Evergrandizing

Wednesday Nov 03rd, 2021

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Evergrande Real Estate Group is the second largest property developer in China by sales. It is ranked 122nd on the Fortune Global 500. It is incorporated in the Cayman Islands and headquartered in the Houhai Financial Center in Nanshan District, Shenzhen, Guangdong Province, China. It was founded in 1996 by Xu Jiayin. It sells apartments mostly to upper and middle-income dwellers. In 2018, it became the most valuable real estate company in the world.

I'd like to start off by saying that I'm not a global macro guy. I'm not even a Canadian macro guy. I'm still trying to figure out what exactly I am, but in this context it's Canadian micro and consumer psychology that have inspired me once again to write something down. The reason I need a disclaimer like this is because I do believe what's happening with Evergrande will become significant to the global macro, but I'm not really remotely qualified to understand or explain why.

Setting that aside and understanding the systemic risk, macro risk and recessionary consequences that could happen as a result of Evergrande's position. This position is frequently compared to Lehman Brothers, solely because the debt magnitude is around $300BN. This comparison ignores the reality that the global monetary system has increased nearly 10x since Lehman Brothers, and it has nearly doubled within the last year. As such, the global magnitude of Evergrande may not be as massive as Lehman Brothers once was.

This is not to say that the domestic magnitude will be insignificant. Furthermore, Evergrande conducts the majority of its business activity in China, not America. China's economy would appear oligopolistic, similar to the Canadian economy, rather than the US economy, which had more than two thousand financial institutions at the time of Lehman Brothers. This oligopolistic similarity is what makes it so interesting to watch, from my perspective. In China, the oligopolistic systems evolved with their direction toward communism, which I'll get to in a minute.

I find important to examine this outside of the institutional and capital markets scope. This is important because I represent small- and mid-cap real estate investors and owners. If risk is apparent, it could impact them if realized. This risk could also impact my investors if it is not realized, in such that it impacts the consumer psychology around real estate investment. If Lehman Brothers taught us anything, it's that the institutions will almost always walk away unscathed, but toxic financial stress can impact those who are not protected by scale. Below are a few examples of why I think Evergrande is significant to Canadian real estate, beyond that obvious systemic and macro risk.

I use these examples with the assumption that Chinese Capital is the greatest source of Foreign Direct Investment (FDI) into Canadian real estate, and that their parallels in China and Canada could ultimately create a meaningful impact in sentiment.To be honest, it's been made impossible to verify whether or not China is the largest FDI source in Canadian real estate, which is why I stipulate that this is an assumption.

The nature of banking oligopolies:

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China's banking system, under the People's Bank of China (PBOC) is divided into four "state" banks, although their nomenclature implies their specialization is sectoral, not geographic. These four banks, colloquialized as the "BIG 4" (sound familiar?) represent the vast majority of the Chinese financial system. For better or worse, how Evergrande ultimately shakes out will provide some insight into the strength of a seemingly oligopolistic banking system against the financial stress of massive real estate institutions and credit.

 

City growth outsizes state growth:

Asset and development failures in SEZ's (special economic zones) could be illustrative of the long-term unsustainability of fast-growing cities in global markets. To my understanding, Special Economic Zones (CEZ's) basically evolved because Marx theorized that a great communist system had to be built upon a prior capitalistic system - and these areas were designated for that type of activity, with the objective of building a foundation for greater success in a subsequent rollout of communism.

It turns out China is really good at capitalism.

Essentially, this allowed their growth to far outpace the remainder of the market, which caused massive anomalies in their property values in an asset class that has been traditionally tethered pretty reliably to geography (location, location, location.)

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It could be argued that Canadian real estate gets its sustainable competitive advantage here because it is so bound in bureaucracy that it couldn't expand at the same rate as China's SEZ's.

Naked, levered calls on real estate

Apparently, Evergrande has 1.5M pre-sale units not yet completed, with buyers deposits hanging in the balance. Canada has a very similar system of funding residential development, by pre-selling property in phases, insuring the buyer's deposits as collateral against the construction. Functionally, this gives purchasers the opportunity to buy an options contract on the housing product, while providing the seller of the call (developer) the ability to leverage the capital they've raised from the sale of the option.

As with the banking system and the growth of cities, the sentiment around property options contracts will be correlated with their fate in Evergrande's fallout. This sentiment would primarily impact Chinese FDI and Chinese-Canadian capital, which has been considered responsible for a good portion of the strength in Canada's housing market.

The Bull Case

Alternatively (and I honestly consider this the most likely scenario) is that any pain Evergrande feels in China could actually create a flight to quality into Canadian real estate.

"A flight-to-quality, or flight-to-safety, is a financial market phenomenon occurring when investors sell what they perceive to be higher-risk investments and purchase safer investments."

We already know that FDI does see Canadian real estate as a safety asset in the global context. Remembering the pre-covid tensions in Hong Kong also evidences some propensity for capital flight into the commonwealth as a result of instability. Compounding this and operating on the aforementioned assumption that China is, at the very least, one of the top 3 FDI sources in Canada, this entire fiasco could actually have a profound positive impact on Canadian real estate.


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