After years of rapid growth, the Chinese economy is now starting to lose the momentum that has made it the Asian economic miracle of the past 30 years. In 2018, the country’s economy grew by just 6.6 percent, the slowest growth since 1990. The slowdown has now exposed some of the weak points in the Chinese economy, one of the most notable being the real estate sector.

For the largest Chinese developers, the early years of the latest property market cycle, and the deleveraging that went with it, are now far behind them. Faced with the added pressure of rising interest rates and volatile foreign currency exchange rates between the Chinese yuan and US dollar, developers are finding it harder to service existing debt and fuel future growth.

It doesn’t help that greater scrutiny from the central government has also led to a decreasing pool of traditional funding options. As a result, private debt investors are now moving in to fill the gap as developers turn to non-traditional lenders for an alternative – specifically, US dollar-denominated offshore funds offering mezzanine and junior debt.

“[The issue of] how to protect rights in the event of default is not a commonly discussed topic but of course these need to be protected in the future”

Barry Tong

InfraRed NF Investment Advisers – a joint venture between InfraRed Capital Partners and Vervian, an affiliate of Nan Fung Group – is one example of a non-traditional lender offering capital solutions to Chinese developers. In February, the manager teamed up with Firewave Management, a unit of Singapore-based Metro Holdings, to provide Hong Kong-listed real estate developer Fullsun International with a $92 million loan.

InfraRed NF used the Hong Kong properties of Fullsun International to secure the loan along with a credit enhancement facility. In a statement, the manager said the estimated gross value of the underlying collateral is more than $380 million. The capital provided to the property developer is to be used for acquisition financing and growth capital to acquire future assets via a structured vehicle. The investment was made out of InfraRed NF China Real Estate Fund III.

Offering his view on the risk pricing and underwriting method for the loan, Grant Chien, InfraRed’s head of special situations financing, tells PDI that his team has looked at the quality of the portfolio and benchmarked their security with the last dozen assets that they have invested across China. However, Patrick Yip, a Hong Kong-based vice-chair at Deloitte China, tells PDI that these deals are also complex and are not without risks. He also questions how developers can get the money back to China when they are raising money outside the country, asking: “How are foreign lenders going to secure and liquidate their RMB-denominated collateral within China when necessary?”

Patrick Yip

Such deals can also be expensive for the borrower. Barry Tong, a Hong Kong-based national head and joint Asia-Pacific head of transaction advisory services at law firm Grant Thornton, tells PDI that some real estate developers are now paying coupon rates as high as 20 percent to attract corporate credit investors, due to the difficulties of accessing traditional funding sources. He adds: “Because of this, the real estate developers will go to fund of fund houses and mezzanine fund managers to issue convertible bonds, notes or papers.”

Hong Kong-listed China Evergrande Group – China’s second-largest property developer by sales – is a particularly high-profile case of a company that has been under pressure to raise funds to cut its sizeable debt. Last year, the firm’s chairman and founder Hui Ka Yan invested $1 billion in his own company as part of $1.8 billion corporate bond sale. China Evergrande Group is a frequent US dollar high-yield bond issuer, according to rating agent Moody’s, which gave the company a B1-rating as of January.

“We would not be able to see the intention behind the [transaction], but we do not see anything abnormal,” says Gary Lau, a Hong Kong-based managing director for the Moody’s corporate finance group, adding that the chairman’s investment was about demonstrating his personal confidence in the company to the market.

The outlook for the real estate sector is not confident. In a January report on the Chinese property sector, analysts from Credit Suisse projected lower profit margins and a potential decline in gross margin levels for some of the largest developers from the fiscal year of 2018 through to 2020. Sector analysts estimate a normalisation of profit margins among just 20 Chinese developers, including Evergrande and Country Garden.

The market has also become more concentrated, with fewer companies controlling a larger share of the sector amid industry consolidation, partly due to tightening government regulations. A statement from the Chinese State Council revealed that over half of the entire industry’s gross assets came from the 15 largest property developers in 2017, compared with 18 companies in 2016. Meanwhile, the top 53 owned more than 80 percent of the sector’s combined assets, down from 59 firms the previous year.

InfraRed NF’s Chien says his team hopes to invest more than $350 million over the next two to three years if market conditions remain and the regulatory regime continues. Although private credit fund managers and their advisers are increasingly bullish on such credit investment opportunities in the real estate sector, some still express concerns that regulatory changes may make it difficult to invest in the future.

Grant Thornton’s Tong notes that a typical deal structure for cross-border loans include vehicles incorporated in the Cayman Islands, or layers of holding companies linked to domestic Chinese companies. He adds: “[The issue of] how to protect rights in the event of default is not a commonly discussed topic but of course these need to be protected in the future.”