If you missed the best recent articles:
Once a national pride, recognized as the world's most valuable real estate enterprise, but in early 2024, Evergrande Group officially collapsed after multiple failed restructuring efforts. With $240 billion in assets but burdened with over $300 billion in debt, Evergrande is the world's most indebted real estate group.
The causes leading to the collapse of this Chinese real estate developer are attributed to a confluence of multiple factors. However, the primary cause of this disaster stems from the company's excessive risk strategy and overly high leverage, plunging the group into immediate crisis when China tightened debt issuance regulations. Today's article consists of 3 parts:
Part I: Evergrande - Mid-Level Real Estate Tycoon
Hui Ka Yan - journey from poor boy to Asia's richest billionaire
Part II: Causes Leading to Evergrande's Collapse:
Internal Weaknesses: The "Three Highs and One Low" Strategy and Evergrande's Loose Management Throughout Its Development
Unfavorable External Environment: The "Three Red Lines" Policy (3 red lines policy) Puts Evergrande in Peril
Part III: Consequences of Evergrande's Collapse
Video from 3 Years Ago When Evergrande Was Preparing to Collapse:
Part I. Evergrande - Mid-Level Real Estate Tycoon
Evergrande is China's second-largest real estate developer and the 122nd largest company by revenue in the world (according to Fortune Global 500 List 2021). Even as of 2018, it had become the world's most valuable real estate company.
Evergrande has over 1,300 real estate projects spanning 280 different cities across China. The land area owned by Evergrande could cover the entire city of Manhattan.
The group made significant contributions to the urbanization of rural areas and fueled the boom in China's real estate sector (accounting for ~13% of China's economy).
Evergrande primarily focuses on tier-2 and tier-3 cities in China, serving the masses.
When talking about Evergrande, one cannot fail to mention Hui Ka Yan — founder of Evergrande, the “soul” of this group with business acumen and a close network of relationships with many political officials.
Hui Ka Yan - journey from poor boy to Asia's richest billionaire
Hui Ka Yan was born in 1958 in a poor family in Henan Province.
He lost his mother before he was 1 year old and lived with his grandmother in poverty in a rural area, enduring a harsh childhood with steamed buns and moldy bread.
1978: He was admitted to the Wuhan Iron and Steel Institute, graduated in 1982, and worked at a steel mill for a period.
1996: Hui Ka Yan set an important milestone by founding Evergrande Group. Just 10 years later, Evergrande was officially listed on the Hong Kong stock exchange.
2016: Evergrande Enters Fortune 500
2017: Hui Ka Yan became China's richest person.
Growing up in a poor environment, starting a business from scratch, Hui Ka Yan has a bold leadership style with a high risk tolerance.
He was the most aggressive in tapping every financial channel, from bonds and bank loans to issuing wealth management products through third parties like investment trust companies.
It was this aggressive style that propelled Evergrande's meteoric growth in the 2010s, as China's real estate market boomed on cheap capital from the government's post-crisis stimulus package.
Evergrande's past success cannot overlook Hui Ka Yan's connections:
Hui Ka Yan also has a seat in China's political advisory body, the Chinese People's Political Consultative Conference.
FYI: Hong Kong's market regulator even assisted Evergrande once. Citron Research claimed that Evergrande was insolvent and issuing false information in a 2012 report.
But in 2016, the Hong Kong Market Misconduct Tribunal ruled that Citron's assertions were false and misleading.
Citron's founder, Andrew Left, was banned from trading in Hong Kong markets.
When Evergrande's scandals erupted, in an email to Forbes Asia, Left said he felt vindicated.
The risky borrowing practices and cover-ups by local authorities led to Evergrande's loose governance over a long period. And that is the core reason for the collapse of this giant empire.
Reasons leading to the collapse of Evergrande:
1. Weak internal management: The 'Three highs and one low' strategy and Evergrande's loose governance throughout the development period
The two most important factors for a real estate business are (1) Land bank and (2) Cash flow.
A large land bank is the potential for future revenue, while stable cash flow ensures the company's survival and expansion.
High initial investment requires stable incoming cash flow
Typically, home buyers are required to make payments according to progress before handover (the point of revenue recognition).
Land bank
Evergrande's land bank was rated very well because it was extensive and spread across many cities.
Estimated in 2018, the company had 822 undeveloped plots of land (~GFA of about 305 million m2).
Cash flow
Evergrande's development strategy was three highs and one low ('high debt, high leverage, high turnover, and low cost').
High debt and leverage - only with a lot of debt can it develop a lot of land bank. The company's debt mainly came from 2 sources:
Debt from state-owned banks (thanks to Hứa Gia Ấn's close relationships with government officials) and bond issuance.
At its peak, Evergrande's leverage ratio reached over 200% (in 2017) (~4 times that of other real estate companies)
High turnover was because Evergrande focused mainly on mass-market customer segments in tier 2 and 3 cities, so it kept low profit margins to sell as many homes as possible.
Low cost came from centralizing all decisions at the group level, while regional subsidiaries were execution-oriented, and standardizing internal work processes.
→ This '3 highs, 1 low' strategy was dangerous for Evergrande due to very high leverage.
For deeper analysis, let's look at Evergrande's cash flow over the years from 2008-2020:
Evergrande's cash flow situation is very concerning with poor financial indicators:
Days to collect receivables: Relatively stable, thanks to the policy of preselling unfinished apartments.
Days inventory outstanding: Extremely high, maintained at 4 years. This is mainly due to unsold real estate projects, including: inventory, properties under development, and completed properties not yet sold.
Days payables outstanding: Maintained at a high level of 2-3 years, indicating Evergrande's tendency to extend payment terms for its debts.
Overbuilding unfinished housing projects has contributed to a sharp increase in days inventory outstanding, evidencing the supply exceeding demand situation that Evergrande faced.
Evergrande's accounts payable may have been 'inflated' because they include commercial bills for suppliers.
Instead of paying directly for these services, Evergrande issued commercial bills to suppliers and may have added some incentives like higher interest rates to attract them.
These commercial bills can be traded on the market, meaning suppliers can easily sell them for cash.
→ Therefore, although not presented as loans, they are essentially debt.
On the other hand, off-balance sheet loans reached the enormous figure of 2,640 million CNY, with interest payments up to 15%/year.
Off-balance sheet debt is informal debt not on the company's balance sheet, but the company still has to fulfill normal repayment obligations
Evergrande's 15% annual interest rate can be said to be excessively high, when Ant Financial's microloan (small loans) - originally for low-credit customers to buy iPhones - also only had ~12% interest rates.
When Evergrande's creditors imposed 15% interest rates, this indicates the company's borrowing conditions have become very harsh. These loans include:
Creditors lending in the form of taking shares as collateral, in case Evergrande cannot repay the debt, the creditor has the right to sell those shares
...or internal fundraising campaigns like the 'Chaoshoubao' product that Evergrande issued to senior employees.
Chaoshoubao: A fundraising product promising 25% annual interest, requiring Evergrande's senior employees to invest with a minimum of 3 million RMB.
→ Harsh borrowing conditions: High interest rates and difficult terms are signs of difficulty in raising capital.
In addition, Evergrande had other hidden debts not recorded on the balance sheet, such as debts from repurchasing shares from partners or loans to finance unbuilt projects.
This explains the enormous receipts of 653.16 billion CNY,...
...while operating cash flow (OCF) remained continuously negative, indicating that Evergrande was bundling both revenue and capital expenditures (CAPEX) at once when projects were consolidated into the balance sheet.
The big problem with Evergrande's cash flow is in reality, there is no cash flow..
In 7 years from 2013-2020, only two years did Evergrande have positive operating cash flow (OCF) or free cash flow (FCF).
In the two years 2018 and 2020, when Evergrande's operating cash flow was positive, that was due to large changes in accounts payable and contract liabilities.
This means OCF was only positive due to working capital adjustments.
→ Evergrande has never truly reported positive operating cash flow since listing (except for 2009, but that was also due to large changes in accounts payable).
Normally, the discrepancy between net profit and OCF should only be a timing issue, but Evergrande consistently reporting positive net profit and negative OCF for over a decade is suspicious.
Upon deeper analysis, the main culprit causing Evergrande's continuously negative OCF is interest paid.
The ratio Interest paid/Interest expense is very large:
So what creates this discrepancy? Mainly due to capitalized interest expenses.
These capitalized interest expenses are being capitalized into? Into properties under development (PUD).
This is not unusual, but it explains why Evergrande's OCF has vanished over time.
Conclusion 1:
The discrepancy between Net profit and Operating cash flow (OCF) of Evergrande clearly shows instabilities in the company's business model. Negative operating cash flow is mainly the result of capitalizing huge interest expenses. An obvious fact is that Evergrande is overbuilding.
This company has accumulated inventory up to 4 years
They borrow heavily to build the first homes, then continue borrowing more to build the next ones without money to repay the old loans.
Evergrande's business model relies on preselling apartments and using presale cash flow to borrow more. However, when cash flow from the first home sales is not enough to repay the debt for those homes, they are forced to borrow more to pay off old debts.
→ Therefore, if anything breaks Evergrande's capital chain, it will put the company in danger.
And the government's “Three red lines” (3 red lines) policy is exactly what has dangerously weakened Evergrande
2. Unfavorable external environment: The “Three red lines” (3 red lines policy) puts Evergrande in jeopardy
Going back to the past, we will explore the reason why the Chinese government suddenly issued the “Three red lines” policy.
The answer lies in the fact that China's market is an unbroken bubble, in the past decade
After the 2008-2009 financial crisis, the government announced a stimulus package worth 4,000 billion RMB to boost domestic demand, making capital abundant.
This stimulus package focused on infrastructure construction and rural development to promote China's urbanization process
Real estate developers could often borrow at low rates, build apartments, and drive land prices up sharply.
By listing shares in Hong Kong, Evergrande also accessed external funds to buy land in China.
FYI:
Dozens of other developers are doing the same.
Three of them are Kaisa Group, Yuzhou Properties and Fantasia Holdings, all three have defaulted.
By 2010, the market showed signs of overheating.
Right after the financial crisis, there was a large increase in real estate market speculation, driven by credit.
Inventory remained high because real estate developers speculated on prices
The market had a price correction at the end of 2011, when monetary tightening policies took place and real estate prices temporarily declined…
…but most people saw it as an opportunity to accumulate again.
→ The period of ghost towns and the real overbuilding phase truly began in the 2010-2014 period
Meanwhile, the population began to age and will not need as much new real estate in the future.
Although there is no genuine demand from residents, yet:
Real estate developers create artificial demand by relocating residents and providing cash compensation for them to buy from the existing supply.
They build a lot of houses, thanks to debt financing, making the supply excessive
Catching the urbanization wave, with population relocating from rural to urban areas, Evergrande focused on tier 2 and 3 cities in China, and sold to serve the masses.
When credit tightens, real estate developers rely on pre-selling homes to maintain cash flow, causing prices to continue rising and pushing the market into high speculation and unsustainability.
→ The Beijing government launched a war against real estate speculation with the “Three Red Lines” policy. And this was the beginning of the nightmare for Evergrande…
In August 2020, the People's Bank of China issued the “3 Red Lines” restriction policy:
Liabilities-to-assets ratio under 70%
Net debt-to-equity ratio under 100%
Cash must be greater than or equal to short-term debt.
In that context, real estate developers must find alternative funding sources as leverage is squeezed and they cannot borrow more, because without fund turnover, businesses cannot continue projects.
FYI: Most real estate businesses operate based on rolling over payables, whereby conglomerates bid for large land use rights, then design projects to sell to customers, with buyers' deposits used to build the projects.
Businesses then use approved projects as collateral to raise more bank loans or issue bonds to bid for new land plots; once they have land, they collect buyers' deposits to build houses, with debt repaid in line with sales progress.
In a hot market and strong economic growth context, this is seen as an ideal model for investment expansion. However, if additional capital cannot be raised to continue projects, this cycle will break.
To continue securing capital, real estate businesses must accelerate sales by cutting house prices
However:
China has a very high home ownership rate (>80% in most household financial surveys)
Household debt is also maintained at a very high level and has increased by 6.4 trillion USD since the end of 2015.
Demographically: few young people getting married → low home buying demand
→ From the end of 2020 onwards, the number of home purchase transactions has decreased significantly
In reality: Evergrande's 778 projects are highly stalled despite 25-30% price cuts to attract buyers, not to mention aggressive sales increasing management costs by over 6.3% and sales costs by over 37%, eroding profits.
→ Capital chain breakage, Evergrande faces liquidity difficulties and must raise capital/borrow more debt at all costs
Evergrande has fallen into a liquidity crisis and must raise cash from many sources, including:
IPO of its most important business segment on the Shenzhen Stock Exchange, but it failed.
Negotiating with creditors to extend debt
Converting debt to equity and reducing major shareholders' ownership stakes
However, even with debt-to-equity conversions or debt extensions, Evergrande still lacks funds to repay these debts as it cannot liquidate all its assets.
Evergrande pursued a 23 billion USD debt restructuring plan for a group of special creditors for nearly 2 years. However, the initial plan failed at the end of September 2023 when billionaire Hui Ka Yan was investigated.
→ As an inevitable consequence, Evergrande defaulted. The group is forced to liquidate assets to resolve its 300 billion USD debt as it cannot propose a reasonable restructuring plan.
Consequences of Evergrande's collapse
"Evergrande's asset liquidation signals that China is ready to go all the way to end the real estate bubble. This could positively impact the economy in the long term but cause short-term difficulties", Andrew Collier, Director of Orient Capital Research, commented to Reuters.
In the short term, financial difficulties spread across the economy. Successful real estate companies were propelled by the “three-car train”—high revenue, high gross profit, and high leverage. The Evergrande event changed these factors.
For example, potential homebuyers fear not receiving homes and reduce demand, worsening sales declines. Moreover, refusing pre-purchases of unfinished apartments or deposits without deep discounts reduces liquidity and raises financial costs for developers. This reduces revenue and operational capacity of real estate firms and can spread to the entire market.
China's home sales show no recovery signs, even worsening after Evergrande's collapse
House prices in August 2024 continued to fall deeper than the previous month:
GDP has remained stable around 5% for about the past year, lower than pre-pandemic levels
Private investment and infrastructure investment activities have both declined:
Economic stagnation has caused credit growth in China to stagnate since post-Covid:
Businesses limit borrowing for production investment,
Residents are even less willing to borrow for spending-buying homes....
For the first time in 2 decades, bank loans (the main financing channel for small and medium-sized enterprises) have negative growth!
Read more about China's recent economy at:
It can be seen that the collapse of Evergrande ignited the economic recession in China. However, in the long term, the government's tightening policy on financial leverage will help cleanse the market and significantly reduce leverage. From there, speculative price inflation phenomena will gradually improve.
Conclusion
The collapse of Evergrande is a sad milestone in the development history of China's real estate industry and is also considered the event that ignited the economic recession lasting the past 3 years. However, many investors and even the Chinese government believe that this is a 'necessary' collapse to begin the process of innovating the economic model and reducing leverage in the financial system.
The investment models or financial mistakes that Evergrande made are common manifestations of most Chinese real estate enterprises at that time. If we look broader, we can clearly see a larger transformation:
The build-first, sell-later model is gradually becoming ineffective
Population aging changes consumer demand
Policy changes focusing on sustainability rather than the speed of the economy
And more realistically, we can consider that China has entered the end of the long-term debt cycle, and whether this deleveraging process will succeed or not still requires more time.
You can read more about how the economy works and short-term and long-term debt cycles through the article:
Comments (0)
No comments yet
Be the first to comment
Login to comment