Three years ago, the Chinese authorities took the first measures to curb speculation on the real estate market. 2024 is the year of the Wooden Dragon in China. Dragons are usually associated with leadership, achieving goals and are seen as a symbol of good luck. Hopefully, the Year of the Wooden Dragon in 2024 will bring some luck to the Chinese real estate sector.
Housing construction activity has risen sharply in China over the past 20 years, driven by urbanization, rising disposable income and speculation. Thanks to the latter, purchasing multiple homes became a popular investment among Chinese households, as they considered past performance a guarantee of future growth.
But as Chinese developers set new sales records, Beijing authorities grew concerned and, driven by the philosophy that “houses are for living in and not for speculation,” introduced a series of policy measures in August 2020 to curb speculation on the real estate market and the debt burden of builders.
These regulations caused many companies headaches that quickly turned into a liquidity crisis. The introduction of strict pandemic restrictions exacerbated this crisis while eroding household confidence. The lifting of these restrictions in 2022 was not sufficient to address the issues described above.
Some smaller cities (i.e. less developed cities) tried to stimulate demand by relaxing restrictions on home purchases and improving housing affordability. However, an uncoordinated response, depressed sentiment and the evaporation of investor demand (due to Beijing’s crackdown on speculation) resulted in weak demand. Ultimately, it was only in August 2023 that the government in Beijing decided to really increase its national support for the first time.
Key measures included a reduction in the threshold for down payment ratios to 20% for first homes and 30% for second homes, a reduction in existing mortgage rates for first homes and mortgage rates for second homes, and the ability for local authorities to broaden the definition of first home buyers. Although these are national measures, cities retain a large degree of freedom to apply them.
After the August measures, sales of the top 100 developers increased by 17.9% month-on-month in September (-29.2% year-on-year). While these numbers are not impressive and positive seasonality also played a role in the monthly rebound, it is still too early to look at home sales as it will take some time for the policy to be felt.
According to feedback from some real estate agents in Beijing and Shanghai, buyer interest cooled towards the end of September after a rebound in the first week due to the new measures.
Short-term prospects
In the short term, we believe that the recovery will be mainly limited to tier 1 cities (the most developed cities, i.e. Beijing, Shanghai, Guangzhou and Shenzhen) and tier 2 cities, given their reserve of policy capacity compared to cities in lower tiers.
Cities like Beijing and Shanghai can still reduce down payment rates to the new minimum levels and relax home purchase restrictions in line with what Guangzhou did in September (residents are now allowed to buy up to two homes in four new districts and non-residents are allowed buy one house when they can provide proof of only two years of social insurance/personal income tax).
While this policy choice can be rolled out slowly in major cities to provide some stimulus, there remain some barriers to a strong recovery of the overall market:
- Investor demand will be difficult to regain.
- Tier 3 and Tier 4 cities have already started lowering down payment ratios and relaxing home purchase restrictions in 2022, with disappointing results. Flat or negative population growth in combination with high housing inventories makes it difficult to smooth the start and sale of new homes.
- Continued defaults by project developers and uncertainty as to whether projects will be delivered.
- Expectation of falling real estate prices.
- Uncertain economic prospects. Youth unemployment is at an all-time high and private investment remains low.
In the short term, the main challenge for authorities is to boost household confidence and stimulate private investment to improve house price expectations and ultimately increase housing demand.
Medium-term prospects
The “Lost Decade” – that’s what we call the period of economic stagnation that followed the bursting of Japan’s real estate bubble in the 1990s. Beijing is now facing a similar scenario. Below we highlight the main challenges facing China.
- Aging and population decline. China’s active population is already declining and the total population is expected to nearly halve by 2100 from current levels. Combined with expectations of continued negative migration flows (UN data), this represents a strong headwind for housing demand in the medium to long term. Financial incentives have so far failed to change this outlook.
- Overly strict monetary policy. With current inflation close to zero, Chinese policy rates are restrictive despite the recent easing. At this point, it is crucial that China steers its monetary policy so that the bubble does not burst, while coordination of monetary, fiscal and legislative policies seeks to prevent a hard landing.
- Bank problem. As land prices rose in the decades before the bubble burst, banks accepted more land as collateral. Then when the bubble burst and prices fell, the banks suffered losses. Together with the Basel I rules that require banks to maintain 8% capital, this led to a credit shortage. This not only had consequences for the real estate market, but also for other sectors, especially SMEs. In the event of a relapse, the Chinese authorities must avoid this scenario.
- Failing fiscal policy and low investments. The current economic pessimism and geopolitical tensions caused a decline in foreign direct investment and private investment. The authorities must work hard to get the investment engine going again.
Implications for investments
Given the short to medium term challenges, we remain cautious on this asset class and monitor the milestones described above.
The main beneficiaries of the recently implemented measures are project developers with strong ties to government and active in Tier 1 cities, as these cities retain policy space to continue stimulating demand. Furthermore, these cities still benefit from a population influx from smaller cities and are therefore less exposed to the declining population trend that will occur in the coming years. Some of the largest developers in Tier 1 cities are also state-owned enterprises.
The latter category of developers has partly benefited from the turmoil in the real estate market by increasing their market share at the expense of private project developers. Large state-owned enterprises are government-owned, have stronger balance sheets and are preferred by homebuyers given their confidence that projects will be delivered.
The good news is that such companies have bonds outstanding. However, they are not trading at very attractive levels, especially when you consider macro and sector risks. Developers such as COLI and China Resources Land (CR Land) meet the requirements described above; However, the valuations of their bonds are not very attractive with yields currently between 5.5-7.5%.
On the other hand, many private developers’ bonds are trading at unattractive valuations around 1-15 cents. We do not recommend adding major exposure to the segment at this time as volatility remains high and sentiment fragile. Many of these developers are largely exposed to lower-tier cities where the supply/demand balance is very unfavorable. Some of these companies are unlikely to survive given weak contract sales, high debt levels and near-term headwinds.
However, the recent completion of SUNAC’s restructuring provides a good model for other companies to follow. SUNAC is a developer with large exposure to land in Tier 1 and Tier 2 cities that defaulted in 2022. The group achieved contract revenue of CNY 389 billion (USD 54 billion) in 2021 and saw this number drop to CNY 98 billion in 2022.
This restructuring improves the company’s capital structure by converting USD 4.5 billion/10.2 billion offshore debt into equity or equity-linked instruments (convertible and mandatorily convertible bonds).
Companies with a high-quality land bank and/or ties to state-owned enterprises that are willing to go through a similar restructuring process should be closely watched by investors. Other stories to watch include companies that can divest projects and use the proceeds to pay back bondholders.
While much depends on how the factors mentioned above develop in the short to medium term, patient investors should keep an eye on these types of stories because the cash levels of the bonds are very low and could ultimately lead to higher recovery values in the medium term.
Written by Andranik Safaryan, Portfolio Manager at MainFirst’s Emerging Markets/Corporate Debt team