China Evergrande 3333 S
November 10, 2018 - 11:21am EST by
mfritz
2018 2019
Price: 18.70 EPS 3.32 0.7
Shares Out. (in M): 13,090 P/E 5.0 2.2
Market Cap (in $M): 31,251 P/FCF n.a. n.a.
Net Debt (in $M): 104,378 EBIT 124 63
TEV ($): 135,630 TEV/EBIT 6.9 14.5
Borrow Cost: General Collateral

Sign up for free guest access to view investment idea with a 45 days delay.

 

Description

Summary

 

China Evergrande is the most indebted and most vulnerable of the major Chinese property developers. Hawkeye901 wrote about the the stock in 2017, but there are a few reasons why a short makes even more sense today. After speculation in the property market reached a crescendo in the first half of 2018, there are signs that lower tier property markets are starting to crack. The government pulling back the cash subsidies that led to the speculative euphoria that developed since they were introduced in 2015. Discounts are now rising, sell-through rates are dropping and the value sales deposits on Evergrande's balance sheet have started to shrink. Evergrande is the most indebted of the major Chinese developers and is highly dependent on foreign currency borrowing. If the property market or the Renminbi shows signs of weakening, Evergrande should be one of the major casualties.

 

Industry backdrop

 

Sales volumes of residential property have grown immensely from the liberalization of the property market in 1997. China’s floor space under construction has risen by a multiple of 10x since the late 1990s. Prior to this date, housing was provided by the state. In 1997, workers were given the option to buy long-term leaseholds from work units at highly subsidized prices. The reform created significant household equity in a snap, and a building wealth effect as property prices rose in line with rapidly growing incomes after China’s entry into WTO, which unleashed an export boom.

 

 

Urbanization has not been a major driver of China’s property boom. The yearly change in China’s urban population has stayed around 20 million every year since 1996, so it doesn’t account for the dramatic rise in construction. The major driver behind the early days of China’s construction boom was more driven by a wealth effect and rapidly rising incomes in fast-growing economy. The newly urbanized population have never been the typical buyer of commodity housing. Migrant workers tend to stay in company-provided dorms and lack the Hukou needed to enjoy government services in urban areas. They also haven’t had the means to buy property. With salaries of around CNY 5,000 / month a migrant worker would not be able to buy the typical apartment now costing around CNY 1.5 million, as it would imply a price / income ratios of 25x – much above the global norm of 4-6x.

 

 

The second phase of the development of China’s property market started in 2008, when the Communist party responded to weakness in manufacturing centers across the country by a CNY 4 trillion stimulus program, pulling forward the construction of infrastructure and doubling lending in a single year. The broadest measure of credit has now risen about 100 percentage points to GDP since the start of the 2008 stimulus program.

 

 

The credit boom that was unleashed led to an increase in housing construction and speculation as rising prices led to a wealth effect. Despite rising prices, excess inventories started to build in lower-tier cities as construction activity exceeded underlying demand. Instead of letting the housing market adjust on by itself, the leadership tackled the problem by so called supply-side reform, the first step being to reduce inventories to manageable levels.

 

 

The way that the government managed to achieve lower inventory levels was by encouraging local governments to provide generous cash subsidies to the shantytown residents that were displaced whenever new housing was being built on land already occupied by someone else. The funding came from China Development Bank, who in turn borrowed via the discount window from the PBOC. Prior to 2014, displaced residents would receive new housing units but no extra cash. From 2014 onwards the percentage of displaced residents who received cash compensation for shantytown redevelopment projects rose from 9% to 49% in 2016. Researcher Zhang Dawei of Centaline Property has said that:

 

“Over the past several years housing markets in third and fourth-tier cities had come to heavily depend upon monetary compensation provided for shantytown redevelopment.”

 

There is zero doubt in my mind that these cash subsidies – a type of helicopter money – was a significant driver behind the property boom that lower tier markets have experienced since 2014.

 

A certain Mrs Li was quoted in a Bloomberg article saying:

 

“This saved me 10 years of hard work… Where we lived before there were muddy roads outside with chickens and ducks running around. It was so dirty.”

 

This Mrs Li was compensated for her old self-built home with three apartments and 300,000 yuan in cash – a massive amount of money for a small-town resident. The cash compensation used in shantytown redevelopment was essentially fiscal stimulus to prop up the property sector and enable excess inventories to be digested. It is not clear what led the government to take such drastic measures. It might have been related to the appointment of Vice President Liu He as an economic tzar in charge of “supply-side reform” – and his drive to to deal with the oversupply in many sectors of the economy. It might have been related to an effort by Xi Jinping and his cronies to win political favors from local government officials in the run-up to the 19th National Congress in 2017, when the Politburo and Central Committee were reshuffled.

 

The floor space sold in lower tier cities more or less doubled in the two years following the introduction of cash subsidies. Transaction volumes might have increased in top-tier cities as well, had it not been for the home purchase restrictions imposed in cities such as Shenzhen and Beijing since 2016.

 

 

The property market has now reached a point where it is mature at best. The potential for Chinese residential property development seems limited:

  • China’s average space per person was 6 sqm in 1985. Today, China’s per capita housing stock is 37sqm vs 35sqm in Japan and 16sqm in Vietnam.
  • China’s sqm built per capita of (1.15) is higher than East Asian peers such as Korea (0.88), Taiwan (0.48) and the United States (0.45).
  • China’s real estate investment / GDP is around 15% vs 6% for US and 12% for Spain prior to the Great Financial Crisis in 2006
  • Only 31% of new homebuyers do not currently owned an apartment vs 70% in 2008
  • 70% of Chinese millennials own property vs 35% in the US, 31% in the UK
  • The median age of urban housing in China is < 10 years. When Japan's housing bubble burst in 1989, the average age of a housing unit was 12 years. In the US the median age of a house is 37 years.
  • It probably doesn’t make sense to buy property in China, even if you’re unable to repatriate your capital out of the country.

 

In the mid-2000s when nominal income growth was 15-20% and bank deposits yielded 2-3%, while rental yields were over 5%, a mortgage costing 6% essentially paid for itself while rents grew 15pp faster than the yield on bank deposits. The odds heavily favored buying over renting.

 

Today, nominal wage growth in a steady state is likely to end up closer to 7%. Deposits give you about 1%, a difference of 6pp. Top-tier city rental yields are 1.5% vs mortgage rates of 5.5%, giving you negative carry of 4pp. Add maintenance expenses and fast depreciation from the poor quality of construction, you may not be getting much upside from buying over renting anymore. Especially not if you consider the considerable risk of rental yields reverting to historical levels.

 

Rental yields in first-tier cities are now about 1.5%, lower than during any other property bubble in history that I’m aware of. Even during the South Sea Bubble in London in 1720, rental yields never dipped below 2.0%. The upside from these levels should be limited. Lower tier city rental yields are not quite as low, but still far lower than international benchmarks.

 

 

The value of the housing stock as a % of disposable income, puts China in line with previous bubbles at 500%, though lower than Ireland in 2006 at 620% and Japan in 1990 at 650%.

 

Affordability ratios in most major cities are now higher than 10x, compared to historical levels of 3-4.5x for the United States. Tier 1 cities have ratios in excess of 20x, higher than any other cities globally.