Recovery creates new risks for Chinese developers

Experts from S&P Global Ratings assess the impact of a strong first half of the year in China's volatile property market.

Recovery creates new risks for Chinese developers

What’s driven strong sales in China’s property market?

China’s property market has carried the momentum that began in the second half of 2015 into 2016, with around 53% year-on-year (YoY) growth in total sales over the first five months. The sharp acceleration was led by a 34% increase in the gross floor area sold and 14.25% rise in the average selling price (ASP).

The abundance of liquidity is the major driver of the sharp rebound, with lower lending rates and easier access to credit. This is reflected in the 25% rise in mortgage loans in the first quarter, the highest growth since third quarter of 2011. Across the system, total social financing increased by 30% during the first four months of 2016. Strong domestic bond issuance among developers from the second half of 2015 has slowed in 2016.

Will the momentum continue for the rest of the year?

Despite the strong sales growth, we believe the recovery of China's property market this year could be more fragile than it looks. The unevenness of the price rebound, competition for land reserves in top-tier cities, and increasing debt-fueled expansion may hamper the sustainability of recent growth. Funding channels may also stop being so supportive.

We forecast that the China property market sales will grow 5%-10% in 2016, with higher ASP primarily driving growth. Supportive policy measures such as lower down payment requirements and ample money supply will also support sales growth. Oversupply in tier-3 and tier-4 cities will continue to drag down the overall growth momentum.

Have the credit profiles of Chinese property developers changed?

Despite the strong recovery in the property market, the financial position of developers has yet to improve. Credit profiles deteriorated the most for those companies that rushed into the next cycle of investment, mainly through an aggressive step up in land bank expansion and construction. We estimate that the financial leverage of about four-in-10 developers in 2015 was worse than our base-case expectation and only one-in-10 was better. This is also reflected in our rating actions in 2016, with 11 downgrades and five revisions to negative outlooks. The number of negative rating actions is the highest since the first half of 2012.

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We believe it will take a longer time for the credit profiles of rated developers to recover. Overall, margins are likely to stabilize or bottom out, due to higher ASP growth. Companies with good legacy land banks in higher-tier cities have the most to gain, while companies with high exposure to lower-tier cities will continue to face margin pressure over the next one-to-two years.

Financial discipline and operational execution will be the key to the recovery of developers' credit profiles, in our view. Developers' margins and financial leverage rely on prudent management of land banks and consistent sales and project execution. Consolidation trends are instead taking over and the more competitive players (as well as the more aggressive) are eyeing opportunities in acquiring projects and portfolios. But forward-looking financial management will be important to ride over refinancing risks from potentially less-fair funding and operating conditions ahead.

Have Chinese developers benefited from the loose credit conditions?

China has maintained relatively loose credit conditions in support of economic growth, particularly in real estate. These credit flows have channeled through both developers' own borrowings to support supply and personal mortgage loans that have boosted demand. Available funds for fixed asset investment and property development were up 7.9% YoY and 16.8% YoY, respectively, in the first five months of 2016. During the same period, mortgage payments to the property development sector experienced strong growth of 58.5% YoY.

Several new, lower-cost onshore funding channels gradually became available last year, including domestic bonds and medium-term note issuance, "Panda bonds" (renminbi-denominated debt that foreign companies sell in China), and asset-backed securities financing. These new channels have significantly enhanced developers' financial flexibility. Developers' liquidity profiles have also benefited as the companies actively reorganized their debt structure using the new channels.

Following the opening of domestic bonds, the weighted average maturity for our rated developers improved slightly to 2.9 years in 2015, from 2.7 years in 2014. We expect developers' debt maturity will continue to extend in 2016, as some short-term debt (i.e., trust loans) due during the year will be repaid. However, the improvement will only be gradual, because the new channels (e.g., onshore bonds) are not likely to be the primary source of financing.

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Why haven’t favorable funding conditions led to improved financial strength?

Favorable funding conditions have not necessarily led to an improvement in developers' financial metrics. On the contrary, their financial leverage has continued to rise, with the median debt-to-EBITDA ratio reaching 6.0x in 2015, from 5.4x in 2014. Developers have tapped the market for liquidity and used the proceeds for land acquisitions and as a reserve for future expansion, which has led to a material increase in gross debt. At the same time, developers’ capital structures have not improved materially, given their persistent reliance on short-term debt.

Although the new channels help developers manage funding costs and liquidity risk, their window of availability depends greatly on government policies, making it difficult to rely on these channels as a primary funding source. The uncertainty of government policy has also tempted companies to take on more debt, which may add pressure to leverage. Issuance bundling of domestic bonds will also add refinancing pressure down the road. Among S&P rated developers, refinancing need is most acute in 2019- 2020 when high proportion of both onshore and offshore bonds mature. Refinancing risks will arise if funding conditions turns unfavorable, especially for smaller developers that have benefited the most from lower funding costs and abundant liquidity.

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Savings in funding costs from the opening of new onshore funding channels are also much less pronounced than the impact from broad-based policy rate decline. The continual decrease in the onshore benchmark rate has played a primary role in lowering funding costs for developers.

How do you expect the sector’s credit growth to evolve?

In our view, the property sector's currently robust credit growth will moderate in the second half of 2016 because of the Chinese authorities' policy goal of managing overall leverage. Vulnerabilities have also started to appear in the onshore bond market, with rising bond defaults triggering higher risk aversion and stunting the issuance pipeline.

Given the sizzling market conditions in some higher-tier cities and the strong sales performance in the first few months of 2016, we expect the government may enact more measures to restrain price growth, especially for tier-1 and tier-2 cities. China intends to make growth more sustainable and have a more stable credit environment. Hence, the abundant liquidity conditions and explosive mortgage growth in recent months may start to slow down in the second half of 2016.

The article is authored by Cindy Huang, Director of Corporate Ratings and Dennis Lee, Associate Director of Corporate Ratings at S&P Global Ratings.

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