HONG KONG (S&P Global Ratings) May 24, 2022--A spate of acquisitions of Chinese property managers underscores strong interest in this sector, even as the wider real estate market continues to wobble. S&P Global Ratings believes healthy firms will take advantage of the property downcycle to buy the management subsidiaries of distressed developers. At the same time, we are watching for governance risk associated with mergers and acquisitions of related parties.

"To bolster liquidity, some Chinese developers, particularly the ones in distress, may be tempted to unduly extract cash flows from their healthy property management subsidiaries. This would prop up their finances at the expense of the property managers," said S&P Global Ratings credit analyst Jay Lau.

Property managers are looking to buy out each other. As the number of projects available to manage is limited, entities that seek growth will need to use acquisitions. Once acquired, new projects should bring growth and stability to their cash flows. Increased size also brings economies of scale, supporting profitability.

Dealmaking will likely be active in 2022. Country Garden Services recently bought Zhongliang's Everjoy Services, and China Resources Mixc Lifestyle Services recently acquired Jiangsu Zhongnan Property Services.

We expect property management companies will start to explore debt financing to fund their growth. China's domestic equity markets have cooled, as apparent in the slowdown in the number of initial public listings and share placements after July 2021. We assume property managers have few alternative funding channels given their short record and the asset-light nature of their business.

Only some of the larger names have access to bank loans, or debt financing such as through the issuance of convertible bonds to support acquisitions. Such names include Country Garden Services and China Resources Mixc Lifestyle Services.

THE INDUSTRY IS FAST GROWING AND GENERATES STABLE CASH FLOW

Key industry players will grow at a rapid pace over the next two years, in our view. Multiple property management companies have set out aggressive growth targets. In 2021, listed property management companies' gross floor area (GFA) under management grew 58%. Revenues in the same period rose 49%.

"China's property managers have stable cash flows compared with the highly cyclical developers, which have to manage restrictive government policies toward developers," said S&P Global Ratings credit analyst Ricky Tsang. "By contrast, property managers set service fees in contracts that last for one or two years, or longer."

PROPERTY MANAGEMENT SERVICES HAVE HIGH SWITCHING COSTS

Getting approval from an estate's ownership committee makes it challenging to change managers, especially for the large estates with thousands of residents. Some property management companies benefit from the brand of their related property development company, which may have substantial recognition and goodwill among customers.

We believe sector players will continue to look for ways to keep profits stable. Regulations introduced in recent years have increased costs. These include increases to the minimum wage, and enhancements to workers' standard insurance coverage for unemployment and health. To counter rising costs, property management companies are bolstering their higher-margin offerings, such as butler services, community buying, and advertising.

Such services typically have high gross profit margins of about 40%-50%, compared with 30% for the property management sector. Key players such as Country Garden Services, Vanke's Onewo Space-Tech Services, and A-Living Smart City Services have increased this segment to around 30% of their revenue in 2021.

THE PROPERTY DOWNCYCLE WILL HAVE A LIMITED EFFECT ON MANAGERS

We believe the performance of large property management companies will stay resilient even as developers complete fewer projects. There are many existing projects that need managing. Moreover, property managers are far less capital intensive than developers, and are less exposed to liquidity tightening in the Chinese real estate sector.

As a result, we place extra attention to service quality, customer stickiness, and brand reputation, which would all help a property manager to maintain steady cash flow.

The property development downcycle also encourages consolidation. It gives the large, healthy entities an opportunity to grow rapidly via acquisitions, as distressed developers sell their management arms to bridge liquidity shortfalls.

Rapid expansion introduces integration risk where operating inefficiencies could occur. This may squeeze margins while lowering the quality of receivables, lengthening working capital cycles. For example, KWG Living's cash flow from operations was compressed in 2021 even as its revenue doubled, and it GFA under management quadrupled. A spate of acquisitions drove the surge in revenue and GFA. However, receivables management was challenging among the acquired entities, which explained why cash flow did not pick up.

MANAGERS' TIES WITH DEVELOPERS MAY PRESENT GOVERNANCE RISKS

We view some developers' increased investment in, or expansion into, property management as presenting governance risk. This is typically true for distressed developers that may be tempted to tap the strong, steady cash flows of the management arm.

Substantial related-party transactions may be a sign that an entity is unduly redirecting cash flow from a healthy unit, to salvage the finances of the distressed entity. We reflect such transactions in our governance scores. Any cash leakage, or misuse of cash holdings, will ultimately hit the liquidity of the rated company.

Property management companies could extend support to their related property developer through different means, such as buying a commercial building or other projects from the developer. Property developers could also include management fees in their property sales, and then hold off paying this income to the management company. The property management company could also buy bonds of the property developer and classify the securities as assets on the balance sheet.

Instances of potential governance shortcomings include:

• Evergrande Property Services Group revealed in March 2022 that it pledged over 90% of its cash balance for third-party guarantees, which banks subsequently enforced. The incident is being investigated by an independent committee;
• Shimao Services Holdings spent Chinese renminbi (RMB) 1.7 billion to acquire the property management arm of Shanghai Shimao in December 2021, when the property developer was facing a liquidity crunch. Shimao Services and Shanghai Shimao are sister companies, and are both subsidiaries of the property developer Shimao Group Holdings; and
• Aoyuan Healthy Life Group disclosed multiple related-party payments, leading the auditor to recommend an independent investigation, contributing to the delay of the entity's 2021 audited results.

The property downcycle is pushing property managers to grow via consolidation by swallowing up property management companies of distressed developers. It is also in the property manager's interest to grow as additional projects should bring in stable cash flows. We expect property managers to fuel their growth appetite by exploring funding channels other than equity financing.

Editor: Jasper Moiseiwitsch

Related Research

• China's Property Downcycle Won't End With Policy Easing, April 7, 2022.
• Auditor Resignations Flag Governance Risk For China Developers, Feb. 16, 2022
• As The Escrow Flies: China Developers Navigate Convoluted Rules On Presales, Jan. 20, 2022