In this special commentary, we discuss the evolving Evergrande situation. While we do not hold Evergrande in our portfolio, we wanted to share our views because it is the most indebted real estate company in the world, and has created lots of volatility in the global financial market.

Background on Evergrande

Evergrande is the second largest property developer in China in terms of sales value. The company has 160,000 employees and close to 4 million employees related to Evergrande’s activities. It has a total debt of RMB 2 trillion (around USD $300 billion, equivalent to 1% of deposits in China, and almost 2% of China’s GDP), including interest-bearing debts of RMB 571 billion, pre-sale of RMB 216 billion, payables of RMB 963 billion, and wealth management products of RMB 100 billion. It is one of the most levered real estate companies in the world, but its debt is still minor in relation to China’s financial system as a whole. Considering the above data, we believe China’s financial system can absorb, without any mayor problem, all the losses from this company.

Potential of creating a contagion effect on the broader global financial markets?

This is not another Lehman. We think the contagion effect on the broader global financial markets is limited. The Evergrande saga remains a domestic issue. The Chinese government has enough capacity to intervene and will do so to reduce the contagion risk.

The recent news is an example: Evergrande reached an agreement with yuan bondholders on an interest payment due September 23, 2021, without clarifying the terms. The Chinese government injected RMB 120 billion into the banking system on September 22, 2021.

The major risk is a contagion to other developers, banks, suppliers, holders of Evergrande’s wealth management products, and home buyers. A possible scenario is that the government could take over the problem companies with state-owned enterprises (SOE).

As the property policy is unprecedentedly tight at this moment, the government has plenty of room to loosen if they want. It is likely that they are willing to wait in order to show that the real estate sector is not “immune” but that they can come in at any time in order to preserve financial stability. Many loans to Evergrande made by Chinese banks are implicitly backed by the government. We believe that the first priority for the government is to ensure that the pre-sold apartments are delivered to the buyers, otherwise, there will be serious social unrest.

Regulatory headwinds coming from China

The key words for China’s policy is currently “Common Prosperity,” which fundamentally entitles a policy shift towards reducing wealth inequality. The concept is not new; it has been a long-term goal of the Chinese government that has become more relevant recently.

The Central Party and State Council jointly announced the plan on June 10, 2021, establishing Zhejiang province as the pilot zone. The 14th five-year plan (2021-2025) called for an “action plan” to be fully implemented by 2050, to become an advanced, modern economy. Among common prosperity goals are narrowing the income gap, tackling the increasing real estate prices, promoting higher household income growth, increasing public services, such as healthcare and education, and improving living conditions of rural residents, among many others. These common prosperity initiatives will likely rebalance the economy from investments to consumption, targeting the midlow-income population. Moreover, the state’s role in public and private sectors is likely to become more relevant.

In the upcoming Politburo meeting this December, policymakers will set priorities for next year.

Appendix

Examples of contagion risks:

1. Other developers will find financing more difficult, if investors lose confidence in them. Project sales will also become more difficult. As a matter of fact, the selling prices of properties are controlled by the governments, so developers are not able to sell their properties at discounts.
2. Suppliers should be more cautious on payment terms and conditions on other developers. They would also see lower demand and production. Some may need to cut jobs or wages, causing weaker household consumption.
3. Home buyers (more than a million) are also heavily protesting at Evergrande’s offices causing their construction projects to be halted. Home buyers that are working with other developers may also doubt their houses would be delivered, therefore, causing more selling pressure.
4. Local governments receive transfers from the central government with bond issues via Local Government Financing Vehicle (LGFV) which are collateralized with land use rights. Raising funds for local governments could eventually become more complicated.
5. More default scenarios of individual companies are also likely to occur. For example, Sinic (2103 HK) was implied to have financial problems, and the stock slumped 87% on September 20, 2021.

Chinese government successfully resolved the interbank credit crunch in 2013. Tools that the
government could use this time:

• Easing liquidity: RRR cut, liquidity injection
• Verbal support
• Controls of LGFV financing likely to become less tight
• Loosening of property policy
• Accelerating LG bonds
• Maintaining low rates
• Persuading banks to lend

The systemic risk is not high.

• Although Evergrande has a larger balance sheet (RMB 2.4 trillion) than Huarong (RMB 1.6 trillion) and Anbang (RMB 1.5 trillion), its asset contains largely land lots which are much more “tangible than the other financial companies.”
• Since the government controls the financial system, many SOEs could be strategic investors of Evergrande and also adjust the property policies.
• When the People’s Bank of China (PBoC) initiated its support to the property sector (printing money) in-mid 2014, it granted a long term loan to China development bank. PBoC said at that time, “A change emerged in the base money supply channel.”
• The government could buy their own land, as they did in 2014-2015.
• In the case of Evergrande, the government can let them fall, avoiding a contagion or make an orderly debt restructuring. In similar cases they have taken actions. In the case of Anbang, several SOEs took up the company and formed a new insurance company. In the case of Huarong, Citic Group (a SOE) and other “strategic” investors capitalized the company.

Thoughts on the stock market

It is worth noting that the Chinese government seems to have downplayed the importance of paying too much attention to short-term growth. They indeed have a short-term buffer, considering the 2021 GDP target is “above 6%,” and the country is likely to grow in the range of 8% this year. The current outlook is more focused on solving structural problems, which may have short-term collateral consequences, but the vision is to improve the long-term perspective. Indeed, President Xi has emphasized on numerous occasions that the aforementioned long-term goals are not just an economic objective, but serve as the Party’s “governing foundation”. The foregoing is still interesting, since, as previously mentioned, the Western vision is often different. Billions of dollars have been lost in market capitalization of the Chinese assets sector, driven by strict regulatory policy in the afterschool tutoring, together with anti-monopoly and cybersecurity rules in the internet sector. The government has also tightened property policies. Currently, a blanket of uncertainty persists regarding “which sector will be regulated next.” For example, almost one month ago, a state media article equated the gaming industry, which has many companies that trade on the stock market, to “opium”. Although the government quickly quashed this article and there were no official statements, it caused a rapid slump of shares linked to the gaming sector, reflecting the prevailing nervousness among investors. The government recently released new regulations for the industry, including limiting the amount of time children can play video games to three hours a week, and last week state media mentioned that companies should avoid the sole focus of pursuing profit, in order to prevent minors from becoming addicted to games. This sentiment led to another round of losses in gaming-related stocks.

We believe China is trying to improve its society in the long term, but are not very concerned about the effect this may have on investors in the short term. The question then is; how can we better cope and adjust to these policies for the benefit of our clients? China accounts for around 10% of the MSCI EM Small Caps index, making it an important investment for our EM Small Cap fund. Our approach to this new environment is to understand the domestic perspective and invest in companies/sectors that are subject to less regulation and more likely to benefit from the new trends that we see emerging in the future. Each scenario presents a new opportunity and the trends include:

• Greater self-reliance on government-fostered technology (semiconductors, artificial intelligence);
• Renewable energy;
• Fitness;
• Consumption favouring local brands/companies; and
• Manufacturing industry and robotics for products designed mainly to support and strengthen the Chinese economy.

The global pandemic has caused a sharp, worldwide economic contraction, with supply and demand severely affected across many industries. However, the real estate market was one of the few to experience strong and sustained growth in 2020 and 2021. House prices rose consistently, driven by robust demand and constrained supply.

On the demand side, buyer interest has surged since summer 2020, as people are scrambling to take advantage of low mortgage rates due to fear of missing out. According to the Mortgage Bankers Association (MBA), in the United States (US), the value of mortgage originations for new purchases increased by 13% in 2020, in comparison to 2019, despite the fact that most economic activities were effectively halted in April and May 2020. As America’s biggest generation, millennials have entered their prime years of purchasing power, driving the demand for houses even further. On top of that, as people spend more time at home during the pandemic, demand for bigger spaces increased significantly.

On the other hand, supply has been extremely tight. In the US, months of supply in July 2021 was 2.6, which is an increase from the record low of 1.9 in January 2021, but still at a historically low level. Historically, a balanced market has been defined as 6.0 months of supply. Even before the pandemic, there was a shortage of homes for sale. From 2010 to 2019, the US had the lowest number of homes built than any other decade since the 1960s.^[1] From 2010 to 2019, only 5.8 million homes were built, compared to over 27 million homes built from 2000 to 2009. Strong demand for housing in recent years, fueled by low mortgage rates, has exaggerated the imbalance of supply and demand. As a result, house prices keep going up.

The strong residential market is not limited to the US. In the United Kingdom (UK), house prices have been increasing consistently since May 2020. In June 2021, the average house price was £266,000, up 13.2% year over year and 4.5% month over month. This is partially due to the stamp duty holiday introduced in July 2020 to help homebuyers and boost the UK property market during the pandemic. Even though the stamp duty holiday will gradually taper from July 2021, demand still outstrips supply, and prices are expected to stay on the upward trend. One of our holding companies, Savills (SVS LN), has been benefiting from this trend. Founded in 1855, Savills is one of the world’s leading property service providers for both residential and commercial properties. They have a dominant position in many markets across the globe, with more than 600 offices across the Americas, Europe, Asia Pacific, Africa, and the Middle East. In the first six months of 2021, Savills hit record profits thanks to the hot UK housing market, with revenue in the country having increased by 40% year over year.

This housing boom has been positive news for homeowners; CoreLogic analysis shows homeowners with mortgages (roughly 62% of all properties) in the US have seen their equity increase by a total of $1.9 trillion  since the first quarter of 2020, an increase of 19.6% year over year. However, it has also reduced housing affordability, and shut a growing number of people out of the housing market. In the US, homeownership has been falling after its previous peak of 69% in 2004.^[2] In the second quarter of 2021, homeownership dropped to 65.4%, which is 2.5 percentage points lower than in Q2 2020. The rate varies significantly by race, with the biggest gap observed between non-Hispanic white households and Black households, homeownership rates for which were 74.2% and 44.6%, respectively. If the trend continues, the US homeownership rate will decline to 62% by 2040.

Therefore, it is crucial to increase the supply of affordable homes to meet the needs of future homeowners and renters. Century Communities (CCS US), a top ten national homebuilder and a holding company in our portfolios, focuses on affordable homes. Entry-level buyers represent 80% of their total deliveries. A total of 43% of the homes are under the price of US $250,000, and close to 90% of homes are under the price of US $500,000. In the second quarter of 2021, the company’s home sales revenue increased by 34% to a record $1 billion, and net income increased by 207% to a record $117.9 million. The company has increased their revenue guidance for 2021, and remains confident in its success in the second half of the year.

It’s not just the home buyers, renters also faced a significant amount of financial stress. In the first quarter of 2021, 17% of all renter households in the US reported being behind on rent. This rate is 21% for Hispanic and 29% for Black renters. Several companies in our portfolio contribute to the rental market’s affordability.

Boardwalk Real Estate Investment Trust (BEI-U CN) is one of Canada’s largest multi-residential real estate owners and managers. Founded in 1984, the company owns 33,513 residential suits, concentrated in Alberta, Quebec, Saskatchewan, and Ontario. The REIT is committed to providing the best product quality and experience to their clients, at affordable prices. The average rent is approximately 20% of the average renter’s household income. Thanks to its strong brand of service at affordable prices, Boardwalk has been gaining market share, and maintained an above-market-average occupancy rate.

SBB (SBBB SS) is a Swedish-focused, social infrastructure property company. Of its portfolio, 94% is in rented residential and social infrastructure, including education, senior care, healthcare, and government/municipal buildings. The government backs 88% of the rent. As of Q2 2021, the company invests 27% of its social assets in affordable housing. The average rent levels for SBB’s rent-regulated residential portfolio is about 40% below the rent levels of new productions.

Advance Residence (3269 JP) is the largest residential REIT in Japan. They focus on compact apartments, mainly in Tokyo metropolitan areas; 64% of its portfolio are studio and one-bedroom properties, the rents for which are more affordable. Over 50% of the rents were below JPY 100,000 per month (approximately US $911). As a comparison, a typical mid-range, two-bedroom apartment in Tokyo is about US $1903 per month, according to a Deutsche Bank report.

Affordable housing is part of Goal 11 of the Sustainable Development Goals (SDGs). It’s also central to achieving almost all of the SDGs. The demand for affordable housing keeps growing, given the trend of urbanization and population growth. Investment in this theme will not only allow us to ride the secular trend, but also contribute to a more sustainable and inclusive future.  

[1] https://www.statista.com/statistics/1041889/construction-year-homes-usa/

[2] As defined by the US Census Bureau, the homeownership rate is the proportion of households that is owner-occupied.