Evergrande is the biggest player in the biggest industry sector (real estate) in one of the biggest economies (China) in the world and it is now almost two trillion yuan ($305 billion) in debt.
According to the company's 2020 annual report, 674 billion yuan is interest-bearing debt, which means it incurs interest of 180 million yuan every day! With only 158 billion cash to repay all its short term debt and interest, we will most likely see a major default coming...
How Did Evergrande Get In Such A Shitty Position?
- For starters, real estate developers are notoriously known to have long cash conversion cycles which means the company has tons of cash tied up in accounts receivable and inventory
- This is because it takes months, sometimes years for a project to get from an empty piece of land to a marketable building. On top of that construction is an extremely capital intensive industry, companies needs to hold a ton of equipment and supplies
- While Everygrande was already disadvantaged from the get-go due to the nature of the industry, overleveraging and mismanagement exacerbated its cash problem 10x more
- One common trick that Evergrande often used was to bid land at prices significantly higher than the market. It doesn't matter to them because the risk got transferred to the buyers and banks that finance the purchase
- There are periods in the cycle where real estate isn't a cash flow business, it's an asset appreciation business. Meaning although assets may go up in value, net income will struggle
- To address this issue, Evergrande diversified into other businesses like owning a football team, operating theme parks and developing electric vehicles, all cash-burning businesses
So What Can Evergrande Do Now?
- The real estate developer claims that they are going to liquidate their land holdings to pay back the loans
- Evergrande is so large that it will be in a race to the bottom as they sell off their properties which will lower the average price of properties in the region, lowering their asset value and thus entering into a complete spiral in the real estate market
- Besides, much of the cash that Evergrande has been able to drum up has come from presold apartments that are not yet completed. Evergrande has 800 projects across China for which 1.2 million people have already paid for the down payments
- Not only will buyers lose their deposits but Chinese contractors and suppliers will also not get paid. This will cause a tremendous blow to China's economy, a possible collapse in the market
On the 15th of September 2008, Lehman Brothers collapsed, dissolving $600 billion in US assets which led us to the worst financial crisis since the great depression. While some analysts compared Evergrande's crisis with the 2008 financial crisis, it's still hard to gauge the possible impact it'll have on the global economy.
Lehman Brothers was an investment bank, it went across the entire financial system, affecting millions of contracts with multiple counterparties. With Evergrande, it depresses the entire real estate sector which may start having a ripple effect since the sector makes up 29% of China's GDP and not to forget that China owns 15% of global debt.
Uncertainty and volatility will remain elevated but one thing is certain, there will be an extended slump in construction activity.