreign media and investors: “China can handle the Evergrande situation”.

So far, there’s no clear sign of the state intervening. The message seems clear to corporate giants: “No company is too big to fail”. Controlling financial risks has become a lesson that Chinese enterprises must heed.

The golden age for the real estate industry seems to be waning. The era where property developers leveraged financial gains for rapid growth no longer exists.

Beyond the above, city investment bonds (often referred to as “城投债” or “City Investment Bonds”) have also become a topic of concern. These bonds, mainly issued by local government financing platforms (LGFVs), have played a pivotal role in fueling China’s urbanization drive over the past few decades.

There’s a close relationship between developers like Country Garden and city investment platforms. For instance, Country Garden might buy land from these platforms or collaborate with them for development. This means that when these platforms face financial risks, developers like Country Garden are directly impacted.

To combat these risks, many developers, including Country Garden, are searching for new partnership models and funding sources. But, clearly, this isn’t an issue that can be resolved overnight. This implies that China’s real estate market might face a prolonged period of adjustment and change.

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