The profitability of property development in China is spiraling down. That's no secret. S&P Global Ratings has emphasized this phenomenon since it started about three years ago. We expect the sector's gross margin to drop by more than 8 percentage points (ppts) over the next two years, from the peak in mid-2018, with an average of 5 ppts annual decline in 2020-2022.

And we even see a risk that margins could undershoot our already-low expectations, given the hefty obstacles of government market-cooling measures and market factors. We still forecast that China's residential sales will be roughly flat in 2021, given our expectation that prices will drop by up to 5%. But this will be largely offset by growth in gross floor area.

In our view, the sector can withstand further downside. Developers are likely to more stringently control debt over the next few years under the unofficial "three red line" policy, which targets their leverage and liquidity, and "two red line" restrictions on banks' property (see "Related Research").

Our sensitivity analysis shows that ratings on more than 70% of developers will stay intact even if margins slump another 2 ppts from our current base case. Over 50% of developers could come under pressure under a second scenario of a 5 ppts point cut, an austere scenario that we view as unlikely.

Despite the general industry trend, the profitability of individual developers that we rate varies substantially. And margins are becoming an increasingly important differentiator. Those developers that can hold back the margin decline will have an extra edge. This differentiation comes from strategies around land reserves, including whether the companies have alternative sources from which to acquire land rather than just public auctions, where prices tend to be higher.

Recently announced measures on new land sales may reduce overall competition, but the contest for prime land parcels will likely intensify. Coupled with a tighter funding environment, both offshore and onshore, developers with weak fundamentals may find themselves between a rock and a hard place.

Margins Search For A Trough

Margins are falling in both higher- and lower-tier cities, but for different reasons. The average selling price for contracted sales generally can't keep up with land costs, which have been rising for years. Hence, developers are pre-selling projects while costs are still rising, further squeezing margins.

Many larger cities have price caps in place, a local administrative measure to cool the market. Demand is stronger in these cities and secondary prices might be even higher than presale prices, but developers must abide by the government's dictated price points even while land costs are rising. As such, we are now seeing projects in places like Shanghai, Hangzhou, and Nanjing that barely break even or have only single-digit margins.

In lower-tier cities away from key economic areas, on the other hand, profitability is dampening because of generally weaker demand, economic pressure, and tightening liquidity that has spurred faster presales to recoup investments.

Developers Will Stay Steadfast So Long As Margins Don't Tumble

We forecast overall debt in the sector will grow by just 7%-8% in 2021-2022, given the government has rolled out measures to constrain funding. In our view, many developers are in breach of at least one "red line," and have little leeway to legitimately incur more borrowings.

Chart 1

The less-severe scenario of a 2 ppts slump is more realistic, in our opinion, should margins further drop below our current expectation. Developers that we rate 'B+' or below will feel the brunt of the blow, given their weak cash flow generation and financial management profiles. But percentage wise, the developers most vulnerable to a downgrade are those that we rate 'BB-' to 'BB+'. That's because these companies have less financial headroom and are held to higher requirements related to leverage levels in this rating category.

Diversifying Land Banks Will Alleviate Some Pain

The strain on profitability is not a new issue, and some developers have planned early to enhance their capability to source land via channels other than public auctions. To lower land costs, alternate channels include project acquisitions, industry cooperation with local governments or other corporates, and urban redevelopment projects.

During 2016-2020, the ratio of average transacted land costs via public land auctions divided by the average selling price for China's top 100 cities surged to around 35% from 15%-20% in the earlier part of the decade. However, the average ratio of land costs divided by the expected selling price for the existing land banks of our rated developers was slightly better at 30%. The difference is likely because the average ratio of rated developers' publicly acquired land is about 60%, revealing most should have alternative means of sourcing land (see chart 2).

Chart 2

Over the next two to three years, we expect margins to decline the most for developers that have the highest historical gross margins but rely mainly on public auctions. This cohort consists of 21% of our rated developers (see chart 3); these companies bought two-thirds or more of their land reserves at public auctions, and we estimate their gross margins in 2020 were higher than the average of 26% for all the developers we rate. In contrast, margins will be more stable for those developers that buy less than one-third of their land reserves from public auctions, in our view. This group also accounts for 21% of our rated developers.

Chart 3

Funding Conditions Don't Favor Weak Players

From Jan. 1, 2021, to March 10, 2021, offshore issuance from rated developers slumped to US$12.4 billion from US$19.6 billion over the same period in 2020 (see chart 4). Average coupon rates dropped notably for issuers we rate in the category of 'BBB-' to 'BBB+' and the category of 'BB-' to 'BB+', compared with 2018-2020 (see chart 5). In contrast, coupons for bonds that we rate in the category of 'B+' or below remained at a level roughly similar to those in 2018. This suggests that risk premiums for weaker players have not shrunk as much as for their stronger peers.

Chart 4

Domestic issuance did edge up slightly to US$6 billion from Jan. 1, 2021, to March 10, 2021, versus US$5.5 billion over the same period in 2020. However, we believe the issuance momentum may not last. The default of China Fortune Land Development Co. Ltd. (unrated), a large industrial park developer, and Chongqing Sincere Property Group (unrated), a smaller developer, have caused substantial volatility in the domestic market, and may dampen investors' risk appetite for some time.

In contrast to offshore coupon rates, average coupons edged up across all rating categories for domestic issuances (see chart 6). This is also due to funding conditions normalizing from a more accommodative environment during the pandemic when monetary policy was loosened. In 2020, China's one-year to five-year government bond yield averaged 2.2%-2.7%, compared with an average of 2.6%-3% from Jan. 1, 2021, to March 10, 2021.

Chart 5

Chart 6

Could New Land Sale Policies Save Developers' Margins?

New policies on land sales and a potential increase in land supply in 2021 may help reduce overall competition. Four cities--Tianjin, Zhengzhou, Qingdao, and Jinan--announced revisions to their public land auction policies in late February. These cities will only roll out land sales in three batches across the year, instead of throughout.

According to media reports, another 18 cities including the four tier-1 cities may follow suit (see table). These cities have significant importance to China's land market since out of the top 100 cities, they accounted for 39% of auction volumes and 59% of renminbi amounts in 2020. The media also report that a potential policy may stipulate that land supply in major cities in 2021 cannot be lower than the average transacted land sales volume during 2016-2020.

Table 1

We believe it will be more difficult even for the largest developers to grab all the best land, given a more synchronized supply. Developers will need higher working capital since some local governments require deposits before bidding. More joint ventures, even among the top players, could be formed to ensure stakes in the best projects.

While this may quash overall competition, the new arrangements are unlikely to cool demand for prime projects. For example, Shenzhen implemented a preliminary measure for land supply concentration in 2020 (land sales only happened in March-June, and October-December). However, land there remains highly sought after, and may result in more cooling policies. In Nanjing, developers are limited to buy only one piece of land per batch to give smaller developers a chance. The fine print of these policies, as they become available, will likely have significant impact on these markets.

Developers with weak internal cash flow generating capabilities--that include slow asset-churn, sell-through, and cash collection--may find themselves uncompetitive under the new rules and regulations. Concentrated land sales could also result in concentrated project launches down the line. As homebuyers are faced with more choices, they could become more discerning on location, quality, and price. This could only spur the polarization of stronger and weaker players.

Related Research

• China's New Curbs On Real Estate Loans To Flatten Sales, Jan. 6, 2021
• China Property Watch: Issuers Go On A Debt Diet, Nov. 11, 2020