Marc Rubinstein has over 25 years experience as an analyst and investor in the financials sector which he distills into a free weekly newsletter, Net Interest, which I think is a really great read! Between 2006 and 2016 he was senior analyst and portfolio manager on the Lansdowne Global Financials Fund, a fundamental long/short equity fund focused exclusively on the global financials sector. Prior to that, Marc was an Institutional Investor ranked analyst on the sell-side, most recently at Credit Suisse, where he was a managing director overseeing its European banks team. As well as writing Net Interest, Marc is an active angel investor in fintech. He can be contacted via his newsletter or on Twitter (@MarcRuby). As with all of our guest contributors, Marc’s post may not represent
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Marc Rubinstein has over 25 years experience as an analyst and investor in the financials sector which he distills into a free weekly newsletter, Net Interest, which I think is a really great read! Between 2006 and 2016 he was senior analyst and portfolio manager on the Lansdowne Global Financials Fund, a fundamental long/short equity fund focused exclusively on the global financials sector. Prior to that, Marc was an Institutional Investor ranked analyst on the sell-side, most recently at Credit Suisse, where he was a managing director overseeing its European banks team. As well as writing Net Interest, Marc is an active angel investor in fintech. He can be contacted via his newsletter or on Twitter (@MarcRuby).
As with all of our guest contributors, Marc’s post may not represent the views of Epsilon Theory or Second Foundation Partners, and should not be construed as advice to purchase or sell any security.
When I shut down my Bloomberg and exited the Mayfair office of my hedge fund for the final time a few years ago, one of the last prices I saw flickering on my screen was the bond price of a Chinese real estate developer called Evergrande. The price was part of my ‘canary’ screen. Evergrande is the biggest player in the biggest industry sector in one of the biggest economies in the world. It is also very highly leveraged. So when its bond price falls, it’s useful to take note.
This week, its bond price fell.
It’s not the first time it’s happened, which is why it may not have made it to the front pages of the newspapers. But that doesn’t make it any less significant. Its balance sheet is bigger now, at $356 billion, and it is the largest issuer of dollar-denominated Chinese junk bonds. The fall in Evergrande’s bonds was sparked by news that one of the Chinese banks had frozen some of its deposits. Piling on the woe came news that it had been asked to suspend new home sales in the city of Shaoyang due to a lack of funds in its accounts and that potential buyers were being refused mortgages by some Hong Kong banks. One line of its bonds fell to 49 cents on the dollar.
China is a country full of paradoxes and one of them sits at the heart of the residential real estate market where Evergrande operates. Lest you forget, China is a communist state, and all land is owned by the state. In order to solve a funding problem, early reformers came up with a fudge. Zhao Ziyang, a former premier, describes in his memoir how he was introduced to the idea of selling land to raise funds:
It was perhaps 1985 or 1986 when I talked to Huo Yingdong [a Hong Kong tycoon better known as Henry Fok] and mentioned that we didn’t have funds for urban development. He asked me, “If you have land, how can you not have money?”
I thought this was a strange comment. Having land was one issue; a lack of funds was another. What did the two have to do with one another? He said, “If municipalities have land, they should get permission to lease some of it, bring in some income, and let other people develop the land.”
Indeed, I had noticed how in Hong Kong buildings and streets were constructed quickly. A place could be quickly transformed. But for us it was very difficult.Prisoner of the State: The Secret Journal of Premier Zhao Ziyang (2010)
In 1988, the government changed the constitution to allow rights to use land – not to own, to use – to be bought and sold under long term leases. Residential use typically comes with a seventy year lease; commercial use with fifty years. No-one really expects land to revert to the government after that time, but the fudge serves a purpose. In the seven years between 2009 and 2015, the Chinese government collected 22 trillion yuan from selling land. By privatising this state asset, the government has been able to fund massive infrastructure investment on a scale that the taxpayer wouldn’t have been able to bear.
The constitutional change paved the way for a commercial market to take root around residential property. But the real turning point came later, in 1998. At the time, most city dwellers lived in housing provided by their state employer. The problem was that state employers lacked the motivation and resources to build housing on sufficient scale. In 1998, the government introduced urban housing reforms that removed the obligation of employers to provide housing. People were encouraged to buy their homes from their employers, who sold them at heavily discounted prices. A massive transfer of wealth took place between the state and its people. That transfer of wealth seeded the growth in the residential housing market as homeowners reinvested their gains back in the market by buying bigger and better homes.
(Ironically, having not been interested in investing in housing themselves prior to 1998, many state enterprises got heavily involved in real estate ten years later as the returns exceeded what they could get in their core business. In 2010, the central government mandated state companies to divest their property arms and return their attention to their core businesses.)
My interest with Chinese property developers began in the mid 2000s, soon after I had started at my hedge fund. Several developers had come to the market and I would visit them on trips to China. Plastic shoe covers on my feet so as not to spoil the newly laid floors, I would tour the sweeping developments springing up around cities like Beijing, Shanghai and Guangzhou.
The investment thesis was simple: China was urbanising fast and that drove an insatiable demand for residential real estate. Developers could buy land from local government and turn it into aspirational accommodation at 25% margins. Back in my hotel room I would fire up my laptop and plug in values for the inventory of land and unsold homes sitting on developers’ balance sheets to gauge what their stock was worth.
It didn’t take long for the market to get frothy. Demand for housing came not just for its utility but also for its investment features. Interest rates were kept exceptionally low and easy money boosted investment demand for housing. Since 2002, housing prices in China’s tier 1 cities, like the ones I visited, have risen more than six-fold (which compares with an 80% overall national increase in US housing prices between 2000 and 2005). With the market this frothy, analysts began plugging into their laptops the value of land developers hadn’t even acquired yet, but might.
It was into that environment that Evergrande was listed, at the end of 2009. It was the biggest residential real estate developer of them all. At the end of the year, it had a total land reserve of 55 million square metres, giving it years of runway compared with the 5.6 million square metres of gross floor area (GFA) it sold that year. The company’s strategy was built around scale, affordability, turnover and brand. It adopted a standardised approach to its operating procedures. One of the bankers on the deal called Evergrande the McDonald’s of the Chinese residential property market. Its stock was 46 times oversubscribed in the retail tranche and it popped 34% on its first day of trading.
Successful listing of the Group set the milestone in the corporate brand building. From the beginning of 2009, the Group quickly leveraged the gradual heating up of the property market, and immediately adjusted the business strategy, obtaining excellent results of RMB30.3 billion in contracted sales. Besides, the Group captured the best opportunity of the capital market and was successfully listed on the Main Board of the Stock Exchange on 5 November 2009. The Evergrande brand became a household name in China, the recognition and reputation of the brand reached an unprecedented level.2010 Annual Report
The IPO also helped Evergrande clean up its balance sheet. In the years prior to IPO it had operated with very high levels of debt relative to equity. Following its IPO, it sat on a net cash position.
That wasn’t to last. The company immediately geared up and started to expand in a literal land grab. The year after IPO, it grew its land bank by 75%, investing in a pipeline of developments across 62 cities, up from 25 the previous year. It took scale to a new level, building mini-cities rather than just apartment blocks that could accommodate as many as 65,000 people on a single site. The company raised cash from pre-sales, signing up prospective buyers years before completion. And it also raised debt: net gearing (net debt as a percentage of shareholders’ equity) rose to 52% in the year after IPO.
A couple of years later the company attracted the attention of short sellers at Citron Research, the team that would later give up short selling in the aftermath of the GameStop affair. They highlighted the risks creeping into Evergrande’s balance sheet. The company had grown its assets five times faster than peers in the past five years and was burning cash. Citron’s report made a number of other accusations about the company and its chairman, and Andrew Left, Citron’s founder, was eventually fined for market manipulation on the basis his report had been somewhere between negligent and reckless. But he was right about one thing: Evergrande was burning cash.
In the ten years leading up to 2020, Evergrande has overseen RMB230 billion in cash outflows from operations. Its net debt currently stands at RMB536 billion, reflecting a 153% net gearing ratio. Excluding the revaluation of investment properties, that ratio is over 170%. Add in large accounts payable obligations (RMB829 billion) and the company’s liabilities are even larger. Much of this debt has been channeled into land acquisitions; the company now owns 231 million square metres of land across 234 cities (equivalent to four Manhattans). Over the past few years the company has been funding at rates of 8-11% via dollar-denominated bonds, but even these bonds were trading at higher yields before the recent bond price collapse.
Over the years, the government has intervened numerous times to influence the residential real estate market in China. Using tax, mortgage rates, mortgage quotas, controls on secondary market listing prices and other tools, it has attempted to steer the residential property market between boom and bust. More recently it imposed some ‘red lines’ on property developers that require them to control their debt levels. Evergrande remains firmly in the ‘red group’. 
Some people liken Evergrande to a giant pyramid scheme. There are periods in the cycle where real estate isn’t a cash flow business, it’s an asset appreciation business. As long as debt can be serviced, that can work, but problems emerge when it can’t. To address this, Evergrande has pursued two strategies.
First, it diversified into other businesses. It’s had a football team since 2010 which has gained success under coaches Marcello Lippi and Luiz Felipe Scolari. It operates theme parks, is involved in grain, dairy and mineral water businesses and has a cultural entertainment division. Its electric vehicle business is now worth $26 billion (down from $93 billion in April).
Second, Evergrande has made itself too big to fail – literally ever grande. Real estate investment is a very important driver of the overall Chinese economy. It has grown from a 5% share of GDP in 1995 to over 13% in 2019, of which over 70% is residential. Incorporating industries downstream and upstream of real estate, the sector makes up 29% of Chinese GDP (comparable internationally only to pre-crisis Spain and Ireland).
Banks are particularly co-joined. Real estate loans make up around 28% of their loans and 40% of new loans. As a robust source of collateral, banks have an incentive to extend more loans to firms with land holdings. Incentives are similarly skewed in local government, where construction activity represents measurable economic output against which officials are assessed. Zhao’s economic realisation still drives local government budgets today.
Because it’s too big to fail, Evergrande’s demise may be less a product of its financial position and more its political position. Recently, China’s financial regulator instructed banks to conduct a stress test around an Evergrande failure so the endgame could be getting close. How they choose to allocate losses will determine whether Evergrande bonds bleed out of the canary screen and onto the main screen. 
 Targets are: net debt/equity ratio below 100% by 30 June 2021 (company was at 153% at end 2020); cash/short-term debt above 1x by 31 December 2021 (company was at 0.47x at end 2020) and liability/asset ratio below 70% by 31 December 2022 (company was at 83% at end 2020).
 @TheLastBearSta1 has an interesting theory that Tether (which we discussed here) may have invested customer funds in Evergrande commercial paper. Tether owns just under $30 billion of commercial paper, yet trading desks in Europe and New York have not had dealings with it. Evergrande, meanwhile, is one of the biggest issuers of commercial paper, with $32 billion outstanding at the end of 2020 (although consolidated number could be higher).