As the Evergrande crisis deepens, what's next for the Chinese real estate sector?

Amidst credit concerns for China Evergrande and a regulatory crackdown in the broader market, the MSCI China Real Estate Index (Figure 1) has fallen by -30% over the past year. In this article, we highlight some key trends in the Chinese real estate sector that investors should look out for.

Figure 1: The MSCI China Real Estate Index started to dip in July

In a healthier housing market, tier-1 cities continue to outperform

In order to curb speculation and stabilise the housing market, Chinese regulators have slapped the real estate sector with several policy curbs over the past year. To name a few, there were limits on debt growth, cap on banks’ lending to the sector, and the hiking of mortgage rates.

Such regulations appear to be working. Based on latest data from the National Bureau of Statistics, China’s housing boom has continued to slow down, with average prices in 70 major cities rising 4.0% year-on-year in August 2021, the lowest in six months. Month-on-month, prices grew at 0.2%.

Additionally, we observed that the growth in housing prices is differentiated based on city tier. Within the 70 major cities, tier-1 cities of Shenzhen, Guangzhou, Shanghai, and Beijing have continued to outperform (Figure 2). This is followed by the tier-2 cities and then, the tier-3 cities.

Thanks to the relaxation of hukou 户口 (i.e. household registration) restrictions, larger cities have seen population influx which creates strong demand for housing. This also comes as China strives to transform migrant workers into urban residents, resulting in more efficient allocation of resources that will spur the economy.

We favour the higher-tier cities where housing prices are driven by strong fundamentals. Supported by demand, we expect higher-tier cities to maintain some level of growth even as tighter regulations stay in place. Meanwhile, we anticipate further weakness in the lower-tier cities due to a lack of tailwinds on the demand side. Based on our findings, the majority of developers (87%) in the MSCI China Real Estate Index are focused on tier-1 and tier-2 cities, while the remaining are focused on tier-2 and tier-3 cities.

Figure 2: Tier-1 and 2 cities are more resilient

Margins have fallen, but is expected to stabilise

Meanwhile, in the open land market, there has been an aggressive bidding of land. This has pushed up land prices, leading to a decline in developers’ gross margins in the last few years. As shown in Figure 3 below, the gross margin of companies in the MSCI China Real Estate Index has fallen by 8.9 percentage points since 2019.

Figure 3: Gross margins of companies in the MSCI China Real Estate Index

We mentioned in our previous article that China’s new land sales rule is pushing 22 big cities to coordinate land auctions, clustering them into specific sessions. This is a step up from previous procedures where local governments release land parcels unevenly without a schedule, causing developers to aggressively bid for land.

The first batch of centralised land supply has already been conducted from April to June. However, it did not produce the intended results as the average land premium rate in the 22 cities did not wane as compared to 2020. Nonetheless, we observed that Fuzhou, Beijing, and Shanghai saw a substantial decline in land premium rate (Table 1).

In view of the above, many cities including Shenzhen and Chongqing recently announced that they will lower the land premium cap to 15%. Apart from that, they are also postponing the second batch of centralised land supply in order to consider ways that can tame the appetite of developers. With the lowering of land premium caps, we anticipate land prices to be kept under control, allowing gross margins of developers to stabilise.

Table 1: Findings from the first batch of centralised land supply

Not all developers are created equal

Moreover, the competition for land is expected to recede as deleveraging continues on across the sector. To recap, under the Three Red Lines introduced by Chinese regulators, developers are required to meet the following requirements:

(1)       Liability to asset ratio (excluding advance proceeds from projects sold on contract) < 70%

(2)       Net gearing ratio (i.e. net debt to equity) < 100%

(3)       Cash to short-term borrowing > 1.0X

Based on our compilations, we find that slightly over 40% of developers have yet to fully meet the requirements under the Three Red Lines (Table 2). This includes Country Garden (HKEX:2007), Sunac China (HKEX:1918), as well as the infamous China Evergrande (HKEX:3333).

Such developers bear the brunt of China’s stringent policy. As debt reduction becomes the top priority, they have been slowing down on land acquisitions. Some developers even had to sell off non-core assets or sell homes at a discount.

Table 2: Debt growth is capped based on colour code

Meanwhile, the remaining 57% of developers who have met all requirements under the Three Red Lines are likely to enjoy a brighter outlook. Their stronger balance sheets allow for a prudent expansion of land bank, which can translate into healthy and sustainable earnings growth.

As margins from property development have passed their peak, some developers have been moving towards the provision of construction services. Property management, which provides recurring income, is another way that can help drive developers’ earnings growth. Such diversification in income stream could also balance some risks from the property development business.

Take for example, China Resources Land (HKEX:1109), a large developer that has met the Three Red Lines. It derives around 18% of revenue from construction services and property management, which is one of the highest in the entire sector.

Key investment risks

Fears of contagion from Evergrande: Currently, the sector, as gauged by the MSCI China Real Estate Index, is trading at a historical low of 0.62X its book value. While valuations look cheap, we don’t know whether the contagion risk from Evergrande has been priced in fairly.

In our worst case scenario, the collapse of Evergrande would raise refinancing risk in the sector, dragging down other developers. We anticipate that the impact will be more significant for developers which are highly leveraged.

In our base case scenario, we expect Evergrande to undergo restructuring. Healthy developers could be asked to take over Evergrande’s unfinished projects in exchange for a share of the distressed developer’s land bank. We believe that the potential impact of this is still unclear, but we note that Evergrande’s land bank has a focus on tier-2 and tier-3 cities. Generally, housing demand in tier-3 cities has been weak.

Lastly, in our bull case scenario, it is assumed that Evergrande gets a bailout from the Chinese government. This scenario is least likely to happen, in our view, as the bailout of Evergrande would send the wrong message to other highly leveraged developers.

Downgrade fair PB for the sector amidst near-term headwinds

As China ramps up efforts to narrow inequality, it is undeniable that the real estate sector would face additional regulations in the future. In the current backdrop, growth in this sector is also likely to slow down.

In view of the near-term headwinds, we have downgraded our fair PB ratio to 0.9X from 1.0X. This translates to an upside potential of 73% as of 23 September 2021. Despite the attractive upside potential, we see a lack of catalysts in the near-term that could drive up the sector’s share price performance and its corresponding ETF, Global X MSCI China Real Estate ETF (NYSE:CHIR). Moreover, we are cautious that valuations of the sector has even more room to fall due to contagion risk from Evergrande.

Nevertheless, we believe that the impact will still vary across different developers. Investors can choose to be prudent and be selective in their investments within the Chinese real estate sector. Moving forward, we seek to uncover some bright spots. Hence, in our next article, we will be highlighting a developer that we think will be more resilient amidst the near-term headwinds.

Table 3: Earnings growth projection

Declaration:

For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) and the analyst who produced this report hold a NIL position in the abovementioned securities.