Property sales are past their peak in China. After robust growth for more than two years, the momentum waned in September and October, traditionally prime months. A downturn for such a cyclical sector has been widely anticipated, but the timing is particularly bad since credit conditions aren't conducive either. S&P Global Ratings expects the tougher operating environment to have a differentiated credit impact. It could bring opportunities for some and headaches for others.

Sales by area fell 0.8% in September from a year earlier; and other leading indicators such as land acquisitions and real-estate investments are also dipping for the first time in about two years. Various restrictive policies gripping the sector have finally taken their toll. From price caps in major cities to slower pre-sale approvals, policies are now gradually reversing runaway prices and dampening volume across China to varying degrees.

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Developers are already starting to selectively increase promotional activities to drum up sell-through rates. Further price cuts are likely, given contracted sales progress are still lagging those of last year, while sales transactions are also tapering as homebuyers could be sidelined due to weaker sentiment. Stiff competition will intensify into next year.

As such, we expect prices to drop by up to 5% and volume to decline by 3%-7% next year, likely leading to an overall sector contraction of 8%-12%. However, most rated developers should achieve stronger sales than the sector average, as with the previous cycles. The challenging environment will allow larger developers to gain as uncompetitive players exit the sector and offer their ditched projects to market leaders for cash.

Unequal Decline By Location Will Have An Uneven Impact On Developers

Smaller cities with weaker economic fundamentals will likely lead the price decline. Caps have kept prices stable for tier-1 cities but have inflicted the most pain on developers this year. Most companies have weathered this with decent project diversity, with only a few exceptions. Developers such as Oceanwide Holdings Co. Ltd. (CCC+/Negative/--), Hopson Development Holdings Ltd. (B-/Positive/--), and Guorui Properties Ltd. (B-/Negative/--) were caught out by policies impeding planned pre-sales in tier-1 cities. Without sufficient project diversity, their sales took a hit.

However, lower-tier cities are much more vulnerable in a downturn and could quickly turn from growth drivers to sector drags. This would mean that developers focused on lower-tier cities such as Country Garden Holdings Co. Ltd. (BB+/Stable/--) and China Overseas Grand Oceans Group Ltd. (BBB-/Stable/--) are likely to bear the brunt of price drops, compressing their improved profitability to levels seen in the upcycle. Lower sell-through will also test the fast-churn model exemplified by Country Garden and widely adopted by the sector. Many small developers that expanded rapidly during the past two years could be wrong-footed by a downturn.

That said, while weakening sales and profitability will undoubtedly affect credit profiles, the magnitude is unlikely to be significant. Most rated developers have large unrecognized sales containing solid margins, good sales execution, and decent project diversity. We believe they will continue to exceed average sector growth and to soak up market share in a downturn.

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Land transactions and prices will continue to slide next year as they have since earlier this year. But we still expect land prices in higher-tier cities to hold up better, given they have smaller supply but higher demand. Developers have already done a fair amount of land replenishment while either expanding or adjusting their geographical footprint in the upcycle. These reserves should last them a longer period, especially when growth is fading, lessening further replenishment needs. Sunac China Holdings Ltd. (B+/Positive/--) and Ronshine China Holdings Ltd. (B/Stable/--) are among those that took the opportunity to replenish. In addition, financing has become harder and more expensive to obtain, and some financing channels that developers used to fund their land purchases are no longer available. As a result, developers are more discerning and more reliant on the cheaper alternative of project acquisitions rather than public auctions for land.

Refinancing Is Still The Name Of The Game

The key risks for developers still stem from liquidity and refinancing. Conditions have been tight on all major funding channels for developers. The financing landscape is the most unfavorable for years--whether it's a clampdown on alternative financing, domestic bonds being designated only for refinancing, or a surge in offshore bond yields.

Weaker players with poor sales prospects and passive financial planning may encounter liquidity shortfalls. A heavy bunching of maturities is mainly attributable to developers' domestic bonds, which typically contain put options. Companies facing such maturities and weaker liquidity include Xinyuan Real Estate Co. Ltd. (B/Negative/--) and China South City Holdings Ltd. (B-/Stable/--), and may see a strain on their liquidity given their weak cash generation.

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Put Options Add To The Liquidity Strain

If recent cases are any indication, companies have sometimes needed to redeem a large majority of their issuance at put dates, with the sector averaging about 50%. Not only that, exercising put options has instigated several defaults for companies in other sectors in recent months. For example, China Huayang Economic and Trade Group Co. Ltd. (SD/--/--) was unable to meet its put obligations in October 2018, which led to its default.

Furthermore, even if the puts are not exercised, the revised cost on the outstanding amount has been increasing. Coupons have on average stepped up by about 150–200 basis points (bps) after the put date. More recently, Greenland Holding Group Co. Ltd. (BB/Stable/--) had to drastically increase its coupon by 300 bps to avoid redemption.

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Market Appetite And Currency Depreciation Don't Bode Well For Offshore Refinancing

Investor appetite for offshore issuance has retracted to a level where small players and newcomers may be priced out. With the domestic bond market shut for new funding, and alternative financing markedly more expensive or not even renewable, developers have once again shifted their attention to the offshore bond market. This swell in supply from the sector, paired with emerging market capital outflow, has led to substantially higher yields and a weak take-up of longer-dated issuance. Notably, Hengda Real Estate Group Co. Ltd. (B+/Positive/--) set a record high for issuance of similarly dated papers this year. Smaller developers will certainly have to endure higher coupons. In some cases, depleted investor demand will also make new issuances altogether unfeasible.

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To make matters worse, the Chinese renminbi (RMB) has depreciated about 7% this year, adding to the debt-servicing burden. Although developers in general have reduced their foreign currency exposure since 2016 when the U.S. dollar/renminbi rate dropped to US$1:RMB6.9, any further depreciation could exacerbate the negative impact. We estimate that as of June 2018 about 32% of our rated developers have more than 30% of their total debt denominated in foreign currency. For these developers, a 1% decline in the renminbi could on average add 0.4% to both their debt-servicing and repayment burden. While not a huge impact in isolation, further depreciation could stretch some marginal issuers that already face significant liquidity pressure or have a thin rating buffer (see chart 7). Issuers that have unsustainable cash flows and face additional refinancing and market obstacles have a real possibility of collapsing. That's already happened for several small-scale developers that defaulted onshore this year.

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Hastening Consolidation Will Benefit Those With Execution Ability

With a shortage of financing, cash inflows from sales remain the most dependable funding option. Hence, most developers are focusing on sell-through, and may sacrifice pricing to achieve good cash generation. Those with strength in execution, including product positioning, location selection, and sales schedule and tactics, may gain the capacity to snap up more deferred or distressed assets amid a slump. Sector consolidation has started for some years, but is now shifting to a higher gear.

Harsher Policies Look Improbable For Now

If harsher policies on the sector are introduced, a much steeper decline could ensue. These could include measures to alter the pre-sales system, which has greatly benefited developers in the past, or implementing a widespread or draconian property tax regime, which could stifle homebuyer demand. But the increasing downward pressure on economic growth is compelling the government to signal more stimulus ahead. We therefore believe suppression of the property sector looks more remote. Mild loosening is more probable if the cycle turns too far south.

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