The next real estate crisis could come from China

Debt is as much a part of the real estate business as bricks and mortar. And as the great New York builder William Zeckendorf once famously remarked, ‘it’s better to be alive at 20 percent than dead at the prime rate.’

But the Evergrande Group, the second largest real estate company in China, has taken corporate debt to new heights, with liabilities of a staggering $310 billion, to finance its breakneck growth. In 2010, it had revenues of $7.3 billion and assets totaling $16.7 billion. In 2020, the figures were $81 billion and $368 billion.

To be sure, it is a huge company, with 1,300 projects in more than 240 cities in China and 200,000 employees. This year alone, it began 77 new projects. It has also diversified into many other economic sectors, such as banking, sports, automobiles, and resorts.

And it is now in a serious cash crunch. Its stock is down 84 percent since January 1. It warned at the end of August that it will default on some of its debt if it cannot raise sufficient cash. It failed to meet an interest payment of $83.5 million on offshore, dollar-denominated bonds that was due September 24. It has a 30-day grace period to find the money before it will be officially in default. Fitch, a major credit ratings company, has downgraded Evergrande to a rating of just CC, saying that a default appears probable.

If Evergrande were to go into bankruptcy, the ramifications would be global. The Ashmore Group, for instance, a British emerging markets specialist, holds $400 million in Evergrande debt. American investment organizations are also exposed. Everyone remembers that the sudden collapse of Lehman Brothers in 2008 set off a major global recession. Evergrande’s problems resulted in stock markets having their worst month this September since March 2020, when the pandemic forced worldwide economic shutdowns.

Therefore many think that Evergrande is too big to fail and the Chinese government will have to act, perhaps behind the scenes rather than directly, to prevent it. Not only would major domestic investment houses and banks be severely impacted but real estate is more than 15 percent of the Chinese GDP. The spillover in other areas of the real estate sector would adversely impact the whole Chinese economy, which is already growing more slowly than in recent years.

And many thousands of Chinese families have already made down payments or even paid in full for apartments that may now never be finished. They would be financially devastated by an Evergrande bankruptcy. Even authoritarian states like China have to take public pressure into account.

Evergrande was founded by Xu Jiayin in 1996. He had grown up dirt poor but managed to get a college education and to take advantage of China’s rapid economic development after the death of Mao Zedong in 1976. In a single generation, China went from being a rural, peasant-based economy to one of the world’s largest industrial ones.

This resulted in a mass migration from the countryside to China’s cities, spurring a real estate boom of epic proportions. But as often happens when an industry experiences rapid expansion, it over expanded. Today, many Chinese cities have ‘ghost city’ neighborhoods, apartment complexes that have no residents. One project of 15 high-rise apartment buildings in Yunnan Province, in southwest China, was recently demolished by controlled explosions after sitting unfinished for eight years.

The Chinese government has been trying to rein in its highly leveraged real estate sector. It has announced ‘three red lines’ that limit debt-to-cash, debt-to-equity, and debt-to-assets. Evergrande is almost certainly in violation of all three.

China has other economic problems besides its over-expanded real estate sector. With much of the world’s manufacturing taking place in China, supply chain disruptions are causing economic problems globally. And there is a climate conference coming up in China soon. In order to make the numbers look good, China has been trying to reduce its carbon emissions by simply shutting off electricity for hours at a time in parts of the country, stalling manufacturing.

China’s economy has been expanding so quickly for so long that there was bound to be a cooling off. Perhaps an Evergrande default will be the event that brings that about.