Alvin M. Keeling As we recover spasmodically from the Covid-19 pandemic, the potential collapse of the world’s most indebted real estate developer – China Evergrande Group – threatens the global macroeconomy. Between September and November 2021, Evergrande – China’s second-largest real estate developer – narrowly avoided three defaults on its US dollar-denominated bond coupons by paying a total of US $ 277 million on the eve of expiration. the 30-day grace period.
This despite the fact that Evergrande reported around $ 1.34 billion in after-tax profit in the first half of 2021 and $ 11.15 billion in cash as of June 30, 2021.
Time bomb
The Evergrande crisis was a looming disaster. Founded in 1996 in Guangzhou, China, Evergrande grew rapidly, funding its growth through debt and pre-sales – cash collected in installments by real estate developers before construction was completed. and handing over units to buyers.
Evergrande has embarked on independent diversification. The company sold bottled water, owned China’s top professional soccer team, briefly engaged in pig farming, made electric vehicles, and also sold wealth management products to investors, employees and home buyers.
As of June 30, 2021, Evergrande’s liabilities stood at $ 252 billion, or 1.5% of Chinese GDP.
Evergrande’s situation was by no means unique. China’s real estate sector, propelled by low-cost debt, has grown exponentially, which in turn has boosted the country’s GDP growth. The slowdown in the real estate sector, which accounted for 30% of GDP, coincided with the onset of Covid-19.
Three red lines
The central bank of China, the People’s Bank of China, and the state building regulator, the Ministry of Housing and Urban and Rural Development, have decided to curb the debt of real estate developers by introducing the “three red lines”. », Which are indicators of real estate developers’ indebtedness and liquidity.
Funding, which was essential for developers who did not meet one or more of the three red lines, was limited (Table 1). This, as one would expect, led several real estate developers, including Evergrande, Fantasia, Sinic and Kaisa, to struggle to pay off their debt on time.
Apply 3 red lines to India
The real estate industry is cyclical and dependent on debt. Therefore, the test of compliance with the “three red lines” of the 10 largest listed Indian real estate companies – all constituents of the S&P BSE real estate index – is enlightening (Table 2). Only one developer – Sunteck Realty – has complied with the “three red lines” in fiscal 2021. Seven developers have complied with one or two red lines. Two developers – Indiabulls Real Estate (IBREL) and Sobha – did not respect the “three red lines”.
Opaque credit ratings
The domestic investment grade credit ratings assigned to IBREL and Sobha belies concerns about 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 developers (“AA”), Mahindra Lifespace and Godrej Properties – low leverage and support from strong conglomerates – are moderated by their losses. Mahindra Lifespace reported losses in fiscal 2020 and fiscal 2021, while Godrej Properties reported losses in fiscal 2021.
The conflicting results of the “three red lines” exercise and investment quality ratings are not alarming, as ratings are opinions on the ability of borrowers to repay their debt quickly. But the quality of information provided by Indian listed entities and opaque national credit rating methodologies are cause for concern.
Need to improve disclosures
Real estate is an industry characterized by a large schism between an entity’s cash flow and accounting profits.
Accounting policies in most jurisdictions require real estate developers to report income and expenses using the “percentage complete method”, which means that income and expenses are “recognized” as a percentage of projects completed over the course of the year. a reporting period.
Therefore, it is possible for real estate developers to report profits when presales go down and vice versa. This explains the contradictory phenomena of Godrej Properties and Mahindra Lifespace declaring losses in the midst of increased sales.
Oberoi Realty, for example, has not declared any presales. Other developers have reported metrics like new sales bookings, new sales, sales, and presales, which may or may not be synonymous. The consistency, frequency and quality of information provided by listed Indian companies are lower than those domiciled in countries at a comparable stage of development – Indonesia and the Philippines.
The SEBI, the National Financial Reporting Authority and the Institute of Chartered Accountants of India are expected to jointly establish guidelines that will improve the quality of disclosures.
Regulators must specify a set of operational and financial measures that listed companies must report annually for the current year and the four preceding years. Listed entities must also declare their autonomous and consolidated profit and loss account, their balance sheet, their cash flow statements and the notes to the accounts at least semi-annually.
Adopt global best practices
The attribution of credit ratings is a quantitative and qualitative exercise that integrates multiple factors such as the current and projected operational and financial performance of an entity, the quality of management and the operating environment. Credit Rating Agencies (CRAs) assign ratings on the basis of public and material non-public information.
Credit rating methodologies must be transparent so that investors and regulators agree or disagree with the ratings.
SEBI should require rating agencies to adopt global best practices. The rating methodologies of the three largest global rating agencies – Fitch, Moody’s and S&P – define the main rating factors and the weightings assigned to each of them.
For example, Moody’s “Construction Valuation Methodology” assigns a weight of 25% to each at scale and company profile, 30% to leverage and coverage, and 20 % to financial policy.
For factors that can be quantified such as scale, leverage and coverage, ranges are provided for each rating category (Table 4). The methodologies of national rating agencies describe key rating factors that are similar to those of international rating agencies; but the weights and ranges of the quantitative factors are not indicated.
SEBI should also require national rating agencies to mimic international rating agencies by declaring stand-alone and final credit ratings. For example, national rating agencies must report stand-alone credit ratings for companies such as Mahindra Lifespace and Godrej Properties, the number of upgrade notches awarded to reflect the support of their controlling shareholder (s) and final credit ratings.
It is in India’s interest to adopt a timely, accurate and transparent disclosure regime and strong credit rating frameworks. The benefits are numerous, including improved deductibility, identification of key risks and hedging mechanisms, realistic valuations of assets and financial instruments, and greater inflow of FDI.
The writer, a CFA, is the Singapore-based research director at the Korea Development Bank. Opinions expressed are personal
