Chinese developers bet on higher returns with mezzanine loans

Hong Kong

CHINESE property companies are increasingly tapping expensive mezzanine loans as they seek out higher returns, a trend that could undermine government efforts to cool the country's booming real estate sector and rein in debt.

Many developers are turning to offshore mezzanine loans as government measures to tighten credit and clamp down on shadow banking in China are increasingly felt, according to lenders. Others are taking out the loans for M&A activities or to raise working capital that would allow them to prolong construction periods in hopes that the government will lift price caps on new projects, the lenders say.

For more than a year, China has limited financing for and capped the selling prices of new apartments to rein in an overheated property sector. That has left many developers, especially small to medium-sized ones, struggling to find cash to stay afloat.

"From September last year, mezzanine demand has started to build," said Stuart Jackson, chief executive of InfraRed NF, a Hong Kong-based real estate investment manager. He said that demand in the high-interest loans increased when liquidity was tight.

Mr Jackson said his firm was in talks with Chinese developers with a total borrowing demand of US$800 million, the highest level in seven years. He said liquidity tightening had also allowed InfraRed to lend to developers who would normally access cheaper bank loans in normal market conditions. The developers are often mid-tier players and unable to compete against bigger rivals for credit.

Mr Jackson said that some of the companies could be vulnerable to acquisition by bigger players if they did not raise capital to keep their business going. InfraRed is now talking to two smaller cap developers listed in Hong Kong for loans for a residential project in Guangzhou and an eastern city of Yangzhou at interest rates of 15 per cent to 18 per cent.

Mezzanine debt is a hybrid of debt and equity financing that gives the lender the right to convert to an equity interest in the company in case of default, after other senior lenders are paid. Often unsecured, it typically demands a much higher yield than senior debt.

While many developers have been eager to ramp up new apartment launches to boost cashflow in the past few months, the prospect that price caps are unlikely to be removed any time soon has prompted some to delay sales further, even at a high cost.

Major cities imposed price limits on pre-sales in 2016 to cap the selling price for developers at a certain percentage increase over a neighbouring development.

That resulted in a suppression in primary home prices of around 15 per cent compared with the secondary market, Mr Jackson said, citing data from property researcher Soufun. He explained that developers were attracted to the mezzanine loans to tide them over because the cost of the financing was still less than the lower profit incurred from a discount on a whole new property development.

Other borrowers and lenders are turning to mezzanine loans in the expectation that high property prices in China will continue to rise.

"When the asset value provides enough cushion, it gives more incentive for the borrower to pay high interest to get the deal done," said Stanley Ching, senior managing director at CITIC Capital.

Huatai Financial Holdings, a major mezzanine lender in Hong Kong, has invested around US$500 million of its principal capital into mezzanine debt that has helped complete deals worth a total of US$1.5 billion.

Ryan Chung, executive director at Huatai, said companies want to borrow more money when there are more merger and acquisition activities available.

"Given asset valuations are at a high, there's more demand for higher leverage to maintain equity returns compared to the past," said Mr Chung.

But CITIC's Mr Ching also cautioned about the higher risk that comes with mezzanine loans in case of a market downturn. "Mezzanine debt has a high risk unless the project is very profitable. Property price growth projection is lower than before, so the risk is very high," he said.

Mr Jackson said InfraRed adopts stress tests on the cashflows of borrowers and only lends to developers with projects that would be able to withstand price drops of 20 to 25 per cent. REUTERS