CHINA ROUNDTABLE: Rolling with the punches


In March, the ‘weakness’ of China’s property sector was sensationally highlighted when an overleveraged developer in the western province of Zhejiang was allowed to collapse by the government. While defaults among China’s thousands of smaller developers are not uncommon, the instance of Zhejiang Xingrun Real Estate is thought to be one of the largest collapses allowed by the country’s government in recent years, with only a few defaults around the time of the global financial crisis known to have surpassed it.

According to government statements, the provincial developer owed RMB2.4 billion ($385 million) to 17 banks, the biggest creditors being China Construction Bank, Shanghai Pudong Development Bank and Agricultural Bank of China. It owed another RMB1.1 billion to two micro-credit companies, as well as some 98 individuals and some contractors.

The timing was unnerving, as it came just two weeks after China’s domestic bond market experienced its first default in recent history by Shanghai Chaori Solar Energy Science and Technology, a maker of solar cells and panels. In February, China also had its first trust product default via a RMB289 mil-
lion coal company-backed loan.  In the past, either the national or local governments would have stepped in with refinancing options to keep such companies or developers afloat.

Participants in PERE’s China roundtable in Hong Kong last month explained that the government is using these three cases to send a message to the market: China will no longer prop up companies or developers that by rights should fail. The message is intended for developers and investors alike, according to Goodwin Gaw, managing principal and co-founder of Gaw Capital Partners. “The government wants to educate investors that, if developers are overleveraged, they will fail,” he says, “and let the buyer beware.”

A social contract 

The way China’s real estate players see it, the country has entered a critical phase in its economic and property market development, and the next 24 months will be crucial for determining the nation’s future direction.

The debt binge of Chinese property developers is no secret. National and local governments have been trying to reign in excessive lending since last year with any number of cooling and restrictive policies. Since taking power in 2012, the 18th National Congress has made clear its intentions to encourage a more market-oriented economy, and the roundtable participants see this as an important, though painful, first step.

“This kind of failing is healthy,” Gaw explains. “In fact, some international investors are saying the government should let some of these [developers] fail.”

By rights, many of the small localized developers would not be able to stand on their own without government propping, and Stanley Ching, managing director and head of real estate at CITIC Capital, predicts that more collapses will follow.

Xingrun serves as a perfect example. According to a local government statement, the developer’s “administration of its business became chaotic, and its funding chain was fractured. It owed several institutions debt for properties that it couldn’t verify it even had, and its failure to repay its debt has impacted social stability.” The company’s legal representative and its controlling shareholder, a father and son, currently are under investigation for illegally raising funds from retail investors to keep Xingrun running.

 The message seems to be getting through to investors. Keith Chan, managing director and head of greater China real estate at Macquarie Capital, adds that the maturation of the market will require investors to put in effort to get returns, as well as be much more conscious of the underlying fundamentals of properties or companies they buy into. “When investors are doing due diligence, they now are realizing they must look clearly into what is [the company’s] health status,” he says.

The social stability part of this equation, however, is essential to the Chinese government. When a developer goes bust, Ching says, it has ripple effects in all levels of society: the contractors lose their jobs, the buyers never get their home and the lenders do not get repaid. “That becomes a social issue – it’s no longer just financial,” he insists.

All three roundtable participants stress that China’s government does not want to see the collapse of a developer spiral into social unrest. “The Chinese government has a contract with its people: its sole job is social stability,” Gaw says. Thus, when a developer like Xingrun does fail, both local and national governments will stay involved in the cleanup to be sure the social repercussions are taken care of.

Shades of 2009 

Ching points out that this is not the first time shady developers with shoddy projects have caused problems for China. The most prominent example came in 2009, when a 13-story residential building in Shanghai’s Minhang district toppled over. The Shanghai government saw this as a face-losing situation for the entire city, and so they racked their brains for some kind of solution.

To salvage the development, the Shanghai government made a deal with national development giant China Vanke. In exchange for taking over the residential site, the government threw in an adjacent plot of land for a discount. The previous developer was shut down following a government investigation, but Ching considers that a win-win situation. The government saved face, China Vanke made its profit, the contractors got to keep working and, after some negotiation, residents either got their homes or received compensation. “If it was not done that way, everyone would have suffered,” he says.

“We’re definitely going to see [more] arranged marriages,” Gaw agrees. After all, a failed developer could be considered a “black eye” for a region. So, in order to solve any thorny developer default, he expects larger players like Vanke will be asked to step in and given some compensation behind the scenes. So far, at least, deals like that have kept social issues muted.

An ounce of prevention 

Ching believes the government is headed for a freer market. In the meantime, however, it cannot let housing or developer situations get out of control. If speculation drives home prices too high, the average Chinese family is going to suffer, but if too much supply causes prices to drop, homeowners also will lose a lot of money. Hence, once again, the government’s social contract keeps it walking a delicate balancing act.

The experts around the table also are convinced the government will remain heavily involved in the real estate sector simply because it is such a huge piece of China’s growth. Considered “a crucial pillar of China’s economy,” real estate makes up 13 percent of the country’s gross domestic product and contributes 32 percent of government revenue, according to data from real estate services firm Jones Lang LaSalle. Additionally, residential sales reached RMB6.7 trillion in 2013. Indeed, the government would be negligent to not regulate such a hefty sector of the economy.

China has come under a fair amount of criticism in the past for heavy government intervention, with countries like the US calling the system “inefficient.” However, Gaw explains that the Chinese government has not loosened its controls specifically because it does not want to be like the US. A democracy that allows hedge funds to grow housing bubbles until they pop could be devastating to a country as economically diverse as China. The government also has taken note of Russia’s transition to democracy, in which all property wealth fell into the hands of a very small elite.

“Actually, I would argue that the Chinese government is more efficient than the US government,” Ching says. “They are trying to put a stop to the problem before it gets too big.” In fact, ever since the onset of the global financial crisis, the Communist Party has been the one to initiate tightening again and again, rather than waiting for property bubbles
to pop.

“If you invest in China, you really have to believe in the government’s capability and what it is doing,” Gaw insists. “If you don’t believe in the government, don’t touch it.” Indeed, all three participants can recount instances where officials have adapted to very local circumstances for the sake of keeping the market stable and preventing the ensuing protests.

For example, even with national guidelines in place dictating the approval process for development projects, China recently has been experimenting with what Gaw calls “differential policies,” or selective implementation. Ching explains that, if housing prices hike up too quickly in one area, the local government may delay pre-sale permits to try and negotiate prices down. On the other hand, in areas with too much supply, the government may ask banks to be looser to prevent major corrections. Chan adds that communication with the government will be crucial for investors to understand the future direction and potential of each region.

“What the government is really looking for is a free market on their own terms,” Gaw says. To that end, they are only taking “baby steps” to test the market, by widening the currency’s range and, most recently, by allowing Xingrun to fail.

Adapting to a changing market 

By encouraging a more market-oriented and consumption-driven economy, the structural changes that the Chinese Communist Party is guiding are largely welcome but not so easy for domestic players to adapt to. Though bullish on China over a five-year term, Gaw admits that the next 24 months will bring an unsettling amount of volatility – something for which all domestic investors and developers are preparing.

“Many developers are sticking with a very conservative plan for next year,” Chan says. “In fact, they are even factoring in the possibility of no growth.”

China’s infamous ‘credit crunch’ has been directed primarily at developers that have been building too aggressively. The intense oversight placed on China’s shadow banking system and informal trust companies last year has succeeded in tightening liquidity for most of the smaller, local developers, just as the government intended.

Chan, Gaw and Ching all agree that a shakeout of developers in China is inevitable. “The market itself is very segregated,” Chan says, “so smaller developers with more limited capability and capacity getting consolidated may not be a bad thing from the government’s point of view.”

There is no official count of the number of developers in China, though some have estimated as many as 20,000. While not all are in the same straits as Xingrun, the average ratio of their cash flow to short-term liabilities was negative 5.7 percent last year compared to 15 percent in 2012, according to the China Real Estate Association. Sometimes, even the equity of developments can be sourced from illegal lending.

Although localized developers with no specialized focus are expected to be the hardest hit, they aren’t the only ones under stress. In fact, the tightening has begun to impact the larger developers as well. “China is a big ship, so it takes a while to turn,” Gaw confesses. “The government tends to overcool the market when they take measures to keep prices down.”

These ‘overcooling’ measures have made mortgages for residences or other properties less available, Chan explains. Clearing a mortgage with banks used to take one month, but it now takes three or four months. While the developers still get the same cash in the end, the longer time frame does affect cash flow, he says – a crucial factor when developers need to pay back loans within a two-year timeframe.

Still, Chan also is encouraged to see developers becoming more rational about their capabilities. While growth used to be the only priority in the China of guaranteed government backing, quality and profitability are getting higher on the list, he says. If a developer finds that it has built a good brand in a particular city, it usually will strive to do more in that city rather than spreading itself too thin.

“Developers also are more willing to quit projects that don’t do well,” Chan adds. “After all, what’s the point of staying in an unprofitable project for 10 years when another local developer can buy it and do better?” Losing one or two projects out of 100 nationwide is becoming a more acceptable game plan.

Survival of the fittest 

Not all developers are expected to survive under the new rules of China’s property market. The inevitable outcome, as far as the roundtable participants are concerned, is consolidation. The larger and more established players are expected to absorb the smaller players and, as long as the firms actually are constructing assets, it can be handled fairly smoothly.

“If it’s just a liquidity issue for the developer, as long as they are investing in real projects, [a developer’s collapse] can usually be solved,” Ching insists. Chan adds that most of the larger developers are banking on this and, for the first time, have set aside a pool of capital this year specifically for such distressed merger or buyout opportunities with smaller developers.

Whether there is any space for private equity real estate players in this distressed space is open to debate. Many of the distressed developers are expected to be too localized for an institutional investor’s taste, according to Gaw. “The developers focused on one region that happens to be hard-hit will be very distressed, but those are opportunities that fund managers cannot and should not access because they are too fraught with risk,” he explains.

Most such projects are under time constraints or the threat of being reclaimed, and a foreign investor might not be welcome in that mix. Of course, not all the larger developers or institutional investors feel fully equipped to buy other developers, and that is where Ching hopes his firm can step in, whether as a partner or simply as an advisor.

Indeed, all three participants consider developer takeovers and mergers to be one of the “watershed” trends that investors should track in the coming year. “If a fund manager has good relationships with larger developers, it may not be a bad idea to back them in M&A transactions with smaller troubled developers,” Gaw adds.

Chan further notes that the developers and fund managers that will fare best must have a niche strategy. “They face intense competition from domestic capital, as institutions want to do direct [investing] themselves,” he says. As smaller fund managers or developers hit a wall on fundraising, he notes that Macquarie is working towards helping them form partnerships with LPs, and he is particularly interested to see what specialized investment platforms will emerge over the next two years.

Even the developers that are faring well, however, still may run into liquidity issues and will need to look for ways other than debt to improve cash flow, such as unloading specific assets. “In the past 12 to 24 months, they have had high expectations for their projects, but they are now getting more realistic on price,” Ching says. Deals like that are a strategy for which CITIC unquestionably will be on the lookout.

As the ‘victors’ of China’s developer war start to emerge, the roundtable participants admit that they could act more like competitors to the fund manager community. Indeed, some of the largest developers like Vanke already are raising third-party capital, according to Ching, and always insist on taking an equity stake in their own developments. “A developer in China worth their salt won’t do development work for fees; they want equity,” Gaw agrees.

No matter how the shake-up plays out, investors are convinced that the Chinese government will be monitoring the process like a hawk. Getting the developers to deleverage is a national priority, but leverage that took about five years to build up will probably take just as long to correct, Ching points out. In the meantime, social unrest is always a danger.

“The government wants the deleveraging process handled as smoothly as possible but, at the same time, they don’t want to kill the industry,” Ching says. Despite the warning sent by the example of Xingrun, he does not believe the government really wants to see a large national developer actually go under.

“In this process, [the government] is behind the scenes, and they believe they can manage the situations that come up,” Ching says. “And, in most cases, they can.”

The contrarian investors 

In light of all the turbulence in the Chinese property market, all three roundtable participants can’t help laughing when they compare investor reactions now to those of a few years ago. Despite all the negative press concerning China after the collapse of Xingrun, the investors of these fund managers have been surprisingly calm.

Nothing demonstrates that better than the fundraising success of these firms last year. Gaw Capital hauled $1 billion for its Gateway Real Estate IV, the firm’s largest fund yet, and even had to take its $25 million GP commitment out of the fund’s capital count to make room for investor demand. CITIC Capital, likewise, beat its target when it raised $683 million for its first retail-focused China fund last June. And although it doesn’t raise funds itself, Macquarie has been involved in some of the region’s largest deals, such as Brookfield Asset Management’s $750 million commitment to Hong Kong listed developer Shui On Land.

Institutional investors also have gotten much smarter and developed a more focused investment strategy. Rather than simply relying on sweeping, blind-pool funds to make decisions for them, Ching says investors nowadays often have a set strategy focused on property sectors they find attractive and are quite savvy in picking co-investment opportunities in those sectors.

Indeed, Gaw adds that a fund manager must offer investors co-investment opportunities just to attract capital. Whereas six years ago most investors didn’t know how to react when presented with co-investment options and often had to hire third-party advisors to underwrite everything, investors are now very active and can commit capital in very short spaces of time, he says.

To illustrate, Chan points to two major deals this year: Gaw Capital’s $928 million purchase of Pacific Century Place in Beijing and RRJ Capital’s $250 million investment in Shanghai Yupei. As PERE previously reported, Partners Group came on board Gaw’s deal as a minority co-investor, and RRJ’s investment was done in conjunction with Singaporean sovereign wealth fund Temasek Holdings. Investors are not shying away from large deals, he insists.

Even after putting hundreds of millions of dollars on the line, investors have kept level-headed about the market noise surrounding the developer collapse and so-called property bubble in the country. Ching describes a night-and-day difference between now and just seven years ago.

“A few years ago, if there was any negative news in the Wall Street Journal, people would be sending me panicked emails: ‘What’s happening? What are these new measures? Can you explain what’s happening?’” Ching recalls. However, investors have now come to see China as less of an opportunistic play and more of a long-term play, picking managers to play the cycles and no longer expecting a “risk premium” for the country, he says. CITIC’s investors are even thinking that, specifically because of the bad news, this year will offer a great opportunity to invest.

“All of a sudden, I’m getting calls from our investors saying, ‘Hey Goodwin, all this bad news must be great for the fund’.” Gaw says. The three fund managers can only shake their heads and smile at how much their investor community has matured in less than a decade. Even if the next 24 months hold the volatility for China’s property market that the roundtable participants predict, investors seem here to stay.




Goodwin Gaw 

Managing principal and founder

Gaw Capital Partners 

Since founding Gaw Capital Partners alongside his brother in 2005, Gaw has grown the family business into a $7.5 billion firm, with investors from the US, Europe and Asia. The winner of PERE’s 2013 Asia Industry Figure of the Year award, he led his firm to close its largest fund yet last year, with $1 billion in commitments. His firm also has partnered with numerous Asian institutions to assist in finding assets overseas, including advising China’s Ping An Trust on its investment in the Lloyd’s of London building.


Keith Chan 

Managing director and head of real estate for greater China

Macquarie Capital 

With more than 17 years of investment banking experience, Chan joined Macquarie Capital in 2007. In his current post, he oversees all real estate efforts in greater China, including corporate finance, M&A activities and equity and debt capital raisings, as well as Macquarie’s principal investment initiatives. Some transactions he has advised on include the $750 million pre-IPO investment in China Xintiandi by Brookfield Asset Management, the $550 million sale of Corporate Avenue Two in Shanghai to China Life Insurance and the $265 million China Resources Car Park Fund.


Stanley Ching 

Senior managing director and head of real estate

CITIC Capital 

Stanley Ching joined CITIC Capital in 1999 as co-head of debt capital markets and established the real estate group in 2005. On his watch, CITIC successfully launched four China-focused real estate funds with committed equity of approximately $1.3 billion and invested in more than 20 projects in China, 14 of which have been fully exited.  Prior to joining CITIC, Ching worked for HSBC Group, Societe Generale Asia and Industrial Bank of Japan, gaining a total of 19 years of investment management, investment banking and corporate banking experience with a China focus.