HK real estate: Opportunities amid volatility
- Distress amongst mainland developers has deepened with mortgage boycotts and a growth slowdown
- But additional policy support and signs of firmer prices could imply a base in home buyer demand
- Hong Kong developers may be better positioned than mainland developers to capitalize on this…
- … given their stronger financial positions, greater credibility, and lift from commercial rentals.
Opportunity amid distress in China real estate
The Chinese real estate sector is entering a phase where distress has become more prevalent. This may open up development opportunities for other non-mainland-based developers, and Hong Kong developers could be poised to benefit. This is particularly so if Chinese homebuyer demand improves amid a slew of policy support measures.
Risks deepen, but policy support steps up
Defaults among large HY-rated developers that began in late 2021 has snowballed into a significant rise in concern over the financial health of even the largest, better rated developers. Offshore credit spreads had both risen sharply and turned more volatile. If this trend is sustained, it implies prohibitively high financing costs for even major Chinese developers.
The latest bout of offshore credit volatility was due to the emergence of mortgage boycotts. It highlights the problem of prolonged construction halts and under-finished properties to homebuyers—an unexpected fallout from developers’ liquidity crunch. While mortgage boycotts are manageable for the financial sector (see China Bank Credit: Buffers amid headwinds, 22 Jul 22), the impact on homebuyers’ confidence of project delivery has been chilling. July’s residential property sales declined by 58% (m/m), sharper than the typical seasonal weakness. Our seasonally adjusted m/m decline in July records the worst monthly outturn since 2011, excluding the month of April 2022 where sales plummeted in a one-off fashion due to the Shanghai lockdown.
Despite weak sales, support is ramping up to lift demand. One, China has stepped up policy support to the housing sector to restore confidence. On 20 Aug, the authorities announced that policy banks could provide special loans to resume housing project, which reported could amount to CNY200bn. China’s 5y Loan Prime Rate was also cut by a larger than expected 15bps on 22 Aug, which should result in similar sized cuts to mortgage rates. Two, residential property primary sale pricing may already be bottoming, particularly for the Eastern region. The pace of decline has slowed noticeably since May, as lockdown restrictions ease while a reduction in down-payments since February has also stirred demand. That said, pricing in the Central region is still weak, especially compared to year ago levels. This may explain why mortgage boycotts are most prevalent in the central China provinces of Henan, Hunan, and Hubei, as homebuyers may be sitting uncomfortably on losses.
Given new policy support measures and stabilizing prices, homebuyer demand may improve. But already distressed developers may find it hard to capitalize on this if homebuyers continue to steer away from their presales due to low confidence. Elevated funding costs could also force a paring of assets.
Instead, non-mainland developers may be the one to reap benefits from a demand recovery, as they still enjoy the confidence of homebuyers and lower funding costs. Among various options, these developers could scoop up projects and land from already distressed developers at good prices, or increase their JV stakes. There is no question that mainland developers have to execute more asset sales and deleverage to regain credit market access. Furthermore, non-mainland developers could also set better prices relative to projects from riskier developers. Home buyers are likely to differentiate between riskier developers and their accompanying risks of poorly finished projects, vs financially solid developers. We think a crisis for some may well turn to be an opportunity for others.
Disparate financial positions across developers
An aggregate financial analysis of mainland POE, SOE, and non-mainland POE developers reveals widely disparate financial positions. Gearing ratios (defined as liabilities to equity) are strikingly wide between mainland POE vs Hong Kong POEs, and much wider than what net debt to equity ratios indicate. The gap in gearing between mainland POEs and the others has steadily widened over the years, with their aggregate gross gearing ratio ramping up sharply from a normal 2.7 in 2005 to reach an extremely elevated 4.5 in 2020. In contrast, gearing ratios had remained stable around the usually safe 1.5 to 3.0 range for SOEs, non-mainland POEs, and also foreign developers.
Such high gearing has been a major driver behind the sharp equity and sales growth for mainland POEs, on top of their better cost and execution efficiency. Chinese POEs successfully expanded their market share from 78% in 2006-2010 to 90% a decade later. Shareholders’ equity also jumped by a stellar 5.6 times from 2009 to 2020. In contrast, non-mainland POEs’ shareholders’ equity saw a mundane rise of 3.5 times in the same period.
But high gearing implies risks. Equity gains had been ploughed back to accumulate more debt, so liabilities for the mainland POEs climbed at an even faster pace than equity, unlike their non-mainland peers. Only with a regulatory clampdown through the “three red lines” debt limits in late 2020 were the brakes engaged. Without meaningful asset sales, such large deviations from gearing norms have proven difficult to close for mainland POEs, leading to liquidity strains, defaults, and a loss of home buyers’ and investors’ confidence that make them poorly positioned for a market recovery.
Hong Kong developers see lesser volatility
Given the precarious negative feedback loop for mainland POEs, where liquidity is impacted by sales and vice versa, it will be difficult to pick winners and losers. Media reports of potential SOE credit guarantees are likely too small to backstop the entire short-term debt of the sector, and any undercapitalized debt insurer also poses their own credit risks. We expect volatility to continue for credit of mainland POEs, without a broader debt resolution.
The beneficiaries amid such liquidity worries could be the non-mainland developers with lower gearing. If Chinese homebuyers’ demand recovers on the back of policy relaxation measures, Hong Kong-based developers should have the financial wherewithal to acquire assets and expand market share.
Even in the event of a longer than expected downturn, it is an opportune time for Hong Kong developers to increase their land bank at modest costs, raise the share of their JV projects, or even take over distressed projects as a “white knight”. Most Hong Kong developers also concentrate projects and landbanks in the wealthier Eastern region. Correspondingly, they have smaller exposure across regions where local property markets are under strong adverse pressure. Given these factors, and with Hong Kong’s property market conditions also improving (see Hong Kong: Rising lending rates and credit implications, 22 Aug 22), we expect greater resilience amongst Hong Kong real estate developers.
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