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Red Flags On Indebted Chinese Developers

With restricted financing remaining a key risk, larger and more solvent names will fare better amid sector consolidation.

Kate Lin, CAIA 23 July, 2021 | 10:54
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Fallen Bollard

 

The recent debt drama involving China Evergrande Group (03333) should propel investors to evaluate the risks of investing in China’s property development sector. Especially as policy headwinds may only leave the strongest builders standing.

China Evergrande  found itself in a dispute with one of its lending banks relating to loan repayment. The news  triggered a selloff on the  shares and outstanding bonds  of the indebted developer. Although China Evergrande said it has settled the loan repayment raised by the mainland’s Guangfa Bank, property developers across the board still face medium pressure due to a policy overhang, according to Cheng Wee Tan, Morningstar’s senior equity analyst.

“The policy overhang will likely persist and we expect more ‘polarisation’ in the sector,” says Tan, who foresees that regulatory pressure will cap the overall growth of the sector and trigger consolidation in the sector. “There still remains a chance where the government may consider further tightening if the physical market in China continues to heat up.”

 

Three Red Lines

The Evergrande episode collides with credit tightening measures announced last year. China's ’Three Red Lines’ policy is designed as a state-wide initiative to manage systemic risks stemming from the indebted property development sector, which accounts for almost one-third of the country’s economic output.

The rule, enacted from mid-2020, uses three thresholds to evaluate a real estate developer’s gearing situation to determine its borrowing level for the following year:

  1. a 70% ceiling on liabilities to assets, excluding advance proceeds from projects sold on contract,
  2. a 100% cap on net debt to equity,
  3. a cash to short-term borrowing ratio of at least one.

Even if a firm passes all the requirements, it can only borrow an additional 15% in debt volume the next year. The constraints to financial resources will suppress the sector’s growth because debt financing has been critical for developers to sustain operations or bid land for new projects, for example. He believes the current credit environment is especially difficult for small-scale developers that are not listed. As these firms are less likely to receive funding from banks, they are prompted to increase cash levels by cutting the prices of property projects, which translates into a major profitability headwind.

On the contrary, investors that are looking at Chinese property stocks should stick to larger-sized developers with sound balance sheets and reliable sources for funding, Tan says. These features are key to help developers withstand the policy tightening environment while absorbing market share from smaller players that fall out.

 

Move Away from Residentials

Across his equity coverage, China Resources Land (01109) and China Overseas Land & Investment (00688) are in favour. The coverage of the two firms was recently reinitiated by Morningstar equity research.

“There is an emerging trend for the mainland developers to pursue diversification away from residential property development in light of policy headwinds.” He observes China Resources Land and China Overseas Land & Investment embracing this trend, with plans to grow their investment property portfolios.

For example, China Resources Land aims to transition from a pure-play residential developer into one known for developing and expanding large-scale, mixed-use projects. Its investment portfolio and project pipeline are enhanced to bring a more stable rental income stream.

“This business segment is expected to drive the company’s rental income growth to a double-digit level. The recurrent income will help diversify its profit away from the cyclical nature of property development business.” He adds that China Resources Land’s latest success of a commercial property project in Shenzhen has anchored investors’ confidence.

More importantly, China Resources Land is a state-owned enterprise (SOE) which allows it to enjoy low funding costs. The firm’s debt level is also lower than its peers. Tan believes, given more financial resources and debt capacity, the firm can still be focused on contracted sales and rental income rather than debt restructuring under the challenging operating landscape for domestic developers.

Over at China Overseas Land & Investment, also a SOE, the company is planning to more than double its number of malls under operation and management in the next few years and may also seek to expedite the growth by M&A to acquire high-quality malls.

“We expect China Overseas Land & Investment to also fare well in this consolidation backdrop. It will be one of the few developers to successfully maintain growth by focusing on operational efficiency and opportunistic acquisitions,” explains Tan.

Both China Overseas Land & Investment and China Resources Land are rated with no economic moat and are undervalued to our fair value estimates of HKD 28.5 and HKD 44.0 per share, respectively.

 

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar Rating
China Overseas Land & Investment Ltd21.55 HKD5.38Rating
China Resources Land Ltd32.25 HKD4.37Rating

About Author

Kate Lin, CAIA

Kate Lin, CAIA  is a Data Journalist for Morningstar Asia, and is based in Hong Kong

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