Investment implications of the Mainland real estate debt crisis for the Greater Bay Area
Concerns about potential defaults by real estate developers have triggered risk aversion in the market, prompting a sell-off in property-related stocks; however, real estate is a broad term encompassing residential, shopping malls, and retail properties, with considerable regional differences. We take a closer look at the implications of the current debt crisis for equity investors, as well as how it might translate into opportunities in the Greater Bay Area.
1 The Mainland real estate debt crisis could lead to further credit tightening in the sector. Will this event result in systemic risk?
Investors should first understand an important fact: The real estate sector has long been a focus of the Chinese government. From 2016 onward, the government has reiterated at high-level meetings that “residential properties are for housing, not for speculation.” Numerous policies have since been implemented to curb real estate speculation (excluding moves to combat COVID-19 last year). This has included enforcing the three red lines policy¹ in 2020 and 2021 to discourage real estate speculation through excessive borrowing by developers.
In fact, deleveraging and reducing the financial risks related to real estate have been the government’s primary objectives over the past two years, while investment in the industry has steadily retreated from its peak at the start of 2021.²
Growth rate of investments in real estate development nationwide (%)
Source: National Bureau of Statistics, September 15, 2021.
In terms of systemic risk, we believe that the likelihood of credit events at state-owned and private real estate companies that could create a domino effect is rather low. While some might compare the collapse of Lehman Brothers to the latest real estate debt crisis, the former was an unexpected development, whereas the latter was a gradual process that unfolded over time.
Given today’s era of big data and internet technology, regulators have become much more proficient at anticipating and adapting to change. Meanwhile, the central government has been preparing the property sector for deleveraging in advance. It’s also important to recognize that the price-to-book ratios of real estate developers are trading at wide discounts, implying that their valuations have fully reflected the negative impact from the credit crunch caused by deleveraging. The overall nonperforming loan provision coverage among banks stands almost 200%,³ a solid level far exceeding the required 120% to 150% stipulated by the China Banking Regulatory Commission. We believe that there’s no need to worry too much about systemic risks such as those during the Lehman crisis.
As such, we think that the negative impact of the event on nonperforming loans should mainly affect selected banks. Furthermore, the bad news is, to a certain extent, already reflected in the share prices of financials.
Concerns among investors are inevitable, and we remain vigilant of volatility in the real estate sector over the next three to six months; however, we believe that the real estate sector should emerge from this period unscathed and follow a healthy growth trajectory. In our view, market information can be difficult to follow at times, so individual investors should seek advice from investment professionals with good research capabilities, especially those who have witnessed many financial crises over the years and understand the characteristics of each crisis.
2 What is the outlook for China’s macroeconomic policy?
Monetary and fiscal policies will generally remain tight. There may be some moderation in regulatory tightening at the year-end Central Economic Work Conference, but since the COVID-19 outbreak, the central government has taken a focused approach by directing resources into strategic industries and providing targeted sector support to those areas closely related to investment and consumption.
It’s worth noting that since the pandemic, quantitative easing has instilled international markets with confidence. Yet such measures may not apply to China. First, accommodative monetary policies could create hot money and lead to speculation. Second, should the pandemic persist or worsen, it may not be possible to introduce another round of expansionary (as opposed to tapering) measures to bail out markets and see the crisis through, thereby hampering the recovery. In our view, under this scenario, China’s policy approach may be more favorable, so tighter macroeconomic policies will not be easily changed at this time.
3 How could the debt crisis among Mainland real estate developers affect suppliers in the property (residential-related) supply chain? Which industries do you think will be less affected by this crisis or credit tightening?
Upstream, midstream, and downstream industries linked to the residential sector are more fragmented. Should they require central government support, this could be similar in structure to the measures implemented during the pandemic, such as allowing the delayed payment of loans and a series of initiatives targeted at helping small and medium-sized enterprises.
For the real estate industry, we believe that financially sound companies may use this opportunity to expand and consolidate, resulting in already strong firms becoming stronger. Property management businesses with stable operations have already faced sell-off pressures, but their stock prices rebounded sharply after markets calmed. In addition, the Hang Seng TECH Index has stabilized after undergoing a substantial correction in the third quarter of 2021. This was possibly due to capital flowing back into bellwether tech stocks (which had fallen by 40% to 50%) from old-economy stocks (such as finance and real estate) after a period of risk aversion.
4 Will the debt crisis affect national and regional (for example, the Greater Bay Area, or GBA) real estate and financial stocks differently?
It’s worth noting that real estate developers in the GBA are primarily diversified businesses with stakes in commercial, hotel, and retail ventures, as well as residential projects. These developers have generally secured other financing channels, possess favorable fundamentals, and are in a better position than national developers.
Aside from real estate developers and property managers, there are also numerous real estate investment trusts (REITs) in the GBA. Thanks to macro-policy planning⁴ and investments in commercial activities (e.g., office buildings and shopping malls), REITs were more resilient while shares of developers sold off. REITs can be characterized as an asset class that can generate a potential income plus growth for investors due to their lower volatility profile (as opposed to stocks), with an earnings yield that ranges from 6% to 7%, making this asset class a well-rounded option.
The Pearl River Delta region has solid economic fundamentals, stronger corporate governance, and good local demand, all of which translate into better prospects for growth recovery.
5 Mainland property sales have slowed in recent months, but investments in financial assets by Chinese households have continued to grow. In addition to residential property, which investment channels or instruments are most likely to gain traction? With the launch of the GBA Cross-boundary Wealth Management Connect Scheme, what investments in Hong Kong are likely to attract southbound capital?
We believe that the government encourages more diversified, institutionally managed investment products for domestic investors and actively promotes financial market innovation through connectivity.
Following the introduction of the Shanghai-Hong Kong Stock Connect (2014), Shenzhen-Hong Kong Stock Connect (2016), Northbound Scheme (2017), and Southbound Scheme (2021) for stocks and bonds—and after two years of planning—the Cross-boundary Wealth Management Connect Scheme in the Guangdong-Hong Kong-Macao Greater Bay Area was launched on September 10, 2021, with service expected to begin as soon as mid-October 2021.
In general, the scheme will allow investors to conduct cross-boundary investments directly in the renminbi and can offer investors greater risk diversification options through a wide range of investment products.
As previously mentioned, REITs are well-rounded (having both defensive and growth characteristics) investment options. In addition, REIT funds in Hong Kong can act as super connectors between Hong Kong and the Mainland⁵ REITs may choose to list in the Hong Kong dollar or the renminbi. Notably, the relevant authority has also suggested including REITs in the stock-connect programs in the future. Once confirmed, investors on either side of the boundary can access each other’s eligible REITs through the stock-connect programs. For overseas investors in Mainland infrastructure assets, the arrangements are expected to be implemented as a priority. Meanwhile, Mainland investors will have the opportunity to access Hong Kong and global real estate projects.
We believe the Cross-boundary Wealth Management Connect Scheme will consist mainly of lower-risk products. When REITs can be accessed through stock-connect programs, funds will likely increase their allocation to REITs, resulting in a potential market revaluation of the sector.
6 How do you manage the policy risks associated with local residential property markets and identify any overlooked opportunities among local real estate stocks?
In recent years, international investors have taken a great interest in sustainable development. For real estate developers, helping the government resolve social issues can be seen as an important contribution to the social aspect. As the community grows more vocal, we foresee social issues becoming more important in the city’s real estate development. With an environmental, social, and governance platform, investors can raise the transparency and communication of sustainability issues. Many developers are already providing updates on sustainable development in their investor relations updates and annual reports. They’ll likely receive more attention from markets on this topic in the future.
1 In 2020, the People’s Bank of China and the Ministry of Housing and Urban-Rural Development announced new financing regulations for the real estate industry. Developers wanting to refinance are being assessed against three thresholds: a 70% ceiling on liabilities to assets, excluding advance proceeds from projects sold on contract; a 100% cap on net debt to equity; and a cash to short-term borrowing ratio of at least 1x. 2 National Bureau of Statistics, September 15, 2021. 3 The nonperforming loan coverage ratio was 182.23% as of the end of 2020, “China Financial Stability Report,” People’s Bank of China, September 3, 2021; the ratio increased to 193.2% as of the end of June 2021, according to JP Morgan estimates. 4 The area of Qianhai economic zone will be expanded from 15 km² to 120 km².
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