Evergrande: debt behemoth

Name the following Chinese company:

It boasts an enterprise value of $145bn. In the first half of the year it generated $44bn of revenues and $4.5bn of profits, paying out half in dividends. It has $98bn of debt, $44bn of it due within the next twelve months.

The answer is China Evergrande, a real estate kraken with tentacles stretching across China. It does all things property including development, investment, management and construction, along with a host of smaller ventures in technology, finance and healthcare.

That reach makes some of the numbers mind boggling, particularly when it comes to the company's debt. For instance, it paid $4.2bn of interest over the first six months of 2018 — more than the revenues of 259 of the S&P 500's constituents in the same period, according to S&P Capital IQ.

In part that's because Evergrande pays a lot to borrow: its average financing cost of 8.3 per cent is the highest of peers, which pay an average 5.9 per cent interest rate, according to China Merchant Securities.

Matthew Chow of Standard & Poor's, the rating agency, has voiced some caution on Evergrande's debt structure. Noting that while it has improved, “the company still has $44bn of short-term debt” and “we definitely want to see more improvement” before it revises the B rating it currently has on 3 of its dollar denominated bonds, totalling $6.6bn.

However the debt should not be that much of a worry if results, such as its profits which grew 64 per cent year-on-year, continue to improve. Even now Evergrande can meet its interest payments comfortably — its half-year operating profits of $14bn covered its interest payments 3 to 1.

But the size of its debt means Evergrande must choose which real estate projects it invest, develops and sells wisely. Otherwise a deterioration in its asset base could spell trouble for its relatively small $47bn equity, which currently funds 18 per cent of its assets.

Evergrande's assets, as suggested above, are large. For instance, its current land reserve, which spans 822 projects, covers a mammoth 305m square meters, close to 120 square miles, a touch below the size of Malta.

We thought we'd turn our attention to a corner of that expanse, $23bn worth of investment properties. According to one equity analyst we spoke to, little attention is paid to these investments which, despite only accounting for 9 per cent of total assets, represents half of Evergrande's equity due to its levered nature.

According to its half-year report, Evergrande's investment properties “include commercial podiums in living communities, office buildings with gross floor area of about 8.43 million square meters and approximately 408,000 car parking spaces”.

Yet it does not look like these investment properties generate much cash. In the past six months, rental income from investment properties amounted to $68m, an annualised yield of only 0.6 per cent. A figure significantly below the Shanghai Interbank lending rate, which stood on Wednesday at 2.49 per cent, according to S&P Capital Markets IQ.

One reason for the low rental incomes is that some of the properties are still under construction, but at the end of 2017, this was the case for just 14 per cent of the portfolio. So unless all are let at peppercorn rents, some must be empty, provoking memories of China's ghost cities, vast unoccupied real estate developments built in the hope of future demand.

The Economist recently profiled one such city, Tianjin, which as of August, boasted the slowest GDP growth among the Chinese provinces since the beginning of last year and an office vacancy rate in its latest financial district, Binhai, of just under 70 per cent.

Evergrande have 11 projects in Tianjin currently, worth around $1.8bn, with $313m worth of contracted sales due from this area over the coming years, according to its half-year report. The first phase of one of these developments, Splendor Tianjin, was completed in September 2009, according to that year's report. In 2012, the project was still in Phase I, despite the 2011 report saying the project was in “Phase 2 to Phase 3 (partial)". So it is puzzling as to why, close to a decade after the site broke ground, the 846k square meter site hasn't been sold.

As with many things mysterious in finance, the reason may boil down to an accounting rule.

The rule in question, HKAS 40, can be read here. The key definition for this story can be found on page 6:

Investment property is property (land or a building — or part of a building — or both) held (by the owner or by the lessee under a finance lease) to earn rentals or for capital appreciation or both . . .

So perhaps the properties are just being held for capital appreciation? That would go someway to explaining the low yields and why some properties, such as Splendor Tianjin, are still on the books. (Evergrande did not respond to requests for comment.)

Here's a table from last year's financial report, which outlines the different methods Evergrande use to arrive at fair value for its investment property portfolio:

As you can see, the direct comparison method — when assets prices are valued relate to local and comparable properties — accounted for $18bn, or 80 per cent, of Evergrande's valuation of these assets.

There can be issues with using local sales prices as a yardstick to value real estate. For instance, the quality of a property can vary street-to-street, and even building-to-building — take Chelsea's brutalist World End Estate, a one bedroom flat in the state-owned block would not command the same value as a similar sized property in a local Georgian townhouse.

In times of a real estate boom, such as in China, exuberant prices could give an aggressive developer an excuse to write up or maintain the value of assets where demand for space is not quite so white hot.

Mismatches between prices and actual values would only become clear when sales are made. In 2017, Evergrande only sold $359m of its investment properties. In 2016 the figure was $347m. At this rate, it would take 50 years for Evergrande to dispose of the investment properties valued by direct comparison, assuming no more are developed.

Evergrande's ambitions certainly appear to include diversification away from property. In June it acquired for $860m, via its listed Health unit, a 45 per cent equity interest in Faraday Future, an electric vehicle start-up. Much more is planned, as the company has said that over the next decade it expects to invest a further $15bn into futuristic opportunities such as “quantum technology, new energy, artificial intelligence, robotics and modern technology agriculture”. Mind boggling ambition, to go with the mind boggling numbers.

Related Links:
Chinese real estate, charted — FT AlphavilleAccounting for China's real estate boom — FT Alphaville