How Evergrande found itself on the wrong side of China’s regulators

The high-rise apartment buildings in the Riverside Mansion development under construction by China Evergrande Group in Taikang, Jiangsu Province, China, Friday, September 24, 2021.

Kelay Shane | Bloomberg | Getty Images

BEIJING – China’s property developer Evergrande has made little progress toward complying with Beijing’s crackdown on property debt — until it’s too late for investors to pour money into its offshore bonds, now worth at least $19 billion.

Concerns about the giant developer’s ability to repay its debts and a total of $300 billion in liabilities have unnerved global investors. Beyond the company itself, there are concerns about potential repercussions for the rest of China’s real estate industry or the economy.

A closer look at Evergrande revealed a company that had many of the same problems as other companies in the Chinese real estate sector, but it did not act quickly to respond to government rules aimed at solving these problems.

Evergrande has failed to meet several payment deadlines since September, most recently on October 11 for interest due on one of its US dollar-denominated bonds. That brings the total missed payments to $279 million since last month, according to Reuters.

Analysts said that while the developer has taken on debt for years, its latest problems have already come after regulations have been tightened in the past two years.

China’s central bank said Friday that most property developers have stable operations, calling Evergrande a unique case in which the company “blindly” diversified and expanded. There was little sign that a full bailout was on the way.

Here’s how the world’s most indebted real estate developer ended up in such dire straits:

Evergrande crosses all three red lines

Chinese authorities met with 12 real estate developers in August 2020, and asked them to reduce their reliance on debt. State media said Evergrande was among those who attended the meeting.

The report described the “three red lines” policy that had not been officially announced. State media describe “red lines” as three specific balance sheet conditions that developers must meet if they are to take on more debt. The rules require developers to limit their debt in terms of the company’s cash flows, assets, and capital levels.

Last summer, all 12 developers at the meeting crossed at least one of their red lines, said Julian Evans-Pritchard, chief China economist at Capital Economics.

The problem this entire industry faces is that the entire model relies a lot on financing.

Zhang Wenjie

Senior Fellow, ICR

One year later, Evergrande and Greenland were the only two of the original dozens of companies still crossing at least one of the red lines, Evans-Pritchard said in a report dated September 22. As of the end of June, he said Greenland had crossed one line, while Evergrande had crossed all three red lines.

In contrast, “among the top 30 [developers]Less than a third are exceeding any of the limits, he said, compared to more than two-thirds a year ago. “Even companies that are not formally subject to the rules have generally complied.”

Evergrande warned investors of a default in late August. Just days ago, China’s central bank and other authorities told company executives in a rare meeting to solve their debt problems.

“The problem the entire industry is facing is that the entire model is too dependent on funding,” said Zhang Yingyi, senior fellow at the China Real Estate Research Institute ICR.

He said the constraints on the speed with which developers can expand come because ensuring affordable housing is a key part of China’s economic development plan for the next five years.

The average price of a residential home in China — usually an apartment — more than quadrupled between 2001 and 2019, while the median price of a new home in the United States rose 80% during the same time, according to official data from China and the United States.

The price hike came even as Beijing in 2016 began promoting the slogan “homes to live in, not to speculate.” It was an attempt to control the real estate market, which many likened to a bubble.

Evergrande’s foreign debt in US dollars

However, in the next few years, Chinese developers continued to borrow, especially in overseas markets.

Between 2016 and 2020, the industry’s value of offshore dollar bonds grew by 900 billion yuan ($139.75 billion) — nearly double the growth of 500 billion yuan in inland yuan bonds, according to Nomura.

Evergrande was by far a leader in offshore debt issuance, acquiring six of the ten largest offshore dollar-denominated bond deals by Chinese real estate firms between 2016 and 2021, according to Dealogic.

As of the first half of this year, Evergrande owned 19% of the high-yield US dollar-denominated bonds among Chinese real estate firms — the largest stake, at $19.24 billion, according to Natixis.

The data showed that Kaisa, Yuzhou, China Fortune Land Development and Guangzhou R&F Properties ranked next in terms of the share of overseas bonds. All four of these companies crossed at least one red line, with China Fortune and R&F all crossing three, according to Natixis data analyzed by CNBC.

Natixis data showed that Hopson Development Holdings, which is said to be acquiring a portion of Evergrande, has crossed none of the red lines and is ranked 28th by asset size.

Hopson declined to comment. Evergrande did not respond to CNBC’s request for comment.

Heavy reliance on pre-sale

Like many developers in China, Evergrande sold apartments to individual consumers before the properties were completed. This allowed the company to generate cash, while taking out loans for property development.

Over the past decade, the value of Evergrande properties under construction has risen so rapidly that it has far exceeded the value of the company’s completed projects as well as what the company has been able to sell.

By 2020, Evergrande had projects under construction worth 1.26 trillion yuan ($195.89 billion). But that was more than 70% of the real estate the company was able to sell that year, worth 723.2 billion yuan. Only 148.47 billion yuan of projects have already been completed.

The value of properties under development accounted for just over half of Evergrande’s total assets, reaching 54.7% in the first half of this year, up from 54.3% at the end of last year.

Keeping up with this high percentage of construction projects became unsustainable once the new regulation began and affected Evergrande’s ability to obtain financing.

“Financial institutions have already reduced their direct exposure to Evergrande over the past two years,” Moody’s analysts said in a note on Oct. 11.

They said the company’s loans from banks, credit companies and other financial companies fell to 393.9 billion yuan at the end of June, down sharply from 604.7 billion yuan at the end of 2019.

Many of Evergrande’s projects are located in smaller Chinese cities, where economists say there is an oversupply of housing, compared to China’s largest, where there is a housing shortage.

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S&P Global Ratings analysts said in a note on September 20 that the company is in a more difficult position than other developers due to its extensive use of commercial supplier invoices — tradable contracts to pay suppliers and building contractors.

“Contracted sales of Evergrande fell more than other exporters in the sector who were in distress,” the report said.

Standard & Poor’s said that without sufficient funding, it would be difficult to maintain construction and other assets that could be sold. “This shuts down Evergrande’s most important source of cash flow: the contract sales of its real estate projects.”

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