Debt managers eye distress deals in China

Real estate developers in China are turning to private credit managers to meet their financing needs amid a continuing liquidity crunch.

Distressed debt managers are seeing an increase in lending opportunities to Chinese developers as they grapple with limited refinancing options and a pullback in bank lending for risky investments.

Earlier in July, InfraRed NF Investment Advisers, a Hong Kong-based joint venture between InfraRed Capital Partners and Vervian, an affiliate of the Hong Kong-headquartered Nan Fung Group, closed its latest single-asset non-performing loan transaction in China.

The firm, together with two other institutions, invested $88 million via mezzanine tranches in a residential project in Yangzhou to continue to be developed by Keyne Properties. The gross asset value of the project is estimated to be $900 million, according to a company statement.

Each party’s commitment size was not disclosed, although PDI understands that the mezzanine loan is initially set for two years. Part of InfraRed’s commitment has come from the InfraRed NF China Real Estate Fund III. Fund III was launched this January with an undisclosed target. Its predecessor vehicle InfraRed NF China Real Estate Fund II raised $360 million in 2015.

“The China property market is a special situation story,” said Grant Chien, an investment director at InfraRed NF Investment Advisers.

Several changes in China’s real estate market of late have opened the doors for more distressed debt and mezzanine transactions. Firstly, rising land costs have adversely impacted developers’ operating profits.

Gary Ng, an economist at Natixis, a Paris-headquartered investment bank, says the land acquisition cost accounted for 18 percent of the total cost of developers two years ago, but as of end-May it has risen to around 28 percent.

To address this issue, China has been creating new rules on inter-provincial land transfer to end the housing price surge, according to Baoliang Zhu, chief economist and director of economic forecasting at the State Information Center.

Zhu told participants attending the Credit Suisse Asian Investment Conference earlier this year that from this year on China will change its land policies in two key ways. Chinese farmers will be allowed to use their collective land for trial projects to build more housing and rent out the units. Additionally, industrial land and land for commercial use in urban areas can be transformed to residential use.

“The new policy aims at providing more supply of land in tier-two cities where the prices are high,” he added.

In addition to a heated residential market, developers have also been facing funding pressures as banks are retreating from lending to the real estate sector.

Major commercial banks in China have faced higher credit costs during the first quarter of 2018. According to Credit Suisse’ latest equity research, these higher credit costs are due to the adoption of the IFRS (International Financial Reporting Standards) 9, which requires banks to recognise a one-time loan loss reserve adjustment for their existing loan books.

As banks record a lump sum amount for their loan loss provisions to comply with the latest accounting standards, this will leave less room to make new loans.

Furthermore, Chinese property developers are also restricted from tapping the offshore bond markets for refinancing, according to an announcement from the National Development and Reform Commission in China.

In such an environment, Chinese developers are increasingly opting to use joint venture structures with other institutions to acquire land.

Simon Wong, associate managing director of corporate finance at Moody’s, explained to PDI that since such JV structures are not recorded on balance sheets, the leverage sourced to these vehicles may not be consolidated onto the balance sheet of real estate developers.

Another recent example is that of Gaw Capital, the Hong Kong-based private equity real estate firm, that launched a JV with Shenzhen Paladin Asset Management, an investment arm of the Guangdong-based developer, Country Garden Group. PDI understands that the JV has set up a $1 billion special situations fund targeting distressed real estate assets across China.

However, the distressed investment opportunities haven’t yet extended to the non-performing loans sector. According to Credit Suisse’s report, the asset quality has continued to improve in the first quarter of this year, with lower new NPL formations recorded across ten banks in China.

In addition, industry participants tell PDI it is not clear how high the return rate should be to motivate the Chinese banks to dispose their non-performing loan (NPL) portfolios.

There is still a significant gap between the expectations of the recovery rates of the commercial banks relative to the price that distressed debt buyers are willing to pay, according to Michael Levin, a Hong Kong-based managing director at the international wealth management division of Credit Suisse and head of asset management for the Asia Pacific region.

“Frankly, I haven’t seen the pressure from those banks [in China] to sell the NPLs yet,” he said, adding that NPL funds and distressed debt players tend to have a larger amount of uninvested but committed capital from investors.