The good news for China's property developers is that a bottom is in sight. The bad news is that the sector will likely bump along this floor for years. S&P Global Ratings expects that the low number of construction starts, an inventory overhang in lower-tier cities, and ever-tightening escrow restrictions will keep property sales depressed.

The sector will continue to diverge. The government's continuous policy relaxations aimed at stabilizing the sector will benefit the upper-tier markets, the first-tier cities in particular. Lower-tier cities are contending with excess supply and depleted confidence.

Conditions will also widen the gap between the state-owned developers, and the private ones. The state-backed entities have always been more focused on the upper-tier markets, a clear strength in current conditions. The entities also have relatively smooth access to funding, while many private developers have difficulty borrowing. A string of large private property firms have missed debt payments, hitting market confidence.

All developers will have to manage slowing sales; their leverage will stay high for the next two years, in our view.

State-Owned Developers Are Dominating

State-owned developers' continued access to funding means they can still buy land and build homes. They have more capacity to roll out saleable resources than the private entities.

Prospective homebuyers are favoring the state-backed entities' healthier balance sheets and liquidity. This is an important consideration when about 80% of residences are sold using the pre-sales model, which requires a confidence among buyers that the developer will stay solvent long enough to build and deliver the home.

The high-churn business and funding models previously favored by private firms have also become untenable. These entities raised a lot of debt in offshore bond markets, often at double-digit coupon rates. This was expensive capital. The firms would take that money, buy land, presell homes, and move on.

The practice was premised on the false belief that land and housing prices could only go up. Developers would build and then quickly sell, eliminating the need to pay interest on the debt backing projects for long. This minimized the capital cost of each development. Now, as this model fades, so has the previous dominance of the private entities.

State-owned firms' share of the total property sales increased 6 percentage points in the year to July, to about two-thirds of property sales. This is according to China Real Estate Information Corp., a consultancy, which tracked the sales of the country's top 100 developers.

Developers Still Have A Few Moves To Manage Leverage

Firms will likely continue to discount units to boost sales and cash flow (see "Chinese Developers' Profitability Is Searching For A Trough," published on RatingsDirect on Sept. 4, 2023).

Slowing sales and margin pressure will take its toll. We estimate that the leverage (debt to EBITDA) of rated developers will rise to close to 5.0x between 2023 and 2025, from around 3.0x in 2019.

Chart 1

A likely normalization of conditions in higher-tier cities may stabilize sales in those markets, but margins will remain under pressure, in our view. To keep leverage levels within manageable levels, sector players are:

• Raising equity;
• Selling noncore assets; and
• Fortifying sources of recurring-income such as through rental and by bolstering property management arms.

Table 1

Property Sales To Continue Their Decline In 2024

Our study of China's past property cycles indicates annual sales will find a support level at Chinese renminbi (RMB) 10 trillion-RMB11 trillion.

We assume this support level and state interventions will stop sales from following a "descending staircase"--that is, sequential declines over the next three to five years.

We assume sales in the fourth quarter of 2023 will stabilize at RMB900 billion-RMB1 trillion a month, a meaningful improvement from the nearly RMB800 billion monthly level seen in July-August this year.

The low sales in July and August were temporary, in our view. They were distorted by the high summer travel after three years of pandemic restrictions, and an expectation among prospective homebuyers that they should wait for policy easings that many believe are likely. We also assume:

• 2023 sales will drop to about RMB11.5 trillion–RMB12 trillion, a decline of 10%-15% over the prior year; this will exceed our original expectation that sales would drop by a mid-single digit this year;
• Developers' sales in the first eight months have only reached RMB7.8 trillion;
• 2024 sales will decline by another 5% to RMB11 trillion–RMB11.5 trillion; and
• A greater decline in 2024 in property sales is less likely given the double-digit shrinkage seen in both 2022 and 2023.

The government still has means to steady the sector, such as further relaxations in home-purchase restrictions and an easing of the rules on mortgage downpayments (see "China Still Has More Policy Tools To Stabilize The Higher Tier Property Markets," Sept. 26, 2023).

Chart 2

An Improving Demand Outlook In First-Tier Cities

As the "extended L" recovery plays out, China property sales will continue to diverge between higher- and lower-tier cities, in our view. Demand remains depressed in lower-tier cities. Developers will further discount residential prices to boost sales. We expect sales in lower-tier cities will drop 9% in 2024.

Second-tier cities will likely incur a modest sales decline of about 3%. This encompasses all the provincial capitals, and also some strong tier-three cities such as Suzhou, Ningbo, and Xiamen.

Recent relaxations on mortgages will support sales volumes in the four first-tier cities: Guangzhou, Shenzhen, Shanghai, and Beijing. The cities will likely see a 3% increase in sales in 2024, albeit on flat prices.

Chart 3

Chart 4

Tightening Escrow Accounts Remains As A Sector Risk

Housing deliveries remain the priority for the sector. Buyers' confidence in lower-tier cities is low. The two previous largest private-sector players, China Evergrande Group and Country Garden Holdings Co. Ltd., focused on lower-tier cities. They have both run into liquidity problems, culminating in missed debt repayments.

Chart 5

In line with our assumption that sales will continue to weaken in lower-tier cities, we expect developers most exposed to these markets will be hardest hit.

We recently downgraded Seazen Group Ltd. and its subsidiary Seazen Holdings Co. Ltd. The rating action reflected a likelihood of falling sales given the entities' heavy exposure to lower-tier cities (see "Seazen Companies Downgraded To 'B+' On Declining Sales; Outlook Negative," Sept. 8, 2023).

For other developers--especially distressed developers--ever-tightening restrictions on escrow accounts often stop firms from stabilizing. We have seen repeated defaults from the same set of developers, even after a debt restructuring that may involve substantial tenor extensions.

More and more provinces and lower-tier cities have taken action to discourage presales in recent months. For example, Zhengzhou, Kaifeng, and Xiongan are prompting developers to sell completed houses (see table 4 in Appendix).

In July, Shenzhen introduced the first land slot at an auction that ranked bids according to developer commitments to sell completed homes. To compensate for the higher capital needs of selling completed homes (versus presold units), some city governments, are loosening selling price restrictions for such transactions. The Chengdu government, for example, is doing this.

The transition away from presales has nevertheless been slow. This speaks to the difficulty of quickly exiting a mode of selling that frontloads cash inflow, particularly when companies keenly need capital.

About 80% of sales by gross floor area (GFA) came from presales in the first seven months of 2023. The remainder were via the sale of completed homes. This is a near doubling of the 12.7% of sales by GFA that came via built homes in 2020. Clearly, however, the gains are off a low base.

History Repeats, Policies Disrupt

We view the recent history for the China property market as falling into three stages. The first stage, 2009-2015, was the aftermath of the global financial crisis. This was a stable period for the China property market, with no extraordinary outlier events, regulatory actions, or swings in buyer sentiment.

Chart 6

The second period, 2016-2021, was the bubble phase. The government launched its shantytown program in August 2015. This opened vast tracts of derelict residential blocks for redevelopment. It sparked a big pickup in property development--sales climbed 35% in 2016 and stayed elevated for a six-year run. Significantly, much of this development and selling activity was in China's lower-tier cities, which property firms previously largely ignored.

Chart 7

This brings us to the current phase (2022-present). It began with the introduction of "three red lines" in 2021. The rules restricted developers' bank borrowings if they did not meet thresholds on three ratios: liabilities to assets, net debt to equity, and cash to short-term debt (see "China Property Watch: Issuers Go On A Debt Diet," Nov. 12, 2020).

The rules, along with a batch of other government restrictions on fundraising and mortgage lending, were aimed at cooling an overheated market. They succeeded too well: sales subsequently dropped by about a third.

Chart 8

The lesson for us is that policies come and go, and sentiment ebbs and flows. But the relatively drama-free first period is perhaps the mean to which things will ultimately revert. We view it as a kind of baseline.

To get there, we apply current home prices to GFA sales over 2009-2015. Our price expectation assumes that homes in higher-tier cities will sell for RMB20,000 per square meter (sqm), and RMB6,200 per sqm in lower-tier cities.

In the broadest strokes, we assume that GFA sales in the stable phase one period represent real demand, largely absent speculative investment buying. Meanwhile, current price levels already reflect steep discounts from their highs, and won't likely fall much further. This translates into annual sales of about RMB11 trillion-RMB12 trillion in annual property sales.

We adjust further by assuming a 10%-15% drop in sales, from the phase-one threshold. This accounts for some recent trends, such as a slowing urbanization rate and a population that has recently started to decline.

This leads to what most economists and market participants believe is an equilibrium point of yearly sales of RMB10 trillion-RMB11 trillion.

In another nuance, the country is earmarking 8.7 million units in social housing in the 14th five-year plan, from 2021 to 2025. This would mean that roughly 10% of new housing annually would involve subsidized rents (see "China's Affordable Housing Leasing Plan Could Cost Up To RMB2 Trillion," Oct. 31, 2022). That may further pressure homes prices and developers' sales volumes in the primary market.

Trickle-Down Redux

China's property recovery will be sequential. Policymakers are first using measures that get tier-one cities back to health. We already see that sentiment, sales, and prices in these markets have started to normalize.

Steadied upper-tier markets will likely lift sentiment in the lower-tier markets. As one tier recovers, home buyers will have more confidence to go to the tier below, we assume. The markets will thus recover in order, by tier.

We see commonsense in this plan. The upper-tier markets have always been healthier, driven by real underlying demand.

The big developers that are now in trouble fanned speculation by building millions of units in lower-tier cities, far in excess of people's actual need for living space. The government's shantytown development policies gave these firms the land allocations needed to make this development possible.

The upper-tier markets are now simply easier to fix. They are also the most important part of the market: the cities represent more than 40% of GDP and almost a third of the national population.

The government's focus on restoring upper-tier markets first necessarily pushes back the rebound of the lower-tier cities, and their bubble-like tendencies. The likely outcome is our presumed L-shaped recovery, a stabilized market that connects sellers with real buyers, with little immediate chance of a boom reigniting.

Appendix

Table 2

Table 3

Table 4

Writer: Jasper Moiseiwitsch

Digital designer: Evy Cheung

Related Research

• China Still Has More Policy Tools To Stabilize The Higher Tier Property Markets, Sept. 26, 2023
• Seazen Companies Downgraded To 'B+' On Declining Sales; Outlook Negative, Sept. 8, 2023
• Chinese Developers' Profitability Is Searching For A Trough, Sept. 4, 2023
• China Property Watch: Peripheral Pain, May 22, 2023
• China Property Is Heading For A Transformation, And Maybe A Turnaround, Nov. 21, 2022
• China's Affordable Housing Leasing Plan Could Cost Up To RMB2 Trillion, Oct. 31, 2022
• China Property Watch: Issuers Go On A Debt Diet, Nov. 12, 2020