News of Evergrande’s default was the gunshot heard across the real estate world in December 2021, leading to a cascade of financial troubles that continue to threaten the entire Chinese economy. For context, the country’s real estate sector contributes over 25% of the country’s GDP, so the debris of the Evergrande financial fiasco is far reaching. While the ensuing debt bombshell may not yet have truly snuffed out the commercial real estate sector, the real estate crisis has already dismantled several steel producers, government-controlled asset managers state and private banks. But that could only be the beginning.
Cracks in China’s economy have emerged after Evergrande’s initial collapse, followed by a parade of postponements of a debt restructuring plan. Then the rest of the dominoes started to topple over. Other major property developers have started to pull back. More than 30 Chinese property companies, including China Evergrande Group and Sunac China Holdings, have defaulted on their foreign debts.
Investors are growing increasingly frustrated with the insistence of failing developers, regulators and even the Bank of China that all is well and the property market will work out. Yet, despite the best efforts of the censors, the Chinese people have had enough, and so have Evergrande’s lenders. After nearly a year of promises to repay its loans, the world’s most indebted property developer has just seen its headquarters in Hong Kong, a 26-storey office building which happens to be one of the most valuable from the promoter, seized.
As easy as it is to blame all of China’s real estate problems on Evergrande’s mismanagement, the truth is that the ongoing debt saga is the result of systemic problems with Chinese financial institutions and the propensity to taking excessive risks in real estate transactions. The Chinese government has tried to get the sector back on its feet, but solving a $7 trillion housing bubble simply won’t happen overnight. A staggering amount of China’s money is being taken from its real estate, so every day as millions of square feet of unfinished buildings continue to be abandoned, it prevents very cash required. Policy makers in China are absolutely feeling the pressure to manufacture a silver bullet to the current crisis.
If the fallout from Evergrande doesn’t spur the Chinese government to forge a quick fix to the real estate crisis fast enough, a nationwide boycott stemming from a much-abused real estate practice will.
Pressure before sale
If you’re wondering why so many media are labeling China’s real estate market as “Ponzi-like,” then here’s why. In China, real estate accounts for more than 70% of individual wealth, and property buyers frequently make upfront payments for unfinished construction. This practice, known as “presale,” accounts for more than 85% of all new home sales in China. One of the many reasons Evergrande and other developers had gotten so out of control was that developers were eagerly accepting presale money and using it to fund many projects simultaneously, and therein lies the problem. .
Presales are so widely accepted in China that they have become one of the most important sources of cash for homebuilders. By 2021, nearly 90% of newly built residences in China had been pre-sold. The funds are virtually interest-free and are used to pay for construction. Until this year, 50-70% of presale funds had to be kept in escrow accounts under local government management, as each city has its own set of rules. But again, this led to opportunities for abuse, and some governments used prepayment money to fund their own initiatives in exchange for favors from developers.
As China is one of the fastest growing real estate markets in the world, the pre-sales have certainly had advantages for buyers. House prices in China have more than quadrupled since the year 2000. The income-to-price ratio of a building in China is 1:34.9, which means it would take 34.9 years for a winning individual an average wage to pay for a house. By comparison, the income to price ratio in the notoriously expensive New York area is 5.4.
The whole presale system is at a crossroads. China should strengthen pre-sale monitoring instead of abolishing the practice entirely, at least in the short term. Hopefully regulators push to move away from this model. Using money raised from new investors to pay existing investors or fund other long-term projects is eerily similar to Bernie Madoff’s infamous scheme.
Unfortunately, the pre-sale model has caused several Chinese developers to go bankrupt, which means the Chinese are effectively watching their wealth evaporate before their eyes. As the housing crisis worsens, a growing number of developers may find themselves unable to deliver properties that have already been pre-sold, potentially disappointing even more buyers. Frustrated, tens of thousands of buyers in China flatly refuse to pay their mortgages on their unfinished properties.
For Chinese buyers, after shelling out an exorbitant sum of money to buy a property, they were stuck for months waiting for the developer to show up, causing them to throw their hands up and walk the streets. In a country that does not tolerate dissent, the fact that more than 300 developments are not receiving their cash flow, even though construction has not yet started, is no obstacle for the government. The boycott has so far spread to more than 90 cities, and regulators must act quickly before the boycotts grow big enough to drag other sectors down.
Policymakers in China have pondered a grace period for mortgage payments to calm the streets. Beijing officials gave the impression that local governments and banks would determine a homeowner’s eligibility and the length of the delay between payments. At the same time, local governments were also asked to take action to push their incomplete construction projects, but the boost was left to the discretion of the local government, so there was no coherent solution for pacify the boycotts. The mortgage boycott is still ongoing as abandoned homebuyers increasingly believe they are being scammed all over the place.
China’s real estate crisis is a terribly complex ordeal that could potentially wreak havoc on a global scale, and sadly, the crisis seems to be getting worse. The rapid speed of house construction was once a symbol of China’s growth. Today, confidence in the real estate model has diminished. Buyers are leaving the market, debtors are on strike over mortgage payments and developers are struggling with cash.
The effect of a collapse in the Chinese real estate market would be felt far beyond its borders. Currently, China accounts for about 18.8% of global GDP. That’s not too far behind the United States, which accounts for 24.4%. Systematic failure in the country’s financial system could wipe out enough wealth to plunge the world into another recession, much like what we saw with the mortgage debt crisis of 2008. The difference is that there are far fewer foreign ownership into Chinese ownership, which means the pain would be felt most by Chinese companies and citizens. Evergrande may have been the first domino to fall or may have just been an outlier, either way Chinese real estate investors are cautiously awaiting what will become of the mess the sector has become. Chinese real estate.