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High Stakes: Analyzing The Risks Of China’s Property Joint Ventures

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Chinese developers are increasingly partnering on property projects, to spread financial risks and reduce balance-sheet strain. However, this growing practice makes it harder for analysts and investors to determine financial risks and exposures in the property sector. S&P Global Ratings follows the paper trail of reporting on jointly controlled entities (JCEs) to identify areas in the accounts where obligations and exposures may be obscured.

The use of JCEs does not intrinsically bring risks. In our view, most developers maintain a similar leverage in these projects but are able to boost their scale while lessening investment burden at the same time.

That said, information transparency is a key issue and it's getting worse. Often times these project entities are unconsolidated and sit off-balance sheet. Hence, most companies don't provide much disclosure, let alone audited figures. This leaves room for dressing up financials, for example by hiding debt-like investments as minority interests. In a stress test whereby we reclassified a portion of minority interests as short-term debt, nearly a quarter of our rated Chinese developers would breach downside financial triggers.

JCE Use Will Only Intensify

We expect JCE use will continue to rise. By spreading financial burdens through partnerships, JCEs help the sector to stay within the "three red lines" set by authorities from the start of 2021 to prevent risky debt-fueled expansion in property. Furthermore, expected batch releases of land for sale in China will lead developers to seek more partnerships to lower funding needs as they scramble to bid for the best sites (see "China Property Watch: The Margin Slide Is Far From Over," published on RatingsDirect on March 31, 2021).

Recently, top-tier developers have started consolidating more of these entities to address investor questioning on their off-balance sheet activities; and to boost their toplines. But consolidation doesn't necessarily make the situation less opaque. In most cases, the result is an increase in minority interests on the balance sheet, which can still leave room for hidden debt. Moreover, the timing of consolidation can distort credit metrics. As such, balance sheets become bigger but actual cash inflows don't really change.

Financial analysts, including ourselves, can in many cases only approximate off-balance sheet obligations arising from JCEs. One approach is to tally the third-party guarantees banks often demand for loans; this information is available in the notes to accounts. As long as third-party guarantees to these entities roughly match the shareholding percentage of debt at unconsolidated JCEs, such risks are largely covered by S&P Global Ratings' adjusted metrics and reflected in our credit ratings.

We also proportionately consolidate earnings and debt from these off-balance sheet entities to create a "look-through" picture (see "China Developer Joint Ventures: The Case Of The Vanishing Revenue," June 10, 2020). Look-through leverage captures a more holistic picture, given both off-balance sheet debt and earnings are taking into consideration.

Partnerships Provide Wiggle Room For Financial Reporting

Accounting treatment of these entities mostly only offer a point-in-time "peephole" into their operations and leaves much room for interpretation. While developers can operate up to hundreds of JCE projects, only five items in financial statements condense the impact from these investments:

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Complexity and obscurity arise because there's more flexibility on how sales from JCE projects are reflected in financial statements. It's nearly impossible to decipher from these accounts how cash actually flows since they don't explicitly demonstrate when developers start to upstream presale proceeds from JCEs.

Analysts and investors often tally JCE-related items as a workaround to estimate the size of developers' off-balance sheet activity. However, this exercise becomes valueless if there's a netting-off of the amounts due to and due from JCEs, as is allowed in some cases. Furthermore, when developers choose not to wind up their completed JCE projects due to tax considerations, these balance sheet items will linger as deadweight and could thus increase distortions.

The accounts requirements on JCE projects are not completely opaque. For example, they must report external guarantees when banks (as is often) request these on JCE projects. Comparing these guarantees to the "share of profit" item on the income statement provides a sanity check on off-balance sheet projects. We do this to gain insight into the efficiency and profitability of developers' JCE strategy.

The amounts of equity investment to the partnerships are also reported, which helps to better track the industry trend of debt versus equity funding on JCE projects (see chart 2). That said, later we will discuss our view that some stakes classified as equity may mask loan-like financial arrangements.

Guarantees Are Somewhat A Proxy But With Exceptions

We believe our ratings methodology captures much of the off-balance sheet debt. For example, we adjust debt holdings to incorporate third-party guarantees, including those to JCEs. Among the top-30 developers with the highest use of JCEs, guarantees could account up to 30% of their adjusted debt. We've also compared the guarantee amounts from financial statements to the amount of attributable off-balance debt developers provided us on a confidential basis, and have found these to be roughly equal in a majority of cases.

Chart 1

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Often times, developers with state-owned backgrounds don't provide full guarantees (see companies marked with an asterisk in chart 1). This means guarantees wouldn't be an effective proxy and only company disclosures can help to gauge their off-balance sheet exposure. But since most state-owned companies have sound banking relationships and lower interest costs, we believe risks from their off-balance sheet activities are partially mitigated.

Some privately owned developers also under-provide guarantees to their JCEs. We calculate developers' total JCE investments against the sum of guarantees and total JCE investments; we consider analogous to equity to equity plus debt ratio. For rated China developers, the ratio usually lies in the 60%-80% range (see chart 2). A high ratio could mean the developers are not employing much guarantees, which lessens the accuracy of using guarantees as a proxy.

The more concerning trend is that some developers have started to pull back on offering guarantees to their JCE projects in recent years. While this signifies their banking relationships are strong, it also means leverage ratios would be understated without also assessing their look-through levels. As such, the transparency and data quality from these developers become even more crucial.

Chart 2

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Amounts Due To JCE Partners Could Be Material To Credit Profiles

Incentivized to meet regulatory metrics, some developers may encourage their minority JCE partners to fund their stakes via equity rather than through non-interest-bearing shareholder loans. Those shareholder loans are classified as amounts due to minority interests in the liabilities section of the balance sheet. A reduction in such loans can help developers to meet one of the three "red-line" thresholds, liabilities to assets, which is arguably the hardest to comply with. However, in our view, the improvement may be more in appearance than substance.

Nonetheless, some of these loans could become interest-bearing to developers if JCE partners inject more capital to JCEs than their attributable stakes. This essentially means developers are willing to pay interest to borrow from their JCE partners.

When these loans become interest-bearing, developers have to disclose them in the financial footnotes. About half of our rated developers have made such disclosures. JCE loans (including amounts due to minority interests, joint ventures, and associates) could be material to developers' credit profiles as they could be as high as 16% of reported debt (see chart 1). Along with guarantees, we also include interest-bearing amounts when making debt adjustments.

On the other hand, equity contributions from minority JCE partners would be classified as "minority interests" within total equity. As long as these equity contributions do not contain fixed-return mechanisms, they should have no direct impact on developers' leverage profiles. However, as there are usually fewer footnote disclosures on equity, more minority interests could further weaken a company's financial transparency.

These Arrangements Could Be Cash Drains In An Extreme Scenario

If JCEs go into financial distress without enough liquidity to finish the project, developers may need to repay their debt or reinject cash, potentially creating a liquidity drain. In a more extreme scenario, if de-facto debtors concurrently request repayment, liquidity risk could be significantly understated as true repayment terms were never disclosed.

A deeper look at the "Others" item within the financing cash flows in financial statements could signify repayment of other types of JCE-related obligations or debt. However, only the financials of "A-share" listed companies use the direct cash flow method, which provide such color. Most rated developers adopt an indirect cash flow method under international standards IFRS or GAAP, which lacks such information. When these scenarios arise, the problem could spin out of control faster than what financial statements suggest.

Playing With The Consolidation Ratio Changes The View

Most developers give guidance only on their consolidation ratios (portion of total contracted sales to be consolidated) rather than disclosing them in financial reports. However, their guidance could deviate from our own estimation using a framework (see chart 3). Historically, about three in 10 rated developers' guided consolidation ratios exceeded our estimates by 10 percentage points or more. In our view, the wider the gap, the higher the risk for developers to underdeliver on revenue later.

Chart 3

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Unless developers have ample completed inventory ready for sale and booked immediately, a higher guided ratio than our estimate would mean they may have to rely on acquiring and consolidating off-balance sheet JCEs. Low contract liabilities (an audited figure representing sold but unrecognized contracted sales) against attributable contracted sales could also indicate such risks (see chart 4).

This is a risk because developers' consolidated leverage could be understated if these originally off-balance sheet JCEs are acquired and consolidated at a late stage of development. Revenue and profit would be fully recognized on the income statement due to full consolidation, while most off-balance sheet, project-level debt would have been repaid. As a result, developers' credit metrics could be artificially strengthened.

Some signs can offer a hint of this occurrence. For example, consistent net-loss contribution from joint-ventures and associates on income statements could indicate developers are continually choosing not to recognize profit contribution from their off-balance sheet JCEs--but instead consolidating them later on.

Another scenario can arise if off-balance sheet JCEs are acquired at a net cash position (in which case sizable contract liabilities are disclosed in the footnotes of financial reports). In other words, the projects are largely sold and debt likely repaid, but revenue has yet to be recognized. Hence, there is no real cash inflow at the point of consolidation but the accounts now look bigger. In our view, this type of distortion risk is more profound than even upstreaming more cash from JCEs than their stakes.

Chart 4

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More Minority Interests, More Room To Hide Debt?

As the amount of minority interests on balance sheets steadily rose over the past years, investors have expressed concerns of whether these stakes are genuine or are in fact debt disguised as equity. We measured the median percentage of minority interests reported for rated developers as a proportion of total equity. The results show the median grew to 39% as of 2020, up threefold from 2015. A further breakdown shows that most of our rated developers fall into the bracket of 41%-50% (see chart 5). This shows that contributions from minority JCE partners is gradually becoming an important funding source for these players.

Chart 5

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Not All Minority Interests Are Created Equal

Better transparency can dispel investor concerns about minority interests. Some developers, for example, provide a breakdown of their minority interests in the footnote of their financial reports. This allows us to see that in some cases, perpetual securities issued by subsidiaries were embedded in minority interests. We include those perpetual securities in our adjusted debt.

We also believe many minority interests are created with identifiable, legitimate business reasons. Examples include a publicly listed property management firm or other subsidiaries; acquisition of major development projects with minority original shareholders; or formation of major joint-venture platforms with reputable partners.

We conducted analytical tests on rated developers with high or rising proportion of minority interests within total equity. This exercise produced mixed results:

Interests likely from a genuine equity base:   Our sample of 10 rated developers indicated that 60% of them have over 70% of minority interest contributed by (1) other property developers, (2) minority shareholders arising from urban redevelopment projects, and (3) employee investment schemes. In our view, these interests are very likely form a genuine equity base.

Interests where more data would help to clarify the structures:   However, 70% of the sample also have JCE partners such as (1) individuals, (2) non-property corporates, and (3) financial investors. This matters because some of these investments could create leeway for debt-like terms such as fixed-return mechanisms. Most developers in our sample have modest to intermediate exposure to such JCE partners varying between 3% and 20% of their total minority interests. However, some have higher exposures of 40%-75%. Although auditors consider them as equity, we continue to request and encourage developers to provide more information on the return mechanisms of such projects. On a few occasions, developers have acknowledged the existence of debt-like arrangements in such interests, and we have reclassified them as adjusted debt.

Our stress test: If we reclassify a portion of minority interest as hidden debt, more than a quarter of rated developers face downgrade pressure.   We stress-tested by recategorizing minority interests as short-term debt; we did this only for the portion of minority interest above 30% of total equity. In such a scenario, more than a quarter of rated developers could see rating pressure as leverage triggers are breached (see chart 6). The results also show that 14% of our rated developers would face liquidity constraints, with the ratio of liquidity sources to uses dropping below 1.2x, a level we would assess as less than adequate. Unsurprisingly, the majority of companies that would breach downside triggers and face liquidity pressure are rated 'B+' or lower.

Chart 6

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Disclosure, Disclosure, Disclosure

Off-balance-sheet JCEs create significant complexities in analyzing a developer's credit profile and contingent liabilities could be overlooked. However, transparency issues come down to a willingness to disclose. Among more than 30 developers which most heavily use JCEs as part of their operations, less than a handful provide supplemental information to improve transparency, such as proportionate revenue, or gross and net profit margins (proportionate debt is not disclosed).

Default rates in the sector have crept up this year under the backdrop of China's policy tightening. JCEs may only complicate matters. In a number of defaults, a common theme is that cash trapped at the project level may not be readily available for debt repayment and could be well beyond the levels suggested by "unrestricted cash" itemized in the financials. The use of JCEs could hinder cash upstream even further if partners do not cooperate. Asset disposals as a last resort to raise cash for debt repayment can be complicated if projects have multiple owners.

Regulators have already started early this year to request some developers, in a pilot program, to submit monthly leverage reports which include JCE debt and debt-like investments. Over time, more developers may have to do the same. While crucial for credit analysis, this information is not publicly available and voluntary disclosure by developers would still be the best remedy. Until greater transparency becomes a norm, stakeholders may worry that they're not getting the full picture.

Table 1

Rated Chinese Developers With Significant Exposure To JCEs
Most look-through leverage ratios are close to their adjusted consolidated counterparts
2020 financials (actual and estimates)
Short name Legal name Ratings & outlook Adjusted consolidated debt/EBITDA (*estimate) (x) Look-through debt/EBITDA (*estimate) (x)
Agile

Agile Group Holdings Ltd.

BB/Stable/-- 4.9 4.7
BCL

Beijing Capital Land Ltd.

BB+/Negative/-- 23.6 25.0
CCRE

Central China Real Estate Ltd.

B+/Stable/-- 5.1 4.6*
China Aoyuan

China Aoyuan Group Ltd.

B+/Stable/-- 7.5 7.5
China SCE

China SCE Group Holdings Ltd.

B+/Negative/-- 7.3 7.7
CIFI

CIFI Holdings (Group) Co. Ltd.

BB/Stable/-- 5.5 5.2
Cogard

Country Garden Holdings Co. Ltd.

BB+/Positive/-- 3.8 3.5 - 3.7*
COLI

China Overseas Land & Investment Ltd.

BBB+/Stable/-- 3.0 Slightly above 3*
Dexin

Dexin China Holdings Co. Ltd.

B/Stable/-- 7.2 5.5*
Gemdale

Gemdale Corp.

BB/Stable/-- 3.7 4.2*
Greentown

Greentown China Holdings Ltd.

BB-/Stable/-- 10.9 10.0*
Jiangsu Zhongnan

Jiangsu Zhongnan Construction Group Co. Ltd.

B+/Stable/-- 5.7 4.9*
Jingrui

Jingrui Holdings Ltd.

B/Stable/-- 7.7* About 7.0*
Jinke

Jinke Property Group Co. Ltd.

BB-/Stable/-- 5.3 4.7
Jinmao

China Jinmao Holdings Group Ltd.

BBB-/Negative/-- 8.9 above 9
Kaisa Kaisa Group Holdings Ltd. B/Stable/-- 6.6 7.4*
KWG

KWG Group Holdings Ltd.

B+/Stable/-- 9.1 6.6
Landsea Green

Landsea Green Properties Co. Ltd.

B/Stable/-- 7.3 7.3
Languang

Sichuan Languang Development Co. Ltd.

B-/Watch Neg/-- 6.5 Above 6.5*
Logan

Logan Group Co. Ltd.

BB/Stable/-- 3.7 3.8
Poly

Poly Development Holding Group Co. Ltd.

BBB/Stable/-- 4.0* Above 4*
Powerlong

Powerlong Real Estate Holdings Ltd.

BB-/Stable/-- 4.8 4.7
Radiance Holdings

Radiance Holdings (Group) Co. Ltd.

B+/Stable/-- 6.3 5.7*
Redco

Redco Properties Group Ltd.

B/Stable/-- 8.9 Above 9
Ronshine

Ronshine China Holdings Ltd.

B+/Negative/-- 9.7 9.1
Seazen

Seazen Group Ltd.

BB+/Stable/-- 3.5 3.3
Shimao

Shimao Group Holdings Ltd.

BBB-/Stable/-- 3.9 4.2
Sunac

Sunac China Holdings Ltd.

BB/Stable/-- 4.4 4.0
Times

Times China Holdings Ltd.

BB-/Stable/-- 6.2 5.6*
Vanke

China Vanke Co. Ltd.

BBB+/Stable/-- 2.6* 2.7*
Yanlord

Yanlord Land Group Ltd.

BB-/Stable/-- 5.0 5.8
Zhongliang

Zhongliang Holdings Group Co. Ltd.

B+/Stable/-- 5.0 4.2*
Note: Look-through EBITDA proportionally consolidates joint ventures. Consolidated ratios are adjusted to include loan guarantees and the interest-bearing portion of loans to joint ventures, minority interests, and related parties. *All figures actual unless marked with asterisk to designate estimates. Source: S&P Global Ratings.

Digital design: Evy Cheung

Editing: Cathy Holcombe

Related Research

This report does not constitute a rating action.

Primary Credit Analysts:Edward Chan, CFA, FRM, Hong Kong + 852 2533 3539;
edward.chan@spglobal.com
Esther Liu, Hong Kong + 852 2533 3556;
esther.liu@spglobal.com
Secondary Contacts:Christopher Yip, Hong Kong + 852 2533 3593;
christopher.yip@spglobal.com
Fan Gao, Hong Kong + (852) 2533-3595;
fan.gao@spglobal.com
Research Assistant:Coco Yim, Hong Kong

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