From a small northwestern observatory…

In many ways, the explosive growth of the built environment in China has been breathtaking. In my adult life, they’ve moved about 500 million people out of rural peasantry into urban dwellings. The social impacts of this are a matter for another day, but one has to marvel at their industriousness.

That said, Chinese real estate, like so very much of the Chinese economy, is terribly unbalanced. From the outside looking in, we may think that the emergence of “Chinese Capitalism” (very different from what we practice in the west) is a step away from central planning. In fact, Chinese Capitalism, and particularly in real estate, has created all too many too-big-to-fail businesses. In a well ordered, balanced economy, risk taking is a good thing and it is balanced by a small number of businesses failing and a small number hitting home runs. However, when businesses are too big to fail, there is enormous up-side and little down-side. These huge entities are enabled to take on inappropriate risks, leaving it to others to pick up the pieces.

Real estate in the west is surprisingly atomistic. While there are a lot of big players, none of them, individually, has the size to impact the market. The 2008-2010 recession came about because of systematic factors, not any idiosyncratic failures. However, real estate in China has become aggregated in a handful of multi-tiered companies that have taken on enormous debt, are financed operationally by supplier credit, and have had no disincentives regarding risk-taking. Four of them are now approaching the edge of bankruptcy:

Evergrande — This real estate developer and property manager became the most valuable real estate developer in the world in 2018. However, it now has roughly $300 Billion in total liabilities, including $20 Billion of international bonds. Last week they reportedly failed to make a $148 million interest payment on these international bonds, and this appears to be the third missed payment in a row.

Fantasia — A luxury apartment developer that failed to make $315 million in payments to lenders last week and announced that they would probably default on external debts. Rating agencies have already Fantasia a “default” rating.

Modern Land — This developer has appealed to lenders for extra time on a $250 million bond which is due on October 25, and the Chairman and President of the company are making personal loans to support the business.

Sinic Holdings — This homebuilder has announced that they will likely default on at least some of $250 million in bond payments due October 18. It’s stock is down 90%, and last week, Fitch downgraded their credit rating to ‘C’.

These problems will most likely reverberate throughout the Asian economy, if not beyond. Obviously, the bank lenders and other bond holders will feel the pain, but these developers are also in-hoc to suppliers, subcontractors, and even employees. However, Natixis, the French multi-national investment house, has stated that the Chinese government will avoid such failures in the lead-up to the 2022 National Congress of the Chinese Communist Party. They note, however, that this means the failures may snowball down the road. Chinese generic economic growth has bailed them out of past large-scale financial failures, but experts believe this will not be the case today. These failures may have very real impacts on Chinese GDP growth.

In the short-run, the Chinese will probably see a managed restructuring in which other developers take over uncompleted projects in exchange for land holdings. However, in the longer run, this will make it increasingly difficult for Chinese entrepreneurs to have unfettered access to global debt markets, and I would suspect that, like their western counterparts, Chinese entrepreneurs will be expected to have more “skin in the game” in the future.

Back in the hey-day of pedal-to-the-metal real estate development here in the US, there was a saying among developers, “A penny borrowed is a penny earned.” The 2008-2010 bubble burst was a real wake-up call for western developers. It may be that the events unfolding in China could be a similar eye-opener for Chinese entrepreneurs.

As always, we look forward to your comments and questions!

John A. Kilpatrick, Ph.D., MAI — John@greenfieldadvisors.com