Lessons Learned From The Evergrande Crisis

Summary

• Two weeks ago, investors across the globe were beginning to wonder if Evergrande will be able to make a comeback.
• The China-based and largely China-operating company handles multiple ventures, from electric car manufacturing to wealth management services to food and drink manufacturing.
• So now, Evergrande is being forced to sell properties at significant discounts just to stay afloat.
• Fortunately, most US REITs are on much better footing, and in this article I will highlight two such picks.
• Looking for a helping hand in the market? Members of iREIT on Alpha get exclusive ideas and guidance to navigate any climate. Learn More »

Getty Images/Getty Images News

As crowds in Beijing celebrated the Mid-Autumn Festival last month, not everyone was in a festive mood.

One of China’s largest lenders, Evergrande Group – formerly on track to become one of the world’s top 100 largest companies by revenue next year – is now being recognized as the world’s most indebted real estate developer.

Perhaps ever.

Company Chairman Hui Ka Yuan said in a recent internal letter that he firmly believes Evergrande employees will help their employer “walk out of its darkest moment [and] resume full-scale constructions as soon as possible.”

That sounds good and all, but it has to be noted that he didn’t outline a plan to achieve this. Two weeks ago, investors across the globe were beginning to wonder if Evergrande will be able to make a comeback.

Now, they’re just wondering how bad it’s going to be for the global economy. And they’re not being melodramatic in those concerns.

Not at all.

The Great Power That Is – or Was – Evergrande Group

For those who don’t know much about it, Evergrande Group is an absolute giant of a business. For now, anyway. While it’s busy making deals to save itself, as of the end of September at least, it employed over 200,000 workers and had roughly $355 billion in assets.

The China-based and largely China-operating company handles multiple ventures, from electric car manufacturing to wealth management services to food and drink manufacturing. It even owns one of China’s largest football teams, Guangzhou FC.

Most importantly though – and not just from my commercial real estate focused mind – Evergrande is one of China’s largest lenders, owning over 1,300 real estate projects in more than 280 cities across China.

Why does that matter? Let me quote a recent Morning Brew email I received:

“… in China, real estate is the biggest game in town… real estate contributes a mind-boggling 29% of GDP (compared to 6.2% in the U.S. in 2018). Building has literally built China into the superpower it is today.

“But thanks to super-low borrowing costs, the Chinese property sector has been feasting on empty calories, leading to astronomical debt loads ($300+ billion, in the case of Evergrande) and a chronic oversupply of housing.”

As it went on to say, the result has been empty properties strewn across the country.

In short, Evergrande’s rapid growth came at a cost. The company borrowed way too much way too quickly to become one of China’s biggest companies.

Last year though, its government initiated new legislation designed to control how much large real estate developers could owe. So now, Evergrande is being forced to sell properties at significant discounts just to stay afloat.

Now, it can’t afford to make interest payments on its debts. In fact, we’re really not sure what it can afford to do right now.

The Decline of the Evergrande Empire

In case you somehow haven’t been following the saga, here’s a timeline of Evergrande’s last few weeks:

• September 22 – Evergrande missed paying scheduled interest payments to two of its largest bank creditors.
• September 23 – Evergrande stayed silent on whether it made its $83.5 million coupon payment or not. The notes in question do have a 30-day grace period, but still. The silence was very telling.
• September 24 – Beijing told the company to focus on its national obligations, leaving international creditors in the lurch.
• September 27 – Evergrande finally did come out with details, though not about that September 23 coupon payment. Instead, it announced – unsurprisingly – that its New Energy Vehicle Group (an admittedly small part of the company) won’t be pursuing its Shanghai IPO plan for the time being.
• September 29 – Beijing asked some state-backed firms to step in and buy up some of Evergrande’s parts and pieces. This further indicated that the state government itself doesn’t want to get involved, at least not directly, to save the floundering giant.
• September 30 – Fitch downgraded Evergrande, along with its Hengda and Tianji subsidiaries, from CC to C based on just the September 23 (probably) missed payments.
• October 1 – The company announced that it made a 10% repayment on its wealth management products due the day before… but still stayed quiet about its previous payments/non-payments.
• October 4 – One of Evergrande’s competitors, Hopson Development, agreed to take over a 51% position in the company’s Property Services for $5.1 billion. Oh yeah, and Evergrande successfully asked to have its trading activity halted for the day.
• October 5 – Evergrande shares stayed suspended.

Should it go completely bankrupt, construction companies, architects and materials suppliers could also lose out intensely. At this point, that’s looking less likely.

But it’s still a real possibility we can’t completely discount.

Some More Evergrande-Specific Evaluations

Andrew Collier, managing director of Orient Capital Research, believes, "There must be negotiations behind the scenes about a systemic recapitalization [of Evergrande] by state proxies.”

And it seems likely that is, in fact, happening even though there’s been no official word that Beijing is going to save it. But, as already noted, it could be absolutely catastrophic for the country otherwise.

In an interview with the BBC, Economic Intelligence Unit’s Mattie Bekink explained that, “Evergrande reportedly owes money to around 171 domestic banks and 121 other financial firms.” So a default could mean that lenders will be forced to lend less…

Leading to a credit crunch, where companies could no longer borrow money at affordable rates.

At the risk of stating the obvious, that would be a very bad thing for the world's second-largest economy. And therefore, it could be a very bad thing for everyone else.

In the U.S., some are comparing Evergrande’s struggles a to that of the bygone Lehman Brothers, which collapsed in September of 2008 and helped spark the financial crisis. Others say the two situations are exceptionally different.

What I say is that we need to be properly prepared either way.

Just like we always want to be.

This is especially true considering what I wrote in my September 30 blog about the country’s power issues:

“Parts of China during different times of the day – like 7:30 a.m. to 4:30 p.m. – are now being operated by flashlight.

“The country in general is enforcing conservation targets, which some provinces are meeting by cutting power altogether. And some factories are suspending production for days or even weeks. That includes those that help meet Western demand for electronics.”

In short, there’s a lot going on right now.

Still Not in the Clear

Even if Evergrande itself pulls through, the large-scale nature of its projects mean that the smaller companies partnering with it could collapse. Alexandra Stevenson and Cao Li stated last month in “Evergrande Crisis Shows Cracks in China’s Property Market”:

“Angry [homebuyers] are waiting on as many as 1.6 million apartments. Suppliers that sold cement, paint, rebar and copper pipes are owed more than $100 billion in payments. Employees who were strong-armed into lending are panicking now that the company cannot repay them on time.”

Moreover, other Chinese property developers have come under suspicion too. For example, S&P Global Ratings downgraded Sinic Holdings to CCC+ toward of the end of the month on a failure "to communicate a clear [debt] repayment plan."

This smaller Chinese developer fell 87% in one day (September 20), which obliterated $1.5 billion of its market value.

The latest news now – just out on October 5 – is that luxury real estate developer Fantasia Holdings defaulted on a $206 million bond payment on Monday. To quote Barron’s:

“Shenzhen-based Fantasia issues a $500 million senior bond at 7.35% in 2016 but did not repay the outstanding principle when it matured, it said in a Monday exchange filing.”

This has sparked further “fears that debt problems among China’s property development companies spans far beyond China Evergrande.”

Could Evergrande’s Issues Affect the U.S. Economy?

The easy answer to that question is yes. It can.

I know some experts are saying otherwise. But I think these past two years have proven that the tide has shifted.

Not too long ago, it was said that when the U.S. sneezes, the world would catch a cold. Today though, China is becoming a bigger and bigger player.

So its moves and machinations can and do matter on the global stage. Enormously so.

This isn’t a call to panic, for the record. Only to be aware that the remainder of the year could be much more volatile than the first three quarters have been… especially when you add in:

• Supply issues
• Inflationary pressures
• Government bickering.

I can’t say that REITs will be immune to the probable volatility to follow. In fact, I’ll flat-out say that I expect more short-term ups and downs from here.

But that doesn’t mean there aren’t examples out there that aren’t worth holding onto regardless, especially with the faithful dividends they offer…

But We’re Still Buying REITs

Yesterday Physicians Realty (DOC) announced the acquisition of 15 Class-A medical office buildings located in 8 states for approximately $764.3 million. The portfolio, with nearly ~1.5 million square feet, is about 95% leased, with the remaining lease term standing at nearly 7.4 years, the company said.

Late yesterday I interviewed DOC’s CEO, John Thomas, and he said,

“We've built the company primarily working through off-market transactions either directly with physicians, directly with hospitals, directly with developers who are working with hospitals and physicians.”

We’re not sure as to the cap rate for this transaction but we believe that it has a 4-handle, and this deal blows past the $600 million (upper-end) acquisition guidance for 2021. DOC has earned a seat at the table as DOC’s CEO pointed out, “S&P and Moody's both gave us long overdue upgrades.”

DOC has a well-positioned balance sheet with 4.7x net debt/adj. EBITDA and given the modest leverage, we believe DOC can fund the portfolio acquisition modest equity (~40%) and keep leverage at ~5.5x. Approximately 74% of the space is leased to investment grade health systems/subsidiaries. The transaction is expected to close Q4-21.

DOC is an attractively priced pick that is yielding 5.2% and we are forecasting shares to return 18% over 12 months.

Source: FAST Graphs

Omega Healthcare (OHI) is another REIT that we’re tracking close at iREIT on Alpha. Shares in the skilled nursing REIT have dropped below $30.00 per share, a figure that we haven’t seen since March 2020.

Despite $25.5billion of CARES Act funds available for distribution, several of OHI’s operators are challenged by the continued labor shortage. Key findings include:

• 86% of nursing homes and 77% of assisted living providers said their workforce situation has gotten worse over the past 3 months.

• Nearly every nursing home (99%) and assisted living facility (96%) in the US is facing a staffing shortage. 59% of nursing homes and nearly 33% of assisted living providers are experiencing a high level of staffing shortages.

• Nearly 70% of nursing homes are having to hire expensive agency staff.

We remain bullish with OHI, recognizing that the game is all about “survival of the fittest” and we’re encouraged by the massive appetite we’re seeing for private market SNF transactions. At iREIT on Alpha we’re providing members with a detailed thesis on the company supporting our long-term thesis.

Keep in mind, OHI’s dividend is at a higher risk of being cut (short-term), however, we are long-term investors, recognizing shares are worth $40.00 under normal scenarios.

Source: FAST Graphs

Author's Note: Brad Thomas is a Wall Street writer, which means he's not always right with his predictions or recommendations. Since that also applies to his grammar, please excuse any typos you may find. Also, this article is free: written and distributed only to assist in research while providing a forum for second-level thinking.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of OHI, DOC either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.