The fall of Evergrande: What’s next for China’s real estate sector?

From revenue to debt, Chinese property developers are facing 360-degree and tighter regulations. The rhetoric about “common prosperity” means home prices will be controlled with more ceilings, but it comes with a contradictory trend of price floors in some cities. What is behind is some property developers need to find their ways of survival through cutting prices, which is a result of rapid deleveraging and a more challenging operating environment. As a follow-up of?the immediate spillover effect of Evergrande, we focus on China’s real estate sector and analyze the future implications.

Under the radar of regulations, Chinese property developers now find themselves in a trilemma. The constraints on borrowing mean access to capital for refinancing debt is difficult. Property developers may try to boost sales with discount and faster turnover, but price floors can make it challenging to offload inventories for cash. Together with the mortgage quota in banks, home buyers may need to go through a rigorous and lengthy process in getting loans, meaning compressed demand for real estate. For property developers, this means dual pressure on profits and repayment.

Above all, an emerging problem is the heavy reliance of pre-sales, which is now amplified by the regulations. The share of pre-sales to real estate investment has increased from 39% in 2015 to 54% in July 2021, showing the more important role in quick turnover to fund the business operations. The government has introduced the “three-red-lines” policy targeting advance receipts from pre-sales, leverage, and liquidity. As of H1 2021, 64% of property developers cannot meet the criteria linked to pre-sales, which is clearly higher than the other metrics.

Still, the pressure is more severe for private property developers. The overall picture shows the share of firms touching all the three lines has declined from 20% in 2020 to 15% in H1 2021. However, there is a clear divergence of better performance in central SOEs, and to a less extent local SOEs, versus private firms. That said, only 18% of private firms can meet all requirements from the policy, drawing a sharp contrast to 26% in local SOEs and 46% in central SOEs.

Therefore, we expect more private and small real estate developers to fall with tighter regulations and weaker profit generation, especially for the firms with high leverage. A key question is whether the fall of Evergrande will trigger a domino effect and pose systemic risks. The answer is systemic risks will be avoided in the run-up to the 2022 Party Congress given its historical importance. However, this would also imply China Evergrande's debt crisis may snowball down the road considering economic growth will not be here to awash financial losses as was the case in the past. The most likely scenario is Evergrande may be forced to sell assets at a discounted price, but finding a white knight will be challenging given the large corporate size.

Full report is available for Natixis clients.