China Update: Homebuyers refusing to repay mortgages of uncompleted housing projects heightened risks in China’s troubled property sector

Disgruntled homebuyers suspend mortgage repayments

Recently homebuyers in China of apartments and houses in more than 300 uncompleted property development projects across over 90 cities wrote to their banks to unilaterally suspend mortgage payments to the latter until the construction of those projects are making progress. These buyers typically have paid a deposit for the property on presale and have also taken on a mortgage loan from a bank already even the development is still in construction.  As the construction of the projects are stalled due to a lack of funding on the side of the developers, homebuyers refuse to continue to pay the monthly mortgage instalments with the delays in getting possession of the properties being no end in sight.

Presale is the dominant business model of property development in China

Developers in China start selling  units of apartments and houses from their projects to homebuyers usually one to two years before completion and sometime even just soon after they lay the foundation and get permits from the government. Nearly 90% of new home sales by volume in 2021 was through presale.  The property development industry generated funds from presale to satisfy more than 50% of it financing needs for development projects.  Although a portion of the presale proceeds are required by government regulations to be placed into escrow accounts which are supervised, this money in practice can somehow from time to time find its way to end up enabling developers to purchase additional land use rights from local governments.  This model enables developers to be less reliant on their own capital and construction loans from banks. The property industry’s reliance on construction loans from financial institutions is just about 12%. When property demand is strong and property prices are rising, developers can leverage up and make more money and local governments generate more off-budget revenues from more sale of land use rights. 

Developers ran out of funding to complete the projects presold

Things have not been good this year in residential properties.  During the first half of 2022, total residential gross floor area (GFA) sold fell 27% YoY and residential property sales value fell 32% YoY. The decline in sales has negatively affected developers’ cash flows.  Average land purchase price fell 29% in the first five months of 2022 from the same period last year, according to estimates from Nomura Securities.  The fall in land prices has reduced the value of the collaterals that developers have and restrict their ability to borrow from banks. Local governments, getting worried about developers moving monies away from their cities to fund projects elsewhere or to settle other liabilities, have also become more stringent in controlling the use of presale proceeds in escrow accounts.  

Despite the central government’s recent moves to allow local government to relax some home buying restrictions and encourage banks to lend to homebuyers, the “three red lines” having first been introduced in August 2020, have not been relaxed and continue to exclude highly leveraged developers from getting financing.  The three red lines are: debt-to-equity ration not exceeding 100%, liability to asset ratio no exceeding 70%, and cash to short-term debt ratio not less than one.  Among the top 100 private-owned entity (POE) property developers, 35 of them have defaulted or entered some kinds of debt restructuring.  It is widely reported that the smaller POE property developers are facing even more difficulties in servicing their debts, facing double whammy of a plunge in home sales and being cut off from both new loans as well as refinancing. 

Chinese property developers have lost their abilities to raise fund in the offshore US dollar bond markets.  Over the past 12 months, the option-adjusted spread (OAS)of offshore USD bonds issued by China BB-rated property developers have widened by 2,500 basis points to 3,100 basis points and those issued by B-rated developers have widened by 4,200 basis points to 5,700 basis points.  The widening of spread has been specific to the property sectors instead of about the country risk of China.  Senior debts of A-rated and BBB-rated Chinese banks have been steady and trading at OAS 52 and 64 basis points respectively.  For investment grade Chinese corporate, A-rated non-property corporate and BBB-rated non-property corporate are trading at OAS 110 and 180 basis points respectively.  For high-yield non-property corporate, spreads have also widened over the past 12 months but to levels only half of their property developer peers.  Non-property BB-rated and B-rated corporate are trading at OAS 1,400 and 2,400 basis points respectively. POE property developers’ bonds are traded as distressed debts.

Estimating the scale of the problem

The numbers of stalled projects and potentially affected mortgage loans are fluid and are hard to ascertain.  According to estimates from Everbright Bank, GF Securities and CRIC, the GFA of stalled projects is in the range between 230 million square meters (sqm) and 520 million sqm.   Assuming RMB10,000 value per sqm and outstanding mortgage balance of 40% loan-to-value, the mortgage affected is estimated to be between RMB920 billon and 2 trillion. Bloomberg is putting forward an estimate of RMB2 trillion.  Goldman Sachs’ estimates for mortgage loans at risk, using a loan to value of 60% and assuming 15% of the 2.4 billion sqm project backlog, range from RMB2 trillion to 2.4 trillion.  The affected mortgages based on the above estimates represent approximately 2% to 6% of total mortgage loans outstanding in the Chinese banking system. 

Exposure of leading Chinese banks listed in Hong Kong have mortgage loan exposures ranging from 13% to 21% (median 18%) of their total assets.  When including other property related loan exposures, such as the more risky construction loans to developers, the exposures go up to between 17% and 24% (median 21%) of total assets. Applying the 2% to 6% stalled projects ratios, the potential problem loans incurred will range from 0.34% to 1.44% of assets.  This calculation is just a rule of thumb guesstimate without access to the information of the loan book details of individual banks.  It is only for the purpose of putting the scale of the potential problem into some sort of perspective. No representation is made about the accuracy of these guesstimates and they should not be relied upon as so. 

Now let’s look at the problem from the perspective of how much funding needs to be raise to complete these stalled projects in order to avert defaults. Assuming RMB3,000 per sqm cost of construction, the amount that needs to spend to complete these stalled projects of 230 to 520 million sqm is estimated to be RMB690 billion to 1.56 trillion.  The social optimal is probably to come up with RMB690 billion to 1.56 trillion to complete and deliver the properties to home buyers, but how?

The playbook

If the presale proceeds have already been applied to other uses and the developers are in financial distress, how are these projects ever going to be completed? 

On July 17, the China Banking and Insurance Regulatory Commission (CBIRC), through an interview article in its own mouthpiece publication, the China Banking and Insurance News, says that it will work with the Ministry of Housing and Urban‑Rural Development and the People’s Bank of China to stabilize land price and property price and to stabilize expectations, and to support local governments to ensure the delivery of completed properties and social stability.  The CBIRC casts a wide net to instruct banks to extend credits to help completion of construction in accordance to the principle of markets, the law and social responsibilities and at the same time emphasize the responsibilities of property developers and their shareholders and the protection of the homebuyers’ right as consumers.  However, with the three-red-lines in place and the fact that the developers of these stalled projects tend to be in financial distress, it is hard to see how the rhetoric form the CBIRC can get the banks, the developers and the developers’ shareholders to put up money to resume construction.  In many cases, these projects owe construction companies, contractors, workers and suppliers money and they must settle all those claims first before they can resume construction.

Many analysts have their hope on local governments and believe that as the central government is now calling for support to complete stalled residential projects, these local governments will line up behind these housing projects and get them completed.  We do not doubt the local governments desire to have construction workers getting paid and homebuyers getting the properties they purchased so that these workers and homebuyers will not go to the street to protest. The local economy getting boosted and local officials getting credited for ensuring economic and social stability will certainly be much desirable from the perspective of local governments. The problem is that they do not have the money to get this accomplished. 

In most cases, local governments can only broker, from time to time with some arm-twisting, to get the stakeholders to get to the table to try to work out some resolutions.  Banks are unlikely to put up with additional money to complete presold projects which will not generate much cash flows and banks are behind construction workers and contractors in the queue on claims to cash flows from these projects.  The local governments and the banks will try to help the developers to find buyers for these projects. The problem is that in many cases, the market value of these presold projects are below the sum of construction loans, historical construction costs already incurred but unpaid, and future construction costs to complete the projects.  State-owned banks in China are very reluctant to take haircuts in order to get these projects sold, especially to non-state-owned entities.  State-owned banks are worried that any haircuts to loans may later come back to haunt the banks’ management as being accused of selling state-owned assets (i.e. the loans and the collaterals) for cheap.  

One of the solutions to that is to sell these projects only to state-owned entities (SOEs) so that the assets remain in the hand of the state.  Distressed developers are to be broken up.  The “good” assets, which have reasonable prospects of generating positive cash flows after loan haircuts are likely to be marketed to SOE developers as well as SOEs in other industries.  According to our conversation with some debt restructuring specialists, cash rich SOE energy companies have  recently been the place to go to, in addition to SOE developers, to unload stalled property projects. One of the examples is Shangdong Energy Group which is actively looking at the assets of the China Aoyuan Group (03883:xhkg).  Shangdong Energy Group is a SOE and the third largest coal miner in China.  It is also parent of Hong Kong listed Yankuang Energy Group (01171:xhkg).  The “bad” assets, those have slim chance of generating positive cash flows, will be sold to SOE asset management companies (AMCs), which were created by the central government in 1998 to take over problem loans and their collaterals from banks.  While SOE banks are unwilling to sell loans and related collaterals at deep discount to private enterprises, they are much more forthcoming when selling these distressed assets to AMCs as the assets continue to belong to the state.  

Investment implications

POE developers, even those are not overly leveraged, will continue to be facing headwinds.  Despite the rhetoric from the Chinese authorities, it will be much more difficult for POE developers than SOE developers to get financing from banks and the bond markets.  Homebuyers will also assign higher risk premium to POE developers or avoid POE developers on project presale.  On the other hands, as the Chinese authorities are asking banks to support reasonable demand for housing and the stability in the property sectors and banks prefer lending to SOEs, SOE developers will be getting ample and cheap funding.  They will also have the opportunity to acquire value projects at discount from ailing POE developers and banks.  It is partly for this reason, investors have lately been preferring leading SOE developers, such as Hong Kong listed China Overseas Land & Investment (00688:xhkg) and China Resources Land (01109:xhkg) and Shanghai listed Poly Developments (600048:xssc), to POE developers. 

Investors are likely to remain concerned about the asset quality of Chinese banks’ loan books.  While the potentially affected stalled project related loans may represent only 0.34% to 1.44% of total assets of the leading Chinese banks listed in Hong Kong, according to the estimation above, deterioration in the sentiment of the property market may potentially spill over beyond these stalled projects and affect other loans and cause bigger hits to banks’ earnings and valuation multiples.

As China’s total household deposits stands at over 150% of total household loans and the manageable exposures at the leading SOE banks that dominate the market, these stalled projects may be unlikely to incur systemic risks to the Chinese financial system at large.  Nonetheless, for medium and smaller size banks, especially regional and rural banks that have much bigger a proportion of their property sector exposures to lower-tier cities and shantytown renovation programs and often have looser local regulation over the use of presale proceeds in escrow accounts, may be an asset class to avoid for the months to come.