Could China’s Property Sector Create a New Credit Crisis?

Rising land prices and a government credit clampdown are forcing China’s real estate developers to borrow more money at higher rates – a combination that is likely to compress profit margins and put some companies into financial difficulties.

The country’s larger developers are rapidly becoming the biggest borrowers on the international bond markets, and small and medium-sized companies are relying on high interest loans from China’s domestic shadow-banking industry. Both of these funding sources have in common higher borrowing costs.

Higher financing costs are particularly unwelcome for developers who have seen land rise steadily since early 2012 to reach record levels in recent months.

Land Prices Going Up

According to statistics released last week by the Ministry of Land and Resources, the average price of residential land in China rose for the seventh consecutive quarter during the period from October through December of 2013.

The bureau’s figures show that the average price of residential land for housing purposes across 105 cities surveyed increasing 2.6 percent during the fourth quarter of 2013, to RMB 5,033 ($830) per square metre.

In larger cities, where competition for land has been more intense prices have increased at higher rates. During December, one developer paid a record RMB1.1 billion (US$180.6 million) for an 8,594 square metre lot in Shanghai, a premium of 47 percent over the auction’s starting price of RMB 748 million.

At the same time that the land developers need to launch new projects is becoming more expensive, the costs of financing those land purchases is rising even more rapidly.

Developers and the Bond Market

According to a recent report in the Wall Street Journal, China’s property developers are selling more debt on international bond markets than the entire North American real estate industry. So far in 2014, real estate firms from the world’s No. 2 economy have issued $7.9 billion worth of bonds.

This is the second year in a row that China has led real estate bond issuance, amounting for 38 percent of all real estate paper worldwide.

And although interest rates are generally low at the moment, the increasing amount of leverage that these developers are taking on is rapidly raising their borrowing costs.

Higher Risks and Credit Downgrades

Japan’s Nomura Holdings Inc. warned investors earlier this month that an annoucement by China’s central bank that it will increase monitoring of credit this year in a number areas, including property developers will make borrowing more difficult, and expensive for the real estate industry.

When borrowing on the bond markets, China’s developers are typically junk-rated which means funding costs reach as high as 13.88 percent, and pressure on borrowers is likely to increase.

When Wanda Properties International Co., part of Dalian Wanda Group owned by Chinese billionaire Wang Jianlin, issued a 10-year note on January 23rd, it had to provide 455 basis points more than Treasuries. This is compared to an issue the previous day by a Hong Kong bank which only had to provide 375 basis points on similar-rated notes.

Borrowing From Shadow Banks

And the cost of borrowing on the bond market, which is typically only an option for medium to large-sized developers who have been able to list overseas, are much lower than the premiums paid by local developers, who are increasingly reliant on China’s trust industry for financing.

A report this week by the Wall Street Journal using data from the China Trustee Association, showed that China’s property developers borrowed ten times more cash from the country’s loosely regulated trust industry in during the last three months of 2013 as they had during the same period a year earlier.

Total borrowing from the trusts, which loan to higher risks clients who do not qualify for lower-cost but more tightly regulated bank credit, to real estate firms reached RMB139.5 billion during the fourth quarter. The figures for October through December were up from RMB 11.6 billion during the same period of 2012, and actually exceeded the amount loaned to the industry by banks.

As part of China’s shadow-banking industry, the interest rates and terms for loans by these trusts are not regulated, and some of these informal lenders charge rates as high as 5 percent per month (80 percent per year) to borrowers desperate for short-term financing.

Relying on Increasing Housing Prices as Market Slows

Developers who are taking on these higher costs of land and increased financing fees are betting that China’s housing prices can go up forever, and that they will be able to pass along any increased costs to consumers through higher prices for flats.

In perhaps the most extreme case to date, Tianjin-based Sunac paid RMB 2.1 billion for a site last year which could yield a maximum floor space of 59,152 sqm, making the developer’s accommodation cost RMB 73,000 per sqm of built space. All of these deals may work out if the public is able to afford RMB 100,000 per square metre of housing, but if prices level off or drop, then China’s highly leveraged developers may find themselves in a tough situation.

While China’s home prices are still on the way up, data in recent months shows slowing price growth. According to the China Index Academy, prices in January grew 11.1 percent over the figure for the first month of 2013, which was less than the 11.51 percent growth shown in December compared to the rate in the same month of 2012.

January’s nationwide average price of RMB 10,901 (US$1,799) per square meter also reflected a 0.63 percent uptick compared to December, and the academy’s report also showed a deceleration in the month-to-month pace compared to a 0.7 percent increase in December.

While there’s always room for price growth to rebound, investors looking at lending to China’s real estate industry, or investing in developer stocks would do well to consider the higher costs and the risks involved.