Welcome back everyone, a quick follow up on the Evergrande story to discuss
how the Chinese property collapse could affect property prices in rest of the world and in London
in particular. The biggest Chinese developers don’t just build in China, many have developments
all around the world so in today’s piece we will discuss their international investments and how
they might be affected by deleveraging. As I’m sure most of you know, Evergrande
is Chinas second largest property developer and the world’s most indebted real estate developer.
They have been all over the news recently, having sparked fears across global markets two weeks
ago when they missed an important interest payment deadline on their offshore debts.
This wasn’t classified as a default as there is a 30 day grace period on that coupon payment. Then,
last week, another smaller Chinese developer, Fantasia, defaulted on an offshore bond,
and more troublingly we learned that Fantasia also defaulted on a $100 million dollar loan to
Country Garden – which is Chinas largest property developer. The fact that these struggling real
estate companies are lending to each other makes contagion within the industry more of a risk.
There has been a problem for some time with excessive leverage in the Chinese Economy,
and in the real estate sector in particular, and Chinese regulators have been trying to
reduce the economy’s overreliance on debt. Their main approach has been to implement the “three
red lines” policy for property developers which came into effect in August 2020.
The three red lines were hard limits on three leverage ratios for these companies.
The new policy meant that - not only could these developers no longer borrow any additional funds,
but they were actually required to quickly pay down their debts. This required them to sell
assets often at fire sale prices. This of course caused a spiral, as the losses on those sales
only made their debt ratios look worse, putting further pressure on them to deleverage further.
Evergrande right now is the largest firm that’s struggling the most, but the pain
being inflicted by the three red lines on Chinese property developers is much more widespread.
It would now appear that these problems among Chinese property developers could
be spreading to the rest of the world and to their projects in London in particular.
According to the FT a UK property consultant claims to have been contacted by a UK regulator
with concerns about the risks of contagion in London. “The big question is whether the Chinese
will restrict investment overseas,” he said. “That would be a pretty big crisis in the UK
and elsewhere.” We’ll discuss that statement in greater detail near the end of the video.
The London residential real estate market has been struggling since 2014
and high-end apartment prices in Central London are down around 22% since the summer of 2014.
There are a few reasons for this, there have been new taxes on foreign buyers,
there has been political uncertainty due to three general elections over that time period,
there are worries about the impact of Brexit and of course the Covid
pandemic – and the move to working from home has not helped urban property prices anywhere.
Over that period a lot of Chinese money poured into London Real Estate, with the deal value
having peaked in 2017. So far this year there has been no Chinese investment in Central London
according to Real Capital Analytics. And this of course makes sense, as these developers are
not going to expand internationally when they are under pressure from Beijing to cut their leverage.
So, what kind of deals have we seen over that period? Well, in 2014, Greenland Group
a Chinese property developer announced that they would build Europe’s tallest residential tower
in Canary Wharf. They paid 84 million pounds (or around $115 million) for the plot of land. They
laid the foundation for the building, but all construction came to a halt shortly thereafter.
Country Garden, Chinas largest developer by sales, bought a site in East London,
for £80m – a bit over $100 million back in 2018, with plans to create a £400m development of almost
800 homes. So far nothing has been built. R&F Properties in 2017, paid close to 500
million pounds (or 700 million dollars) for a site in Nine Elms, in south-west London, which remains
unfinished. The developers claim that Beijing’s crackdown will have no effect on the development,
saying that they are not heavily indebted and that their projects are fully financed.
They are however, as of June - in breach of all three of China’s “red lines”.
According to a London based property developer, the stresses these developers are experiencing
in London are not just down to their need to reduce their leverage or down to a weak
London property market. The developer argues that before the recent turmoil in China, most
Chinese developers that began building in the UK had fairly disastrous results. They paid an awful
lot for the land, struggled with construction costs, and really struggled with sales.
This is only so much of a surprise. You see this all the time in almost every industry
where a company has been very successful in their home market and assumes that they will be equally
successful in a very different foreign market, only to find that conditions there are quite
different to what they are used to. When newly arrived foreign property
developers consistently outbid English property developers for real estate projects in London,
the only two explanations are either that for all their inexperience they nonetheless
understand the London housing market far better than the locals do, or that they are overpaying.
They could be overpaying because conditions in their home market allow them to ignore profit
considerations in favor of prestige. We saw this in the 1980’s with Japanese property investors
overpaying for trophy assets abroad. Japanese investors bought the Empire State building for
example, only to suffer losses in the long run. A number of UK developers have described being
constantly outbid by Chinese developers in land sales between 2013 and 2018, saying that if you
were up against a Chinese developer, you knew it was inevitable that you wouldn’t get the site”.
As the challenges have mounted in London, and apartment prices have fallen, Chinese investment
in London development sites and property has tailed off dramatically. The pressing question
now is not whether the Chinese will continue to come, but if they will leave altogether.
Greenland – who are building the spire building in Canary Wharf insist that they have no plans
to sell the project and that they intend “to take the development forward as a high-quality,
landmark project — responding to the ongoing residential demand in London’s Docklands”.
They do say that they are considering pulling away from their other London
scheme, a residential development on the site of an old brewery in Wandsworth.
They are allegedly in conversation with “four or five potential bidders” and close to exchanging
contracts with one for the portion of the site that is yet to be built. Greenland say that any
sale would depend “on market conditions in London and the quality of offers received”.
Earlier on I quoted a UK property consultant who said that the Chinese restricting investment
overseas would be a pretty big crisis in the UK and elsewhere. This is not necessarily true.
The idea that a country always benefits from foreign direct investment is based on the
assumption that productive investment in any country is always constrained by a shortage of
capital. That is why when foreigners promise to invest in a country, it is assumed that this will
lead to an increase in productive investment. This only happens in certain specific
circumstances. Under other circumstances, these inflows can actually be harmful.
What matters are the underlying conditions in the country in question.
So, while Chinese investment can cause developing economies to grow faster, it is less likely
to benefit the UK or other advanced economies. In a situation where capital is a scarce resource
foreign investment should cause growth, but because countries like the UK don’t suffer from
a scarcity of investible capital, the benefits of foreign investment are much more limited.
Foreign Direct investment helps grow an economy if capital is scarce, if technology is scarce and
comes with the investment, if locals have not figured out how to invest profitably,
if foreigners systematically overpay or if the country receiving the investment needs
restructuring due to misallocated resources. If Chinese developers stopped buying up sites in
the UK to develop, this shouldn’t really cause an economic crisis for the country, it would really
only be bad for people who own these assets and are hoping to offload them to foreign investors
who will pay more than the assets are worth. Right now, the main effect of Chinese developers
being forced to deleverage is that they might be forced to dump their international assets,
simply because these assets are more liquid and can actually be sold. Often in a crisis,
investors dump their highest quality assets first, for no reason other than that these are the only
ones that can be sold, they find themselves left holding the most toxic assets that were causing
the pain to begin with. As I mentioned earlier central London Real estate is down over 20%
since 2014, the pound has fallen almost 20% over that same period meaning that
international investors are not doing very well on their London real estate investments.
A lot of London homeowners are not feeling as much pain as you might expect,
simply because the low interest rate environment means that their mortgage payments have been
very low since the financial crisis of 2008. Even if their home has fallen in value, their
loss is offset by the fact that their monthly mortgage payment has been significantly lower
than what they would have spent on rent over the same period. The real question is how will
things develop going forward? I’d love to hear your thoughts in the comments section.
If you found this video interesting, check out my piece from a few days ago on the Fantasia default,
which followed the Evergrande default and might be a sign of contagion in the
Chinese property market. See you soon, bye.