Debt overreliance poses crash risks for property developers

Recent study explores the impact of overborrowing on the risk of stock prices crashing among Chinese real estate firms and how the “three red lines” can create some stability

By Ellis Ng

In the past few decades, people across China have grown more and more interested in owning homes and in growing their savings by buying and selling shares in real estate developers. Real estate development is a major pillar of the economy of Mainland China, accounting for more than a quarter of its gross domestic product.

However, the growth of this sector has long been fuelled by debt, with media referring to it as the “grey rhino” of outstanding loans worth 47.8 trillion Chinese yuan (US$7.41 trillion) in the first quarter of 2020. As much as 46 per cent of the US$139 billion in US$ bonds trading at distressed prices around the world at the time were issued by Chinese real estate developers, with China’s Evergrande Group notably being the most indebted firm before eventually defaulting on its debt in 2021.

Following a Hong Kong court order for its liquidation in January 2024, Evergrande’s shares on the city’s bourse fell from a peak above HK$25 in 2020 to just a few cents now. Other major developers like Country Garden, Kaisa Group, Fantasia Holdings and Sunac Holdings have had to deal with similar liquidity crunches and crashes, although perhaps not as devastating.

“The three red lines policy has effectively lowered the risk borne by real estate firms as these firms are more cautious in managing debts, resulting in a lower likelihood of firms suffering from share price crashes.”

Professor Desmond Tsang

A recent paper titled Firm leverage and stock price crash risk: The Chinese real estate market and three-red-lines policy finds that real estate firms that rely heavily on debt financing face substantially higher risks of abrupt and severe stock price crashes. Co-authored by Desmond Tsang, Associate Professor of Real Estate at the School of Hotel and Tourism Management at the Chinese University of Hong Kong (CUHK) Business School, Chu Xiaoling of the University of Macau and Deng Yongheng of the University of Wisconsin-Madison, the study offers a new way to look at China’s struggling real estate developers and explores how the “three red lines” have helped lower the risk of stock price crashes.

The study found that leverage exerts a positive and significant influence on the risk of crashes in share prices. The more leverage that firms have (i.e., the more reliant they are on debt to finance operations and growth), the greater the likelihood of their shares crashing.

From theory to reality

“Crash risk is a precursor of default, and hence, even as our paper focuses on crash risk, it has implications for the total risk borne by real estate investors in general,” says Professor Tsang.

The dangers of such huge levels of debt were not lost on the Chinese government, which in 2020 moved to deleverage the sector with its three red lines rule to regulate how developers take on debt. The rules require developers to keep a debt-to-asset ratio (excluding advance receipts) of less than 70 per cent, a net debt ratio of less than 100 per cent of equity, and a cash-to-short-term debt ratio of more than 100 per cent.

The three red lines sought to tighten credit and halt speculation, reducing the risk of share price crashes not just for real estate developers but for any high-leverage sector, Professor Desmond and his co-authors wrote. The rules have led to firms deleveraging and introduced more stability and sustainability over the long run as a net positive effect.

Chinese real estate firms have traditionally relied more heavily on debt financing than firms elsewhere and use more borrowed money to fund operations and growth, the study showed. Investors worried about overly indebted firms defaulting on their debts and were quick to abandon their shares, leading to crashes in share prices.

“Prior research has shown that weak institutional protection is conducive to managers making more aggressive actions,” says Professor Tsang. “Our findings consistently indicate that in regions with weaker institutional environments, the impact of leverage on crash risk is greater, meaning that managers’ actions bear more significant consequences when the institutional environment is weaker.”

As Beijing loosens restrictions and pumps in new funding to revitalise the sector, Professor Tsang hopes that firms will be more judicious with their debt. “We foresee after the lesson, real estate firms hopefully will be more prudent in managing their debt policies, such that crises like these would happen less in the future for the Chinese real estate market,” he says.

Reducing crash likelihood

The researchers used a difference-in-differences analysis to compare Chinese real estate firms with a debt-to-asset ratio above the 70 per cent red line threshold to less-leveraged firms. The analysis found that the policy has decreased the risk of sudden share crashes, more so for these high-leveraged firms.

An even stronger correlation was visible when all three red line measures – debt ratios, cash-to-short-term debt ratios and interest coverage ratios – were considered together. The combined measures were more strongly and significantly correlated with crash risk magnitude and probability. “In short, the three red lines policy has effectively lowered the risk borne by real estate firms as these firms are more cautious in managing debts, resulting in a lower likelihood of firms suffering from share price crashes,” says Professor Tsang.

While the three red lines rule has at least partially contributed to Evergrande’s defaults by limiting its borrowing capacity and forcing it into a downward leverage-induced spiral, the new policy has mitigated the likelihood of future share price crashes, the paper argues.

Lower trust, more volatility

The researchers also found that the most significant negative effects of leverage on share price crash risk were concentrated in regions with lower social trust, fewer market-oriented reforms and slower economic growth.

Investors in provinces with lower levels of enterprise trust are more sceptical of company reports and financial statements and, in turn, quicker to sell shares at the first sign of trouble, leading to greater share price volatility. Similarly, in provinces with slower economic growth, concerns about default risk were more prominent.

Professor Tsang is hopeful that crises like the one Evergrande experienced will become less common going forward. “As the institutional environment improves, investor confidence will grow and firms will have more opportunities,” Professor Tsang adds.