Chart 1

China property is set for another year of softening. Conditions are coming close to normal in richer, upper-tier cities. However, S&P Global Ratings believes that weaknesses in China's tier three and four cities will keep the property recovery on an "L-shaped" path. Conditions will hit the developers with heavy exposure to lower-tier cities the hardest.

We view this as the latest stage of a crisis that resulted in US$52 billion in offshore bond defaults last year, with about one in four developers brushing against insolvency (see "China Default Review 2023: Where's The Next Wave?" published April 13, 2023, on RatingsDirect).

The downturn in lower-tier markets will hit a large section of the industry. If sales in tier-three or tier-four cities fell by 20%-30% this year--more than our base case of 10%--our sensitivity analysis shows 40%-60% of rated developers could experience rating pressure.

China developer sales nationally will fall by about 3%-5% in 2023, in our view. This is a slight improvement from our prior expectation that sales would drop 5%-8%. Indeed, China property sales were up 9% in the first four months, year on year, according to official data.

Chart 2

The gains followed the government's early termination of COVID-targeted lockdowns, and a series of supportive policies since the second half of 2022, which released pent-up demand.

However, this recovery came and went quickly. In April 2023, China's national property sales dropped to Chinese renminbi (RMB) 0.9 trillion from RMB1.5 trillion in March. This is lower than the average national monthly sales of RMB 1.1 trillion in 2022.

• China's average monthly property sales will range RMB1 trillion-RMB1.1 trillion for the rest of 2023.
• Full-year sales in 2023 will be RMB12 trillion-RMB13 trillion (see chart 1).
• Full-year sales will be about one-third below the historical high set in 2021. This is just a shade higher than total sales in 2016.

Widening Divergence Between Lower And Upper-Tier Markets

Sales in upper-tier cities are stabilizing, while those of lower-tier cities are sinking. We estimate that property sales in the upper-tier cities in the first quarter of 2023 rose to RMB1.5 trillion from RMB1.3 trillion, while sales in lower-tier cities fell to RMB1.6 trillion from RMB1.7 trillion in the same period.

• Inventory levels of primary homes were healthier for tier-one cities at 13 months, and for tier-two cities at 18 months, as at end-February 2023, according to China Real Estate Information Corp.
• For lower-tier cities, the inventory level was 22 months.
• This compares with nationwide inventory level of about 10 months during 2016-2021.

By our estimates, sales in tier-one or tier-two cities will grow modestly in 2023, by about 3%. Sales in lower-tier cities will likely drop about 10% in the same period (see table 1 and chart 2).

Developers also favor purchasing land in higher-tier cities. In the first quarter of 2023, while total land purchases (in renminbi terms) dropped by 16% on a national basis, aggregate land purchases in hot upper-tier cities such as Hangzhou, Xian, Nanjing, Suzhou, and Guangzhou rose more than fourfold (year on year). These were the top five cities in terms of land sales during the period.

Chart 3

Table 1

Under-supply to constrain volumes in higher-tier cities

Sales growth in higher-tier cities will stem from volume gains, in our view. Price growth will likely be flat under the government's "homes are for living, not speculation" policy.

A lack of new supply will be the biggest factor limiting volume growth in higher-tier cities in 2023. In 2022, China's top-100 developers cut their land purchases by about half year on year (in renminbi terms) amid the industry downturn.

These large developers have typically been the major providers of private homes in higher-tier cities given higher capital requirements for land purchases. Even if the entities picked up land purchases in early 2023, such buying would not turn into supply until late in the fourth quarter, at the earliest.

Over-supply to constrain prices in lower-tier cities

For lower-tier cities, we believe prices will continue to fall as developers clear inventory. In the first quarter of 2023, average prices in lower-tier cities dropped about 3% year on year, by our estimate.

Price declines could widen if large, distressed developers that own large land reserves in lower-tier cities decided to sell inventory at steep discounts. China Evergrande Group (unrated) said in early February it would use promotions to stimulate sales from over 450 projects, according to press reports.

Liquidity Risks Are Stabilizing

Developers' liquidity risk has moderated after the government launched in November 2022 a 16-point plan to stabilize the sector (see "China Property Is Heading For A Transformation, And Maybe A Turnaround," Nov. 21, 2022). Nevertheless, we view continued sporadic strains as possible, depending on the size of an entity's maturing debt, the robustness of its cash flow, and its access to capital markets.

Regulators have mandated that bank loans are escrowed, to ensure developers only use the money for the project that it borrowed against. The escrow ends when the developer delivers their homes to buyers. These tightened escrow rules also include an up-to RMB350 billion "rescue" fund that the government announced last year. The funds can be used to complete projects, but the developer must hold the money in escrow until it delivers the homes.

Entities cannot use the bank loans or rescue funds to repay maturing bonds. This is a break from past practice, when escrowed funds fell into a regulatory gray zone. Some developers used money collected for one project to launch another project.

The practice gave firms a faster turnaround on their investments. It also contributed to the current situation, in which illiquid developers are struggling to complete hundreds of thousands of pre-sold homes (see "As The Escrow Flies: China Developers Navigate Convoluted Rules On Presales," Jan. 20, 2022).

Cash flow from contract sales will be key to entities remaining as a going concern, and our rating actions.  Beijing's 16-point plan has been instrumental to setting a floor to this crisis. However, the initiatives are not about ensuring developers repay their bonds. They are aimed at restoring liquidity and backing for developers' debts at the project level, not at the holding company (holdco) level.

This is an important distinction. It speaks to the heart of issuers' bond repayment risk. Bond repayment at the holding company level needs to come from self-generated cash flow, which requires upstreaming of unencumbered cash flows after repaying project-level debt and other obligations.

Our liquidity stress test focuses on a developer's ability to use internal cash flows to repay maturing holdco bonds in a scenario in which lower-tier cities sales fall 30%. This is our most severe scenario (see table 2). Our test assumes banks' project loans and government aid are fully escrowed.

The test also accounts for the fact that weaker private developers are typically more exposed to the lower-tier cities. The entities had previously found it easier to ramp up quickly in those markets, which tended to have much more land available at low prices. As the lower-tier markets continue to slide, these entities are more exposed to the downturn.

How unrestricted is "unrestricted"?

Our liquidity analysis probes the accessibility of an issuer's "unrestricted" cash. This is typically the biggest source of funds theoretically available for debt repayment. This is usually bigger than what rated developers generate in operating cash flow for one year. The reality is that a portion of such funds is inaccessible, and in distressed situations the bulk if not all of the cash is inaccessible.

The ratio of unrestricted cash flow from presales available for holdco bond repayment varies from developer to developer, and project to project.

The exact portion of funds that the developer can use for bond repayment, and the portion that must be escrowed until homes are built and delivered, varies. Influencing factors include how much money developers need to complete the project, the tier of the city in which the project is based, and the requirements of local governments, banks, and joint-venture partners.

In an extreme scenario we assume a 100% haircut on this unrestricted cash holding. We then look at an issuer's capacity to cover maturing bonds with cash from operations. We moreover apply a 50% haircut to the entity's operational cash flow.

In the stress scenario (a 30% sales drop in lower tier cities) almost one-third of our rated Chinese developers would see their liquidity ratios fall to 2x or below (see chart 4).

Chart 4

The liquidity ratio for these purposes is cash from operations in 2023 divided by the volume of bonds coming due in the year.

The 100% haircut is an unlikely scenario, in our view. Creditor confidence would have to be very low for them to impose such strict escrowing conditions to tie up 100% of unrestricted cash.

Cash from operations is contracted sales after taking out construction expenditure, SG&A (selling, general and administrative expenses), and funds committed for land purchases.

These liquidity ratios improve considerably when we apply a 50% haircut to unrestricted cash, and a 50% haircut to cash from operations (see chart 5). All but two of our rated developers would maintain liquidity ratios above 2x in the stress scenario. That suggests to us the importance of monitoring the volume of unrestricted cash an entity has on its balance sheet, and to applying the right haircut to that figure.

Chart 5

We view a liquidity ratio of 4x as providing a comfortable buffer against upcoming bond maturities. A ratio of 2x of below clearly is a thinner buffer. It suggests we may need to scrutinize entities to see if they have other sources of funds for bond repayment.

Our scenarios only look at a developer's cash-generating ability from contracted sales, without factoring in potential offsetting factors, such as rental income or asset sales. In our rated portfolio, for example, Seazen has over RMB10 billion of rental income. Xinhu Zhongbao Co. Ltd. (B/Negative/--) has a large holding of securities that could be monetized.

What if sales in lower-tier cities are worse than we now expect?

Our second stress test incorporates scenarios whereby sales in lower-tier cities fall 20%-30% in 2023. In such scenarios, the average debt-to-EBITDA in 2024 of our rated developers would increase from 5.5x in our base case to 6.1x-6.9x.

Developers with tight rating headroom and/or have significant exposure to lower-tier cities could face downside rating risk.

Under our scenarios, 40%-60% of our rated developers could see a breach in their downside rating triggers. Most of their liquidity ratios could also be weakened under our most extreme scenario (see charts 4 and 5). However, our stress test does not capture the possibility that higher-rated developers may benefit from a flight to quality among homebuyers.

For example, the state-owned China Overseas Grand Oceans Group Ltd. (BBB-/Stable/--) recorded 47% sales growth in the first quarter of 2023, year on year. The sales gains came despite the issuer's focus on lower-tier cities. This contrasts with a 28%-31% drop during the same period among privately owned, lower-tier players such as Country Garden Holdings Co. Ltd. (unrated) and Seazen Group Ltd. (BB-/Negative/--).

Table 2

Chart 6

Chart 7

China's property market remains a pillar of the economy. Even at its much reduced size, it still generates above RMB10 trillion in annual sales. The level puts property as one of the largest sectors in China.

The good news for the industry is that the property markets in the upper-tier cities are normalizing. This suggests to us that where sales are based on real demand for residences, entities can thrive.

Developers can no longer rely on the fast-asset turnover model and will find less cover in financial innovation. Those developers focused on the lower-tier cities will have to deal with a smaller market and tighter escrow restrictions. The upshot is that some distressed developers may not come back. The survivors will need to focus on real demand, operating efficiency, and profit.

Writing: Jasper Moiseiwitsch

Digital design: Halie Mustow, Evy Cheung

Related Research

• China Default Review 2023: Where's The Next Wave?, April 13, 2023
• China Developers' Earning Weakness To Persist Another Year, April 11, 2023
• China's Defaulted Developers Hope For The Best, Prepare For The Worst, Jan. 10, 2023
• China Property Is Heading For A Transformation, And Maybe A Turnaround, Nov. 21, 2022
• China's Property Downcycle Won't End With Policy Easing, April 7, 2022
• As The Escrow Flies: China Developers Navigate Convoluted Rules On Presales, Jan. 20, 2022