China’s multi-year property slump is showing signs of abating, fostering hope that Chinese developers might offer opportunities. From a credit perspective, however, the Transparently.AI platform suggests that a good deal of risk remains among these companies.
On the face of it, property should be one of the safer forms of lending. Lenders can see the assets, know roughly what they are worth and the yield. Time and again, however, lending to developers comes unstuck. This is mostly due to fear and greed, but also partly due to the incidence of accounting manipulation among developers.
Although a seemingly transparent business, the exceptional lag between the recording of sales and the delivery of product means that real estate is fertile ground for accounting fraud.
Although a seemingly transparent business, the lag between recording of sales and delivery of product means that real estate is fertile ground for accounting fraud
Embattled since 2016, the downturn in China’s property market intensified after Covid-19 struck in 2020. In recent months, the severity of the downturn has eased. In March, for example, new home prices fell by just -0.8% YoY, having troughed at -1.8% YoY last October. New home sales fell by -3.6% YoY in the Jan-Feb period compared with a 24% decline for the whole of 2022.
China's property market
More recent data have tempered the housing optimism for housing, and there is still talk of measures to shore up the industry.
Even with improving property market fundamentals, it doesn't mean that the risk associated with Chinese developers will necessarily lessen in coming quarters. If developers engage in account manipulation, their underlying cash position could still deteriorate even if real estate demand improves.
If developers engage in account manipulation, their underlying cash position could still deteriorate even if real estate demand improves.
The chart below shows the average and median accounting manipulation risk scores of large Chinese developers from 2004 until 2022, as generated by Transparently.AI's Manipulation Risk Analyser. We define large developers as being those in the top four deciles of all companies global by market cap at the end of each accounting period.
The list of the large developers varies from year to year depending on stock-market performance. In 2022, there were just 31 companies in the list compared with 117 in 2016. Unsurprisingly, the bear market has thinned the ranks of the large Chinese developers.
The average manipulation risk score of the large Chinese developers in 2022 was 28.8%, the third-highest score since 2004. The average risk score has risen since 2014. The median manipulation risk score was 28.0%, the highest on record. The median risk score has also risen since 2014.
Some might say that a score under 30 is actually not bad, given that the MRA runs on a scale of 100 (with top of the range meaning the greatest probability that a company is at risk of failure because of accounting manipulation).
We would hasten to point out that, on average, large Chinese developers have a manipulation risk score three times higher than equivalently sized global companies.
In fact, the risk score of the Chinese developers remaining in this group has worsened significantly more than the chart suggests because a large number of the worst-performing property companies, almost three quarters of the list, have exited the list since 2016.
On average, large Chinese developers have a manipulation risk score three times higher than equivalently sized global companies
As the poorest quality companies exit the list, the average and median risk scores should fall. The fact that they have risen means that the manipulation risk score of the highest quality Chinese developers has risen sharply since 2016.
Based on this evidence, we conclude that the joint probability of account manipulation and business failure among large Chinese developers has not improved through the bear market.
Normally, a downturn in any industry leads to accelerated structural reform in the firms that survive. With the large Chinese firms, this has not occurred because the better quality firms have been encouraged to purchase land from weaker developers or, in some cases, from cash strapped local governments.
Thus, for the larger Chinese property firms that have survived the turmoil, we would argue that, taken as a whole, they have significantly higher manipulation risk scores today than prior to the onset of the property downturn. Moreover, they exhibit high accounting manipulation risk in relation to their size.
The bottom line: Large Chinese developers are still risky, despite signs this year that China’s physical property market is recovering.