Just as we are spasmodically recovering from the Covid-19 pandemic, the potential collapse of the world’s most indebted property developer — China Evergrande Group — threatens the global macroeconomy. Between September and November 2021, Evergrande - China’s second largest property developer – narrowly averted three defaults on its US$-denominated bond coupon payments by remitting an aggregate US$277 million on the eve of the expiry of the 30-day grace period.
This is despite Evergrande reporting around $1.34 billion profits after tax in the first half of 2021 and $11.15 billion cash as recently as June 30 2021.
Ticking time bomb
The Evergrande crisis was a disaster waiting to happen. Founded in 1996 at Guangzhou, China, Evergrande expanded swiftly, financing its growth with debt and pre-sales, which is cash collected in instalments by property developers before the completion of construction and handover of units to buyers.
Evergrande engaged in unrelated diversification. The company sold bottled water, owned China’s best professional soccer team, briefly engaged in pig farming, manufactures electric vehicles and also sold wealth management products to investors, employees and home buyers.
By June 30 2021, Evergrande’s liabilities stood at a mind-boggling $252 billion equivalent to 1.5 per cent of China’s GDP.
Evergrande’s situation was by no means unique. China’s property sector propelled by low-cost debt grew exponentially, which in turn turbo-charged the country’s GDP growth. The slowdown in the property sector, which accounted for 30 per cent of GDP, coincided with the onset of Covid-19.
Three red lines
China’s central bank, the People’s Bank of China, and the state construction regulator, Ministry of Housing and Urban-Rural Development, decided to rein in property developers’ debt by introducing the ‘three red lines’, which are indicators of property developers’ indebtedness and liquidity.
Funding, which was critical to the developers who failed to comply with one or more of the three red lines, was restricted (Table 1). This, expectedly, resulted in multiple property developers including Evergrande, Fantasia, Sinic, and Kaisa struggling to service their debt punctually.
Applying 3 red lines to India
The real estate industry is cyclical and reliant on debt. Hence, testing the 10 largest listed Indian realty companies — all constituents of the S&P BSE Realty Index — for compliance with the ‘three red lines’ is illuminating (Table 2). Only one developer — Sunteck Realty — complied with all ‘three red lines’ in FY2021. Seven developers have complied with one or two red lines. Two developers — Indiabulls Real Estate (IBREL) and Sobha — failed to comply with all ‘three redlines’.
Opaque credit ratings
The investment grade domestic credit ratings assigned to IBREL and Sobha belie the concerns raised by a rudimentary exercise like the three red lines (Table 3). IBREL and Sobha are rated ‘AA- with developing implications’ and ‘A+ with stable outlook’ respectively.
The strengths of the two highest rated (‘AA’) developers, Mahindra Lifespace and Godrej Properties — low indebtedness and backing of strong conglomerates — are moderated by their losses. Mahindra Lifespace reported losses in FY2020 and FY2021, while Godrej Properties reported losses in FY2021.
The conflicting results of the ‘three red lines’ exercise and investment grade ratings are not alarming because ratings are opinions of borrowers’ ability to repay debt promptly. But the quality of Indian listed entities’ disclosures and opaque domestic credit rating methodologies are concerns.
Need to improve disclosures
Real estate is an industry characterised by a wide schism between an entity’s cash flows and accounting profits.
Accounting policies in most jurisdictions require property developers to report income and expenditures according to the ‘percentage completion method’, which means incomes and expenditures are ‘recognised’ as a percentage of the projects completed during a reporting period.
Hence, it is possible for property developers to report profits when pre-sales decline and vice-versa. This explains the contradictory phenomena of Godrej Properties and Mahindra Lifespace reporting losses amidst rising sales.
Oberoi Realty, for instance, did not report pre-sales. Other developers reported metrics such as new sales booking, new sales, sales, and pre-sales, which may or may not be synonymous. The consistency, frequency and quality of disclosures of listed Indian corporates lag those domiciled in countries at a comparable stage of development — Indonesia and The Philippines.
SEBI, the National Financial Reporting Authority, and the Institute of Chartered Accountants of India should jointly lay down guidelines that will improve the quality of disclosures.
Regulators must specify a set of operating and financial metrics that listed companies must report annually for the current year and the previous four years. Listed entities must also mandatorily report their standalone and consolidated profit and loss account, balance sheet, cash flow statements, and supporting notes to accounts at least semi-annually.
Adopting global best practices
Assigning credit ratings is a quantitative and qualitative exercise that incorporates multiple factors such as an entity’s current and projected operating and financial performance, management quality and operating environment. Credit rating agencies (CRAs) assign ratings based on public and material non-public information.
Credit rating methodologies must be transparent for investors and regulators to concur or disagree with ratings.
SEBI should require CRAs to adopt global best practices. The rating methodologies of the three largest global CRAs — Fitch, Moody’s and S&P — delineate the key rating factors and the weights assigned to each of them.
For instance, Moody’s ‘Construction Rating Methodology’ assigns 25 per cent weight each to scale and business profile, 30 per cent to leverage and coverage, and 20 per cent to financial policy.
For factors that may be quantified like scale and leverage and coverage, ranges are provided for each rating category (Table 4). Domestic CRA methodologies outline key rating factors that are similar to those of international CRAs; but weights and ranges for quantitative factors are not reported.
SEBI should also require domestic CRAs to emulate international CRAs by reporting standalone and final credit ratings. For instance, domestic CRAs must report standalone credit ratings for companies like Mahindra Lifespace and Godrej Properties, the number of notches upgrade assigned to reflect the support of their controlling shareholder(s), and the final credit ratings.
It is in India’s self-interest to adopt a timely, accurate, and transparent disclosure regime and robust credit rating frameworks. The benefits are numerous including improved franchise, identification of key risks and hedging mechanisms, realistic valuations of assets and financial instruments, and higher FDI inflow.
The writer, a CFA, is the Singapore-based head of research at Korea Development Bank. Views expressed are personal