Chart 1

China's residential property sector has bounced back from COVID. However, officials continue to be concerned about surging home prices, and issuers are preparing for tighter funding conditions. S&P Global Ratings expects government controls to exert the biggest influence on the sector next year. These controls should ultimately prove credit positive for developers with strong execution capacity.

Chart 2

Price Over Volume Could Reverse In 2021

In our view, China's residential sales will be roughly flat in 2021. We anticipate average selling prices will drop by up to 5%, but this will be largely offset by growth in gross floor area.

Developers will likely ease prices to boost sales and cash flow as funding conditions tighten. We still see solid demand in larger cities, but this is starting to level off after a strong run following the end of pandemic lockdowns.

Local governments will also likely fine-tune their policies on mortgages to stop prices from falling too hard. Their focus through this turbulent period has always been on price stability. Some local governments have also cooled home prices since the start of September 2020 due to tightened rules on home-buying eligibility and curbs on speculation.

New-home prices in 70 cities rose at the slowest pace in September since May 2016, undershooting even the COVID lockdown months. With price cuts looming, this will likely boost demand mildly, returning home sales (by gross floor area) back to positive territory.

Chart 3

Indeed, despite some promotional activities and more project launches, volume growth was limited during the traditional peak season in September and October. Second-tier and stronger third-tier cities saw particular weakness. These were previously China's most heated home markets, but are now the focus of tightening measures.

Developers focused on tier-one cities are experiencing slow growth, given the price caps in effect. Lower-tier property markets have also cooled since the government in 2018 started to ease policy support for shantytown redevelopment. China's economic slowdown post-pandemic has put more strain on smaller cities, in our view.

This was unlike in 2017, when state funding for shantytown redevelopment in these cities pushed up development volumes by more than one-quarter nationwide. The key question is whether the weakness in lower-tier cities will be more pronounced than that of higher-tier cities, squeezing industry-wide growth.

Funding Options Constricted For The Most Leveraged Entities

China's widely circulated but, as yet, unofficial "three red lines" policy purportedly restricts developers' bank borrowings. According to media reports, regulators track three ratios before letting a developer raise more debt: liabilities to assets, net debt to equity, and cash to short-term debt.

We understand that an issuer could be allowed to increase debt by 5% annually for each red-line threshold that it meets, for a maximum yearly debt expansion of 15%, if the policy is enacted. Chinese officials have not offered any details on how the thresholds are calculated, and we base our estimates on details reported in major media outlets (see chart 4).

Entities are most likely to run afoul of the first ratio, which is arguably the most difficult to address. Companies generally do not have a large asset base, as they prefer to quickly sell (or presell) their developments. While firms do have land banks, they keep inventory levels low to shorten cash cycles, so they can redeploy as much capital into the next project as possible. Only a handful of rated players have built sizable investment property portfolios (see "China Commercial Property: Incumbent Advantages Today Suggest Credit Strength Tomorrow," published on RatingsDirect on Nov. 4, 2020).

Chart 4

To drum up cash, developers are likely to introduce flexible pricing to encourage contracted sales, make hefty cuts to their land expenditures, or even drag out project completions to defer construction spending.

Firms may also lengthen short-term maturities. This will likely become a favored strategy for stronger players holding large unpledged assets, and with good access to capital markets. Domestic bank loans collateralized with commercial properties, along with U.S. dollar bonds, offer the best opportunities to issue at longer tenors.

However, developers whose capital structures are dominated by onshore construction loans (mainly issuers rated 'B-' to 'B+') may find it difficult to quickly end use of short-term debt. Such entities rely heavily on 364-day notes.

Chinese developers' use of 364-day notes has broadly surged in 2020, accounting for 13% of offshore issuance among our rated names, sharply up from the 4% level seen in 2019.

Chart 5

Even if developers are given one to three years to align to the red-line thresholds, the tightening will likely accelerate sector polarization. It will become difficult for most 'B-' to 'B+' rated developers to grow when their bank borrowing is essentially capped.

Some may take on more risk by deploying more off-balance sheet debt via joint-venture projects, or find other loopholes to seek funding (see "China Developer Joint Ventures: The Case Of The Vanishing Revenue," June 10, 2020).

State-owned firms that had used debt to expand aggressively will also need to strictly comply with the new rules. This may limit their ability to add market share.

We believe most investment-grade developers will be able to avoid the most stringent limits on debt growth, handing them advantages. The red-lines policy--if verified--may prove credit positive for the sector, as it restrains debt growth.

Self-Reliance And Core Strength

Given there may soon be limits on debt growth, the current state of developers' balance sheets can give us important clues on how they might perform over the next one to two years. In a scenario where debt becomes nearly constant, large and unrecognized contracted sales (which we track using contract liability as a proxy) would land an immediate boost to an issuer's revenue and profit, facilitating deleveraging (see chart 6).

That said, an unfolding margin squeeze stemming from rising land prices, prolonged price caps, and the potential for price cuts ahead may counter any deleveraging trend. This is especially true for those developers that are aggressively boosting volumes.

We expect the sector's gross margin to slide to 26% in 2021--from 33% in 2018--as signaled in interim results this year (when margins slipped to a 28% weighted average). Several of our rated entities have recently bought land at auction at exceptionally high prices, with the projects barely profitable.

Chart 6

The deleveraging trend hardly tells the full credit story. Many entities will likely have to maximize existing land banks to drive growth, given the controls on funding leaves them little budget to buy new land. Execution is also key to a developer's success, together with the size or quality of its land bank.

In the past years, aggressive land acquisitions supported fast turnover and high growth. This time around, developers need to squeeze value from existing resources.

Developers with large, fully paid land banks should have more firepower to support next year's contracted sales. We add a caveat: Developers sitting on land in remote locations, even if sizable, may find it harder to compete with those that have projects in economically stronger and more stable locales.

Chart 7

First-Half Issuance Spurt Extends Maturities

An issuance window opened immediately after the pandemic lockdowns ended in China. This allowed rated developers to raise new debt and extend maturities. The average tenors of new issuances have reached 3.5 years in the year to date--a level not seen since 2014--increasing by about seven months from the same period last year.

Chart 8

Regulators have cut developers' refinancing quotas for debt issuance into the domestic interbank market since August this year.

However, such debt only accounts for 12% of upcoming maturities in the remainder of 2020 and 2021. The quota cuts would be much more meaningful if they included corporate debt traded on the Shanghai exchange, or raised in the offshore U.S. dollar market. This accounts for most of the domestic and offshore bonds issued by our rated Chinese developers.

Regulators have rolled out similar restrictions on developers' issuance of domestic corporate bonds, but it's unclear how consistently these are applied across all developers.

Our sensitivity analysis shows the hit to free cash flow on each issuer if they lost 15% of their issuance quota in three key markets: onshore interbank-traded bonds, onshore exchange-traded bonds, and offshore bonds. The data suggest that even if an issuer were hit with quota cuts to all three markets, this would only result in minor liquidity stress. A cut of 15% to the total issuance quota to refinance debt maturing in 2021 would only translate into a less than 10% hit on unrestricted cash for most rated developers (see chart 9).

Chart 9

We are more focused on issuers' increased use of 364-day notes, since the instruments are not part of the quota framework. These short-term instruments can burden liquidity and create refinancing risks, and accounted for 13% of total offshore issuance in the year-to-date. As such, their increased use could be credit negative for the sector.

If the mooted policies continue for the next several years, sector growth may slow, but credit profiles may improve among mid to large names. Smaller players could exit the market as the industry enters a consolidation phase. We may also see accelerated sales of projects or even company stakes should issuers hit refinancing challenges. We have seen some cases of defaults or near-defaults this year. Timely project execution is vital.

To control debt growth, more firms may turn to equity raising. This option again is only available to those with the best market access, and depends on regulatory approval. More project-level joint ventures involving genuine equity could be another trend.

But the main variable is policy risk. This is an economically vital sector for which the government tolerates little volatility. Government decisions to continue or even tighten policies over the next few years will shape developers' fundamentals through the period.

Appendix

Table 1

Table 2

Related Research

• China Commercial Property: Incumbent Advantages Today Suggest Credit Strength Tomorrow, Nov. 4, 2020
• China Developers Enter Packed Second Half As Credit Tightens, Sept. 2, 2020
• Webinar Replay: Chinese Developers Steadfast Against Margin And Policy Challenges, Sept. 3, 2020
• China Property: New Curbs A Sign Of Reviving Home Sales, Aug. 12, 2020
• China Developer Joint Ventures: The Case Of The Vanishing Revenue, June 9, 2020
• China Developers' 2019 Results Expose Strains Before COVID-19 Crisis Hit, April 8, 2020
• New Virus, Unprecedented Risks For China's Developers , March 2, 2020
• China's Illiquid Developers Ask, How Long Will The Coronavirus Crisis Last? Feb. 2, 2020