Chinas property sector is the largest asset class in the world, and it's in trouble.
- How will this effect the global property market
- How would this effect Canada, will foreign capital leave?
- What are the potential outcomes
This content was originally published by The Canadian Real Estate Investor Podcast
Transcript:
Nick WELCOME back to episode 117
Im Nick
Im Dan,
Going back to episode 11, trouble in the worlds largest asset, we covered this, and you were talking about it even before then. So it finally happened - Evergrande filed for bankruptcy
NICK: China’s Evergrande Group — once the country’s second-largest property developer — filed for bankruptcy in New York on Thursday.
DAN: And I believe once the largest real estate company in the world in 2018
NICK: It’s funny because we just did an episode on the biggest real estate companies in the world too
DAN: speaking of things that are the largest
NICK: don’t make a bad joke
DAN: China's property sector accounts for more than half of global new home sales and home building, and it is the largest asset class in the world, with an estimated market value of around $62 trillion. The next thing to watch is how regional governments, many of which rely on real estate revenue, manage their debt.
NICK: To compound that - according to the economist - the world’s biggest asset class is actually residential property. With an estimated value of about $200trn, homes are collectively worth about three times as much as all publicly traded shares.
DAN: SO WHAT COULD HAPPEN NEXT?
Since the sector's debt crisis unfolded in mid-2021, companies accounting for 40% of Chinese home sales have defaulted, most of them private property developers.
It has led to many unfinished homes, unpaid suppliers and creditors who are not only financial institutions but also ordinary folks who bought wealth management products linked to trust financing.
Many offshore bonds now trade at low double- or even single-digit cents on the dollar, and their share values have shrunk 90%. There is very little liquidity left in both the equity and debt markets as investors and creditors avoid the sector.
NICK: HOW IS THIS TIME DIFFERENT?
With home sales already very weak, the debt crisis could delay the prospect of a recovery of both the property market and the broader Chinese economy, in which real estate is a core pillar.
S&P Global Rating said on Wednesday it could adjust its forecast for property sales to a "descending staircase" figure from an "L" shaped recovery, if Country Garden officially defaulted.
DAN: Home-buyers could become even more wary of private developer brands, and home prices in many areas could come under greater pressure if Country Garden resorted to fire sales to raise cash.
Country Garden's quick slip into financial trouble did not shock the market as much as Evergrande's because most private developers had already defaulted. However, it emerged when the property market and the economy are in much worse shape.
So if Country Garden is bigger why is evergrande the one that everyone is focusing on?
NICK: probably because the market has “priced in” the news already… pricing in is a concept that we’re going to get to later when we talk about how this could impact CANADIAN real estate
DAN: If the market has "priced in" news, it means that the information or event has already been anticipated and factored into the current prices of financial assets, such as stocks, bonds, or currencies. Investors have adjusted their expectations and valuations based on the available information, and the impact of the news on asset prices may be limited or subdued when the news is officially announced.
NICK: back to the article China’s Evergrande Group — once the country’s second-largest property developer — filed for bankruptcy in New York on Thursday.
DAN: The firm borrowed heavily and defaulted on its debt in 2021, sparking a massive property crisis in China’s economy, which continues to feel the effects.
NICK: Evergrande filed for Chapter 15 bankruptcy protection, which allows a US bankruptcy court to step in when an insolvency case involves another country. Chapter 15 bankruptcy is intended to help promote cooperation between US courts, debtors, and other countries’ courts involved in cross-border bankruptcy proceedings.
DAN: The impact of Evergrande’s default
China’s real estate sector was long seen as a vital growth engine in the world’s second-largest economy and accounted for as much as 30% of the country’s GDP. But Evergrande’s 2021 default sent shockwaves through China’s property markets, damaging homeowners and the broader financial system in the country.
The company’s default came after Beijing began cracking down on excessive borrowing by developers in an attempt to rein in soaring housing prices.
NICK: Since Evergrande’s collapse, several other major developers in China, including Kasia, Fantasia, and Shimao Group, have defaulted on their debts. Most recently, another Chinese real estate giant, Country Garden, warned that it would “consider adopting various debt management measures” — fueling speculation that the company may be preparing to restructure its debt as it struggles to raise cash.
The industry’s problems have been amplified by an overall economic slowdown in the country.
Ok so what does it all mean?
DAN: so… there are a few ways of looking at it
Was it priced in, or is this a domino, catalyst, or wake up call
Will it be isolate or contagious - is the contagion dealt with?
Will it cause a flight to quality, or a negative wealth effect?
NICK: ok so let’s explore those then
Priced in versus “wake up call” or catalyst
DAN: Being priced in
When something is "priced in" by the market, it means that the market participants have already factored in or taken into account a particular event, news, or development when determining the current price of a financial asset, such as a stock or a bond. In other words, the market's expectations and predictions regarding that event are already reflected in the asset's current price.
Using the bankruptcy of China Evergrande Group as an example:
Here's how the concept of "priced in" could apply to the Evergrande situation:
Initial Reaction: When news of Evergrande's financial troubles first started to emerge, investors might have reacted by selling off Evergrande's bonds and stocks. This initial reaction could lead to a decline in Evergrande's share price and bond prices as market participants became concerned about the company's ability to repay its debts.
Market Assessment: As more information became available and discussions about the potential outcomes of Evergrande's financial situation unfolded, investors and analysts would have assessed the potential risks and impacts on financial markets more thoroughly. They would have considered factors such as Evergrande's debt levels, its assets, the potential for government intervention, and broader economic implications.
Pricing In: Over time, as market participants gained a clearer understanding of the situation, they would have adjusted their expectations and factored in the potential outcomes into the prices of Evergrande's bonds and stocks. If the market believed that bankruptcy or significant financial restructuring was likely, this expectation would be reflected in the lower prices of Evergrande's assets.
Resolution: If Evergrande were to eventually declare bankruptcy or undergo a major financial restructuring, the actual event itself might not lead to as significant a market reaction as the earlier stages of uncertainty. This is because the market had already priced in the expectation of such an outcome, and investors would have adjusted their positions and strategies accordingly.
In summary, being "priced in" means that market participants have already taken an event or news into account when valuing financial assets. The concept helps explain why markets may not always exhibit a strong reaction to a major event if that event was already anticipated and factored into asset prices beforehand.
The antithesis of that would be if this was kind of the “first domino” falling down
NICK: The Domino Effect
A "first domino," "market catalyst," or "financial contagion event" refers to a triggering event that sets off a chain reaction of interconnected events or disruptions within financial markets or the broader economy. It often leads to a cascade of consequences, where the effects of the initial event spread rapidly through various sectors and markets.
Using China Evergrande Group as an example:
Initial Trigger: The initial trigger is the financial distress faced by China Evergrande. The company has a significant amount of debt, and if it is unable to make timely debt payments or if its financial situation deteriorates further, it could lead to a default event.
Market Sentiment and Concerns: News and discussions about Evergrande's financial problems could lead to negative market sentiment. Investors and creditors may become concerned about the broader implications of a potential Evergrande default, including the impact on other financial institutions, markets, and the overall economy.
Contagion Effect: The concerns about Evergrande's potential default could spread to other sectors and markets. Investors may start to reassess their exposure to other Chinese real estate developers, financial institutions, and even global markets that have a significant connection to China. This could lead to a sell-off in related stocks, bonds, and commodities.
Risk Aversion and Sell-offs: As the contagion effect spreads, market participants may become more risk-averse and start to liquidate assets perceived as risky. This could lead to broader sell-offs in other sectors and markets, both domestically and internationally, as investors seek to reduce their exposure to potential risks.
Financial System Stability Concerns: A widespread sell-off and market turmoil could raise concerns about the stability of the financial system. Banks and financial institutions that have exposure to Evergrande or related sectors could face increased scrutiny, leading to liquidity concerns and potential credit tightening.
Government and Regulatory Response: In response to the escalating situation, government authorities and regulators may intervene to stabilize the markets and prevent further contagion. They could provide liquidity support, implement measures to contain the crisis, or encourage debt restructuring and negotiations.
In this example, the financial difficulties of China Evergrande serve as the initial trigger or first domino. The market catalyst is the negative sentiment and concerns surrounding Evergrande's potential default. The financial contagion event is the spread of these concerns across various sectors and markets, leading to broader market disruptions.
It's important to note that while this example illustrates a potential scenario, actual outcomes can vary based on a multitude of factors, including government responses, market dynamics, investor behavior, and global economic conditions.
DAN: so those are the 2 potential outcomes - and then we would want to be thinking about how that would impact consumer sentiment. So let’s continue with that domino effect and see what it could look like in Canada:
DAN: Negative wealth effect
The negative wealth effect refers to a psychological and behavioral phenomenon where a decrease in the value of assets, such as real estate, leads to reduced consumer spending and economic activity. When individuals or households perceive that their wealth has diminished due to falling asset prices, they often become more cautious about their spending, which can have a dampening effect on overall economic growth.
Using the potential collapse of China's real estate market as an example:
Suppose there is a significant collapse in China's real estate market, resulting from factors such as excessive debt, oversupply of properties, tightening government regulations, or changes in investor sentiment. This collapse leads to a sharp decline in property values and has ripple effects across the Chinese economy.
Negative Wealth Effect in China: Chinese investors who have heavily invested in real estate properties in China experience a decline in their perceived wealth as property values plummet. As a result, they may feel less financially secure and prosperous.
Impact on Consumer Spending: Feeling less wealthy, Chinese investors might become more cautious about their spending. They may cut back on discretionary spending, delay major purchases, or prioritize savings over consumption. This change in behavior can have a cascading effect on the broader economy, contributing to reduced consumer demand for goods and services.
Impact on Investment Abroad: Chinese investors who have diversified their portfolios by investing in foreign real estate markets, such as Canadian real estate, may also feel the negative wealth effect. As their wealth in China erodes, they may face increased financial pressures, such as the need to cover losses or meet financial obligations resulting from the collapse of their domestic real estate investments.
Liquidation of Canadian Real Estate: To cover losses or alleviate financial stress caused by the collapse of the Chinese real estate market, some Chinese investors in Canadian real estate may decide to liquidate their Canadian properties. They might sell these properties to raise cash and offset losses incurred in their domestic real estate holdings or to meet other financial obligations.
Impact on Canadian Real Estate Market: The sudden influx of properties for sale by Chinese investors looking to liquidate could increase supply in the Canadian real estate market. If demand does not keep pace with the increased supply, property prices in Canada could be affected, potentially leading to price declines.
Domino Effect: The liquidation of Canadian real estate by Chinese investors could trigger a chain reaction. As property prices decline, other investors may also become concerned about the market's stability and follow suit, leading to a broader selling trend and potentially exacerbating the negative wealth effect.
In this scenario, the collapse of China's real estate market leads to a negative wealth effect among Chinese investors, causing them to adjust their spending behaviors and possibly liquidate their assets, including Canadian real estate, to address financial challenges stemming from losses in their domestic real estate investments. This interconnectedness between domestic and foreign markets highlights the potential global impact of financial and economic events.
For some context on exposure here:
Chinese homebuyers accounted for nearly one-third of Vancouver’s real estate market during 2015, spending approximately $9.6 billion of the $29 billion of total real estate sales, according to a new study by the National Bank of Canada (TSX:NA).
National Bank financial analyst Peter Routledge, (YOU MAY RECOGNIZE THAT NAME!!) who compiled the data, said that Chinese homebuyers occupied 33 percent of the total housing volume in Vancouver’s real estate market, and 14 percent of purchases in Toronto – or about $6.7 billion of the $47 billion in deals. In the United States, Chinese investments for real estate properties skyrocketed from just $4.1 billion in 2009 to almost $29 billion in 2015.
Routledge, who called the study a “back-of-the-envelop attempt, calculated the results using two sets of data: the U.S. National Association of Realtors (NAR) and a Financial Times survey of 77 affluent and high net worth individual from China.
This is funny being from 2015 - “The analysis from National Banks comes after the federal government’s budget announcement Tuesday that it will spend C$500,000 (US$377,000) to track foreign homebuyers.”
Chinese Real Estate Investors in Canada – Is Their Ownership Now Less than 4%?
NICK: so that’s the very scary potential outcome - and keep in mind these are potential outcomes, we’re trying to give you scenarios, not opinions here… so that’s the bear case… so let’s look at the bull case now… which would be FLIGHT TO QUALITY
NICK: Flight to Quality
"Flight to quality" is a financial concept that describes a phenomenon where investors move their capital from riskier or more volatile assets to safer, more stable assets during times of uncertainty or market turmoil. The goal is to preserve capital and seek refuge in assets that are perceived to have lower risk and higher quality.
Using the collapse of China's real estate market as an example:
Suppose the collapse of China's real estate market creates significant economic uncertainty and financial instability. Chinese investors who have invested heavily in the domestic real estate market and are concerned about the preservation of their wealth may seek safer investment options abroad. In this case, they might consider Canadian real estate as a "flight to quality" strategy. Here's how this could work:
Concerns about Domestic Real Estate: Chinese investors who have witnessed the collapse of their domestic real estate market may become worried about the value of their real estate holdings. They may fear further declines, economic turmoil, or potential difficulties in accessing their investments.
Seeking Stability: In response to the uncertainty and risk associated with the collapse of their domestic market, some Chinese investors might decide to allocate a portion of their capital to foreign assets that are perceived as more stable and less susceptible to the same risks.
Canadian Real Estate as a Safe Haven: Canadian real estate, particularly in major cities like Vancouver and Toronto, has historically been considered a relatively stable and well-regulated market. Canadian property rights, legal frameworks, and political stability can make Canadian real estate an attractive option for investors seeking safety and security for their capital.
Property Purchase: Chinese investors, as part of their flight to quality strategy, may start buying Canadian real estate properties. These investors may see Canadian properties as a tangible asset that could potentially preserve their wealth in a more stable environment.
Impact on Canadian Real Estate Market: The flight to quality by Chinese investors could lead to increased demand for Canadian real estate, especially in markets that are already popular among foreign buyers. This increased demand could put upward pressure on property prices in those markets.
Market Dynamics: The influx of foreign investment might influence market dynamics, potentially leading to debates about affordability, housing supply, and the impact on local communities. Policymakers may respond by implementing measures to manage foreign investment and its potential effects on the domestic housing market.
In this example, the collapse of China's real estate market triggers a flight to quality among Chinese investors, prompting them to seek safety and stability by investing in Canadian real estate. This phenomenon can highlight the interconnectedness of global markets and the influence of economic events in one region on investment decisions and asset prices in another.
DAN: So the flight to quality is a more likely scenario if you believe the market has priced in Evergrande, then maybe we’ve been seeing capital come into Canadian real estate as a result of These things don’t have to be mutually exclusive by the way - there’s another article from 2016 that follows up the article I was mentioning from 2015 - that talks about why Chinese investors like Canadian real estate so much. While it tells us of the downside exposure, it also shows the upside potential
NICK: Yet the amphetamine rush of Chinese cash has been felt far beyond the disappearing pastures of the Fraser Valley—especially in the last couple of years. Fully 10 per cent of new condominiums being built in central Toronto are now going to foreign buyers, according to a survey released in April by the Canada Mortgage and Housing Corporation (CMHC); veterans of the city’s rough-and-tumble real estate market believe the vast majority are mainland Chinese. On Juwai.com, an online listing service where Chinese buyers can look for international real estate, inquiries about specific properties in Ontario rose 143 per cent in 2015, with the total value of those homes hitting $11.2 billion. Quebec saw its numbers more than triple, while Alberta’s numbers rose 70 per cent.
Meanwhile, Chinese developers have made buys in locations that have left analysts scratching their heads, including Nova Scotia’s remote Eastern Shore and an abandoned mining town in the B.C. Interior. The stated reasons for such purchases don’t entirely compute (neither seems the likely site, as owners and local officials suggest, for a full-service, self-contained vacation community).
But the broader incentives are easy to see. Next to China’s own volatile real estate markets, property almost anywhere in the Western world can seem an island of financial sanity, says Matthew Moore, president of Juwai’s North American operations. “The year-on-year property increase in Shenzhen, one of China’s tier-one cities, was close to 60 per cent,” he observes. “This is about wealth preservation.” Adding to that sense of urgency: even the most privileged Chinese mainlanders have for decades been shut out of buying property, which Moore describes as the “favourite asset class” of Chinese dating back to its pre-Revolution days. This is on top of profound worries many Chinese have about their country’s overbearing political system, the lack of transparent rule of law and rampant corruption.
All of which has landed Canada in an economic paradox. In Vancouver, and increasingly Toronto, fear abounds that Chinese money has helped inflate a property balloon of Hindenburg proportions, driving house values out of reach for even well-off professionals, while raising the risk of a crash at the first sign of adverse conditions. Yet the self-same conditions are adding handsomely to the net worth of millions of homeowners, and supporting a constellation of housing-related industries, from real estate sales to interior decoration.
DAN: where it becomes “pop culture” or common knowledge and erodes consumer sentiment
CG seemed to be priced in by all the EG news
I think this is when it becomes "trending/pop culture" or "mainstream news" and impacts sentiment on main street, not just the market.
Fear and greed index went from extreme greed one month ago to Fear today
NICK: What is the CNN Business Fear & Greed Index?
The Fear & Greed Index is a way to gauge stock market movements and whether stocks are fairly priced. The theory is based on the logic that excessive fear tends to drive down share prices, and too much greed tends to have the opposite effect.
How is Fear & Greed Calculated?
The Fear & Greed Index is a compilation of seven different indicators that measure some aspect of stock market behavior. They are market momentum, stock price strength, stock price breadth, put and call options, junk bond demand, market volatility, and safe haven demand.
The index tracks how much these individual indicators deviate from their averages compared to how much they normally diverge. The index gives each indicator equal weighting in calculating a score from 0 to 100, with 100 representing maximum greediness and 0 signaling maximum fear.
DAN: “My thought is China can easily survive a banking crisis. The CPC prefers lower home prices. Their foreign debt is like 13-14%. Their Banks are state owned. They use classical economics. To them land is not productive. They prefer the capitalism of goods and services. This is much worse for those outside China.
Capitalism of goods and services is for all intents and purposes the production of housing and the stuff we put in them. They way overbuilt in secondary, tertiary centers. Too much household wealth tethered to mispriced residential RE in parts of China.”
NICK - the government wants housing to become more affordable without prices going down
I think that they’re placating a little bit because they obviously don’t want to create fear but there’s really only three ways that you can change housing affordability number one is by decreasing crisis number two is by decreasing interest rates of number three is by increasing wages
None of those things is really happening meaningfully in the economy right now
I guess there’s an alternative scenario where you somehow increase the value of real estate in and from my perspective the way to do that instead of zone everything to make the utility of it with the highest and best use of it better so allowing more units in one house
But that’s largely outside the scope of control of the federal government and whether or not they’re actually capable of executing affordability improvements with our house prices going down it’s a whole different question
But if they were gonna do it, that’s the only way to do it. You would basically be trying to increase the value of the property on a per square foot basis by making the average unit for the average house in Canada, smaller
So right now the average household size is 2.6 in Canada. I’d expect that to start going up
Reminds me of an article “The number of people in the average U.S. household is going up for the first time in over 160 years” . I’d expect the same trend to start in Canada.
People just can’t afford the Canadian dream anymore.
I’ve said for a while now that I think of this is the next phase of Canadian real estate, where we start to see household consolidation, we start to see a decrease in the level of homeownership in Canada are the rate of homeownership in Canada and we start to see multi family, and multigenerational household in a shrinking of the size of household’s
There’s only one way to do it: Just read between the lines here they can either build a massive amount of Outlier product or they can reuse existing square footage.
There’s really only one way you can do this, and it’s to cramming more and more units into existing square footage, therefore making the yield or highest and best use or total value of a home better