China property problem — Bigger than Mt. Evergrande

Spencer Morgan

Spencer Morgan
CFA, Portfolio Manager, 09/29/21


Sunac China Holdings, a real estate developer in China, considered sending a letter to authorities in eastern Shaoxing asking for “special policy support” because operations in the city have become difficult, Bloomberg reported last week. Sunac has “run into big hurdles and difficulties in terms of cash flow and liquidity,” according to the letter from a subsidiary and intended for the local government. “Sentiment in the housing market has fallen to almost freezing point. We face huge pressure,” it said.

This occurred less than a week after competitor China Evergrande Group’s default warnings contributed to sharp declines in global equity markets.

Unsellable properties

Sunac invested 7.7 billion yuan ($1.2 billion) into a Shaoxing project, but has only sold one to two units per week since launching sales in August, according to Bloomberg, citing the document. The firm has recouped just over 200 million yuan. The company’s shares and bonds had tumbled in recent weeks — even before its reported appeal to the government — due to fears about market contagion from Evergrande.

According to Bloomberg data:

  • In 2015, Sunac had $6.5 billion in debt and $2 billion in prepaid deposits (a form of leverage). By 2021, debt ballooned to $47 billion and prepaid deposits rose to $42 billion. That’s a 7-fold increase in debt and a 21-fold growth in prepaid deposits. The company’s market capitalization is $8 billion, or less than 20% of its enterprise value.
  • Out of 100,000 publicly traded securities in the world, only 205 companies have more debt than Sunac’s $47 billion. This is comparable to the debt of McDonald’s Corp. ($49 billion), Deere & Co. ($48 billion), UnitedHealth Group ($48 billion), American Airlines ($48 billion), and Bayer AG ($47 billion). Unlike these companies, which were built over many decades, Sunac accumulated 90% of its debt in just five years.

A potential $2 trillion stack of dominoes

To understand the scale of the problem, consider the debt of all property developers in China and Hong Kong. A total of 241 publicly traded developers have a combined $2 trillion in total obligations, made up of net debt and prepaid deposits. The firms’ combined market capitalization is $500 billion, and operating income is just $150 billion (13x debt to operating income). If real estate prices and/or volumes decline this year, leverage ratios will look even worse.

Six of these Chinese real estate companies (Evergrande, Poly Developments and Holdings Group, Country Garden Holdings Co., Greenland Holdings Corp., Sunac, and China Vanke Co.) have at least $45 billion in debt and rank in the top 220 most-indebted firms in the world.

Indirect risks

As China’s real estate debt crisis worsens, focusing on direct exposures to the debt of companies like Sunac or Evergrande misses the point. During the U.S. subprime crisis, companies like General Electric, Ford Motor, and Caterpillar had zero exposure to Lehman Brothers bonds, but that didn’t prevent their stocks from falling 70% to 80% between 2007 and 2009 as the S&P 500 Index fell 55%. Ultimately, these businesses were affected by a decline in consumer demand and a tighter lending environment.

History doesn’t repeat, but it often rhymes

In a key difference from the U.S. subprime crisis, China is unlikely to allow its banks to freeze lending to one another. As such, there may not be the same degree of panic as when capital markets ground to a halt in 2008. China may currently have less hidden leverage, including derivatives, collateralized debt obligations, and other debt forms, than in the U.S. episode. That said, we can’t be certain, and we might find out in a few years there were off-balance sheet problems lurking beneath the surface, such as the large wealth management products segment of China’s capital markets.

While China has greater control over its banks and fewer derivatives, the scale of its housing problem is potentially far larger. Chinese real estate is a $50 trillion asset class, 2.5x the size of the U.S. real estate market in 2007, or nearly as much per capita. But China’s GDP per capita is only 16% of the United States. Moreover, 70% of urban Chinese wealth is invested in housing — real estate directly and indirectly contributes 29% of China’s GDP. Evergrande alone has 1.5 million buyers waiting for unfinished homes, which is more than the 1.4 million new home starts for the entire United States in 2020.

Authoritarians versus accountants

One often hears the argument that China has an authoritarian government and can easily contain the problem, or in a similar vein, real estate is “too big to fail.” But their control is not infinite. If it could, China’s government would happily wave a magic wand and give every family $1 billion, but that’s impossible. By the same token, they can’t magically wish away a $50 trillion property bubble built on the backs of highly levered developers, miners, and builders.

It is possible the worst of this crisis has passed, and Sunac and Evergrande will quietly fade into the rearview mirror, leaving the rest of the economy unscathed. But investors should be prepared for a potentially bumpy ride as China works through its bad debt and finds a new equilibrium.

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