Evergrande Finale

Why the rest of the world is — probably — isolated from the fallout of the giant Chinese developer

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Last September, Evergrande, once the largest property developer in China, was reported to have racked up debts of more than $300 billion. The home builder brought in external advisers to devise a plan to repay creditors, suppliers and institutional investors. Since then, the world has been awaiting a “Lehman moment” for China — i.e., a financial market implosion similar to when the investment bank’s collapse in 2008 helped topple the U.S. economy, and much of the world’s. 

Five months later, did it happen? 

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Short answer, no.

“The real estate market in China represents China’s main means of savings since the financial system remains underdeveloped relative to that of developed nations. Therefore, the government has a significant interest in reducing the impact of real estate downturns,” said Sara Hsu, clinical associate professor of supply chain management at the University of Tennessee at Knoxville. Hsu has written for over 30 publications on the Chinese economy. “This means that there will likely be policies put in place to reduce price volatility in the housing sector.” 

China’s economic growth for 2022 is now pegged at 4.8 percent, 0.8 percentage points lower than previously expected and a marked slowdown from the 8.1 percent growth achieved in 2021, the country’s central bank announced recently. Judging from the numbers, China’s economy is experiencing lagging growth, but an anticipated financial market crisis hasn’t materialized.

“The regulatory authorities are able to respond very quickly to emerging risks and emerging headwinds to the real estate market, both from a fundamentals perspective and an investment-in-capital markets perspective,” said economist Sam Chandan, head of NYU Stern’s Center for Real Estate. 

Beijing is tightening control over Evergrande while taking measures to stabilize China’s crisis-hit property sector. The developer said on Jan. 26 that it aims to have a preliminary restructuring proposal in place within six months as the debt-laden company missed some dollar bond payments in December 2021 and nearly $20 billion of its international bonds are now deemed to be in default.

“The company is tactfully buying time to avoid potential forced asset sales or, worst case, liquidation,” said Jonathan Morris, the founder of REIT Academy and a former executive at three real estate investment trusts (REITs). “They have been trying to sell some valuable assets and match the sales cash proceeds to upcoming balloon payments. It’s a frenetic and bad way to manage your balance sheet.”

The reason why Evergrande was able to grow to be this gigantic monster was leverage. The demand for housing units was massive as the country tried to reflate the economy from the global financial crisis in 2008. The central government issued a massive stimulus package that made borrowing easy. 

Evergrande achieved scale by borrowing with land as collateral. The developer’s land bank is “ridiculously large [$68 billion] with no immediate liquidity options at a reasonable price,” Morris said. Land doesn’t generate income. Rather it generates expenses in real estate taxes, maintenance of a security fence and advance costs to break ground. “It would take decades to plow through the company’s land bank,” Morris said. 

Over the past year, the ruling Communist Party under President Xi Jinping has tried to curb China’s speculative investment in the property market in order to break the loop between high property prices, low productivity and social instability. “The market for selling the apartments to be built has slowed and doesn’t signal added demand for apartments or condominiums,” Morris said. That’s what broke Evergrande’s capital chain.

In order to keep its leverage, Evergrande had to cash out quickly. It was offering a 30 percent discount on properties for the whole month of September 2021, the kind of sale that’s more commonly seen during China’s Singles Day on Nov. 11, the country’s biggest shopping day. Even with that, the once legendary developer in China still missed crucial repayment deadlines. 

As the world watched Evergrande go down, concerns regarding whether that could impact the global financial market started to pile up. 

CNN reported that the Federal Reserve in November 2021 warned that China’s property problems could elevate “financial stresses in China [that] could further strain global markets and negatively affect the United States.” As the news network noted, real estate and related industries comprise as much as 30 percent of China’s GDP.

Some experts think otherwise. 

“Is there a clear path for contagion where the challenges being faced by Evergrande spill over into the U.S. real estate market? Those are fairly limited,” Chandan said. 

Hsu agreed. 

“Overseas investors are angry but the amount of Evergrande’s debt borrowed from overseas investors is far less than that borrowed onshore, so the fallout will not be extensive,” she said.

Maybe the question is not whether an exploding debt bomb at a Chinese company will spread financial shrapnel abroad, but whether a similar risk lies in other economies. Is there some version of Evergrande lurking in the U.S.? 

The same situation is less likely to occur in the U.S. since banks tend to lend based on close examination of credit risk. In contrast, Chinese banks still lend to some extent based on government policy direction, which in recent years has included property and infrastructure construction, according to Hsu. 

“We can reasonably expect that [Evergrande] is an isolated case,” Chandan said. “It’s highly unlikely that we would see something of similar magnitude occurring in the United States or elsewhere in the world.” 

How about the developing countries that rely in one form or another on property to fuel their economic engines? The only other economy that even approaches China in size and significance would probably be the Indian real estate market. And it’s not quite there yet in terms of established investment players.

“Compared to China’s, the institutional market in India is still developing,” Chandan said. “There’s a very early REIT market in India. They are making progress in terms of more institutional participants in the market, but it’s still in a relatively early stage,” Chandan said. 

Evergrande continues operating in a damaged state, but that could change quickly when lenders come knocking on the door for their capital back and  Evergrande can’t find new investors. Blackstone (BX)’s Byron Wien and Joe Zidle believe that Chinese officials will curb speculative investment in housing this year. In the wake of China’s property market implosion, President Xi will likely keep pricking China’s property bubble without collapsing the economy. Real estate and its related industries account for up to 30 percent of China’s gross domestic product. 

Evergrande is an isolated case globally, though it was part of a group of highly leveraged Chinese developers. These included some of the most active Chinese developers stateside, according to The Real Deal. Oceanwide Holdings, Greenland and China Vanke have also been flagged as risks, TRD reported. Oceanwide, for one, has troubled skyscraper projects in Los Angeles, New York and San Francisco, and could see its borrowing capacity restricted should it fail to comply with loan terms, TRD reported. 

China Vanke, which teamed up with RFR Realty for a condo development in Midtown, Manhattan, was flagged for liabilities surpassing the 70 percent asset limit set by regulators.

“It is better to provide Evergrande with a soft landing versus a disastrous failure at once, with lenders letting their restructuring lawyers pounce and begin pushing for the sale of as many assets as possible to collect on their loans to the company or to the assets themselves,” Morris of REIT Academy said. 

Having turned from being the biggest real estate developer in China to the world’s most indebted one, Evergrande’s future hangs in the balance. What will happen in six months? Is it really too big to fail, or is it just too early to tell?

Update: This story originally misattributed source material. This has been corrected. We apologize for the error.

Emily Fu can be reached at efu@commercialobserver.com