China's affordable housing ambitions come with a hefty price tag. The country is earmarking 8.7 million units for subsidized rent, roughly 10% of new housing annually. S&P Global estimates the program could cost up to RMB2.0 trillion (US$270 billion) by the end of 2025. But it could also involve opportunity costs. That's because local governments and banks could put Beijing's cornerstone policy ahead of commercial interests.

Why it matters:  The recent National People's Congress stuck to its property policy. The affordable housing for lease plan therefore remains the most financially significant housing-security initiative under China's 14th Five-Year Plan. We expect about 190 cities to participate in the program and some 26 million tenants to benefit. It could account for up to half of new housing supply in Beijing, Shanghai, Guangzhou, and Shenzhen.

What it costs:  We calculate the program will cost Chinese renminbi (RMB) 1.6 trillion-RMB2.0 trillion from 2022-2025. Favorable lending rates will strain the profit metrics of the big Chinese banks leading the financing. On the flipside, the program should provide stable cash flow for local state-owned enterprises (SOEs), including local government financing vehicles (LGFVs).

What's at stake:  Opportunity costs for all participants stem from discounted land sales, fiscal subsidies, financing concessions, and upfront capital spending. For local governments, any problem projects could turn into contingent debt burdens. Authorities could also be left with excess inventory if too many units are built or converted. Conversely, if too few units are supplied, the program would have failed to resolve an important social issue.

The Risks Or Rewards For Key Sectors

China's housing policy includes multi-channel support, and encouragement of both ownership and leased forms of dwelling. The biggest outlays for the affordable housing for leasing plan will occur in 2022 and 2023, after a slow start in 2021. The hit varies by sector.

Local and regional governments (LRGs) have a balancing act

The program should have a largely neutral effect on LRGs, depending on how they approach its implementation. They could provide fiscal incentives such as tax cuts, grants, and subsidies to promote take-up. To rein in costs, the authorities are likely to prioritize repurposing and renovating existing properties over new construction, which is more expensive.

But the governments will face opportunity costs if they sell primary land reserves for construction of new units at steep discounts. We think the concessions might be up to 50% lower than the authorities could get on the open market. The discounts are likely to be highest in the biggest cities. We expect any aggressive offers would be selective, however, and typically for land on city outskirts. Such locations would mean only a moderate crowding-out impact on main private housing areas in city centers.

A further negative would be the use of balance sheets to support the programs, with a key risk that problem projects could turn into contingent debt burdens.

The upside would be greater efficiency over the allocation and use of unoccupied properties. Repurposing and renovating existing buildings will help to quickly meet the leasing quotas. The local economy may also be revitalized since the program targets young migrant workers, who could help to increase productivity and local consumption.

Stable cash flow for SOEs and LGFVs isn't without risk

As projects mature, key SOEs and LGFVs are likely to benefit from the program over the long term. Lengthy leases will make cash flows more predictable, improving overall profitability. Rental rates will be close to market pricing (we estimate the discount to be 10% or less for most cities).

Experience will count. The companies that are likely to be involved will already have track records in property development and management. Additional benefits include the opportunity to repurpose idle land and properties to improve efficiency. And this program isn't as capital intensive as the redevelopment of shantytowns in previous years.

Yet the program also comes with sizable risks. In particular, companies may have to incur large debts to fund the upfront cost of new builds. The degree to which this can happen is heavily dependent on occupancy rate, rental level, and the size of any subsidy or discount for the acquisition of land or property. There may also be long loan payback periods. Returns will therefore be conditional on favorable land acquisition prices (for new construction) from the LRGs and preferential long-term funding.

More flexible rent collection policies also increase risk for owners since rental revenues may not be sufficient to cover funding costs and other expenses.

Credit premiums could become more elevated for highly indebted key SOEs and LGFVs. Credit quality will become more differentiated between regions, and government support may turn more selective. That's most likely for regions with more vulnerable economic and fiscal conditions.

During downcycles, weaker regions also tend to be hit harder, adding to risks around the base case for lending decisions. This is a trade-off for having a more local and specialized affordable housing strategy, compared with a national agency with broader funding channels.

A new income stream for developers

Developers could benefit from new business opportunities by becoming construction agents and property managers under the program. But as a revenue stream, affordable housing for lease projects are unlikely to be material, at less than 1% of private residential sales on an annual basis. The overall effect is therefore neutral.

Developers in financial trouble have the option to sell at a discount their unfinished projects, which can then be repurposed for the program. While substantive discounts indicate financial vulnerability, they are more reflective of the property market downturn and weak bargaining position of certain developers.

Chart 1

The biggest banks will lead the pack

We expect policy banks and megabanks to largely backstop the program, followed closely by regional commercial banks. Their participation underpins the central government's view of how banks can lend more to fuel the economy. Lower-ranked banks may be reluctant to become involved, however, given the lack of collateral (as land usage is restricted), relatively low lending rates, and long loan durations.

The likely return on lending is reasonable, in our view. We estimate the return on risk-weighted assets at about 1% (see appendix), only slightly below the sector average of 1.2%. However, as loan terms can be as long as 30 years, it's difficult to predict how counterparty credit risks will evolve. That risk is particularly acute since the banks will be exposed to locally run key SOEs and LGFVs, rather than a single national-level agency.

To show support for this housing program, loan exposure to affordable rental housing is no longer subject to rules that prevent concentration in property-related loans. The rules have contributed to restricted lending to certain overleveraged developers. Supportive regulatory measures such as this encourage wider engagement from banks.

Banks with exposure are also sensitive to changes in perceived government support, which is becoming more selective and differs across cities with varying credit profiles and supportive attitudes.

Overall, the banking sector will be exposed to neutral to negative risk levels.

When Policy Calls, Everyone Chips In

We estimate renovations will cost on average RMB1,100 per square meter (psm), with only a small variation across city tiers. We assume renovations will account for 60% of the target quota for affordable housing for lease, with an average unit size of 60 sqm.

Chart 2a

Chart 2b

Chart 3

The authorities' likely preference to predominately repurpose and renovate buildings is in line with "Opinions on Accelerating the Development of Affordable Rental Housing," issued by the Office of the State Council in June 2021. The renovations include office buildings, hotels, warehouses, and other commercial real estate.

Location, Location, Location

We expect only 191 Chinese cities with positive population growth to take part in the affordable housing for lease program. Our view is based on our examination of over 300 Chinese cities at the county level and above, the announced plans of the top 39 cities, and their population size.

On average, we estimate there will be 1.7 affordable housing units for lease per 100 residents for the top 40 cities. This ratio is twice as high as other smaller cities' and is in line with the program's focus on new urban residents and young graduates.

How the local affordable housing for lease supply target is achieved has a high bearing on overall costs. New builds on average cost RMB11,000 psm in tier-one cities, by our estimates, compared with just RMB5,000 psm on average for cities in other tiers.

In our view, the policy initiative to uplift traditionally under-invested affordable housing (all types) is in line with China's drive for "common prosperity," a policy goal that aims to address wealth gaps and changes in demographics at city levels (see "What Last Year's China Policy Surprises Mean For The Future," published on RatingsDirect on May 19, 2022).

Take Jiangsu, one of China's most developed provinces. Its affordable housing comprised 26.1% of permanent urban households as of end 2020, well above the national average. But it's still below that for Singapore (78.7%) and Hong Kong (45.7%).

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How China's Model Compares Globally

In general, affordable housing is provided under non-profit programs to benefit selected community groups under various public service objectives. Often, these projects are capital intensive and run by state-affiliated organizations as opposed to being financed directly from government balance sheets.

In most developed systems, strong affordable housing providers usually thrive under established regulatory frameworks. They have clear mandates for operations to be autonomous but are strategically influenced by changes in policy direction. The business models typically involve some form of ongoing and extraordinary state support.

For example, providers will offer large rental discounts with the help of preferential borrowing rates, government grants or guarantees, to support a lower funding-cost structure. In other cases, subsidies to tenants provide some buffer to baseline revenues of these affordable housing operators.

In contrast, the operating environment for affordable housing providers in China is still evolving. Beijing has increasingly delegated the execution of national policies to LRGs, which have wide-ranging levels of sophistication and transparency. Prospective tenants expect discounts on rentals, but there's a lack of clarity over levels of state support and investment payback mechanisms, which can be simplistic at the LRG level.

A common approach is to designate local SOEs and LGFVs as main operators. However, these entities are also asked to be more commercial in their business undertakings. This can be a source of conflict if funding and other support mechanisms remain fluid since they are important factors for overall profitability.

It remains to be seen how predictable the cash flows will be for affordable housing operators. At this stage, we generally view government subsidies as necessary and likely to persist, given the program conforms to the national ambition of "common prosperity.". Its early success would pave the way for similar initiatives.

Stepping Stones And Shifting Sands

We estimate the annual supply of affordable housing for lease will account for around 10% of yearly turnover in residential property areas. But that's unlikely to have a meaningful impact on demand for private housing.

As new migrants and young graduates financially establish themselves, they will exceed thresholds that would have made them eligible for affordable housing for lease. They will then transition to the usual market for housing. Apartments used for affordable housing for lease are typically smaller, further away from the city center, and with basic amenities. Concessional housing is not a permanent arrangement, though their formation outlines a baseline living standard for those finding their footing in a new city.

Getting the affordable housing for lease quota right is important to avoid any unintended imbalances in supply and demand. This can be difficult to estimate due to several variables:

• Population growth, birth, and marriage rates are changing quickly in China.
• New urban residents would also weigh employment and income prospects when making migratory decisions. In recent years, policies have significantly altered the dynamics of certain industries.
• If the recovery of the overall Chinese private housing market is dragged out or a further correction occurs, this could affect people's willingness to buy homes, hitting rental prices.

Clear Social Benefits, Mixed Risks

One way for owners to offload risk levels would be to package rental receivables into REIT products, once there's an adequate track record on cash flow returns. In August 2022, China's first public REIT based on affordable housing for lease listed on the Shenzhen Stock Exchange.

We could see more programs that promote preferential leases to other segments of the population that could otherwise not afford the home. This is in line with policy directives and would discourage speculation in the Chinese housing market.

The urban emphasis of the affordable housing for lease program will not have a profound impact on long-term housing demand for China's biggest cities. This is a significant shift in focus from earlier housing security programs such as urban renewal, known in China as "shantytown" renovation and resettlement.

The direct costs of RMB1.6 billion-RMB2.0 trillion is a big burden. To put it into perspective, it's roughly the size of the 13th largest bank in the U.S. and a bit bigger than the New Zealand economy. Other initiatives under the five-year plan, such as public rental housing and shared property ownership, are likely to cost significantly less in comparison.

But we think it's manageable. After all, several parties are splitting the bill.

Related Research

• Non-U.S. Social Housing Providers Ratings Risk Indicators: July 2022, July 27, 2022
• Non-U.S. Social Housing Providers Ratings Score Snapshot: July 2022, July 27, 2022
• What Last Year's China Policy Surprises Mean For The Future, May 19, 2022
• Global Regulatory Framework Report Card: Public And Nonprofit Social Housing Providers, June 8, 2021

Appendix

Designer: Halie Mustow

Editor: Alison Dunn