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For those who have been following the markets for the past few months, you may be aware of news out of China that has been making shockwaves throughout the financial system, the potential collapse/default of Evergrande.
For those who have never heard of this real estate giant, and to be truthful I never knew about them until recently, the Evergrande Group is China’s second largest private sector real estate developer.
Evergrande accumulated large swaths of land and began an aggressive campaign to build entire cities.
A cautionary tale.
Enjoying the economic boom of China, Evergrande got ahead of itself, building these cities assuming that the population will continue to expand and want to live in these areas.
We all know what can happen when you assume something, you make an ass out of u and me.
This was definitely a classic example of putting the cart in front of the horse (ass).
By constructing buildings for anticipated, and not actual, demand, Evergrande was clearly placing a massive bet on the future.
As you and I both know, when betting you have winners and you have losers.
The problem with Evergrande making this bet was that they were not playing with their money or even house money (a fitting term for this subsequent housing crisis).
No, Evergrande chose to build these massive cities using leverage, i.e. debt.
[Perhaps they took my new view of using debt in these uncertain times a bit too far.]
A Field of Nightmares.
Unlike the Field of Dreams, Evergrande did indeed build it but no one came.
Instead of the ghosts of baseball legends appearing on the newly built baseball field, what ended up happening was the phenomenon of “Ghost Cities.”
Imagine 65 MILLION properties vacant after a massive construction phase and you can see the scope of the problem.
All those empty properties are not only not bringing revenue from leases/rent, but they are also incurring additional running costs, further exacerbating the financial predicament Evergrande found itself in.
All that highly leveraged debt also needed to be serviced, but with no cashflow coming, in the writing was already on the wall.
When a butterfly flaps its wings…
So why would a collapse of a real estate giant in China have any material financial impact on other countries, especially the US?
The problem lies with the scope of the debt Evergrande had created.
In June 2021 Evergrande had $88 BILLION in debt.
When you analyze where a lot of this money came from, you begin to realize the global scope of this financial catastrophe.
Big name investment firms, including the largest asset manager, BlackRock Inc, which manages over 9 TRILLION investment dollars, supplied money for Evergrande’s building spree.
When it was finally announced that Evergrande could not service its debt requirements, it set off a cascading chain of events throughout the financial markets.
When Evergrande did not send money to cover the loan interest, some lenders found themselves unable to meet their own financial obligations and the cycle continued downhill.
Even if the actual financial hit to the US economy turns out to be less than anticipated, we know how markets operate, namely on sentiment.
Panic selling to front-run the presumed financial collapse subsequently leads to sharp market downturns such as what we have seen recently.
It becomes a self-fulfilling prophecy and only when the bloodbath ceases will we be able to pick ourselves up and analyze the damages and find buying opportunities (the majority of times in situations like this the market overreacts and these company valuations drop far below book value).
What can we learn from Evergrande?
There are a few points that I think we can extrapolate from the corporate level to the personal level.
1. Some corporations, and some individuals, feel that they are “too big to fail.”
As the Evergrande fiasco exemplifies, this is not the case.
Leaders in certain fields become replaced as more maneuverable competitors can capitalize in market changes.
This can lead to companies being “Blockbustered” when upstarts like Netflix enter the scene.
Likewise, as an individual your reign at the top of the mountain can be short-lived as other individuals vie for that coveted spot.
2. Leverage can be a double-edged sword.
One of the great things about direct real estate investing is that you can magnify returns through leverage.
When assets appreciate this is indeed a winning formula
However when the converse happens, you can find yourself on the hook for the entire amount.
3. Don’t count your chickens before they hatch.
Evergrande tried to get ahead of the curve and build buildings for presumed population growth/migration that never happened.
Likewise an individual can find him or herself in hot water if they try to anticipate what might occur and go all in.
No one could predict a national eviction moratorium during the pandemic.
Landlords that were over-leveraged could find themselves in hot water if their renters chose not pay their rents.
With no recourse to evict these tenants and replace them with ones that could pay, the burden of debt fell squarely on the landlord’s shoulders.
It is nice to think/fantasize that if I own 10, 25, 50, or 100 doors I will collect X amount of dollars.
But until those dollars hit your bank account it is all in theory and one unexpected event can bring the whole house of cards down.
If you are in search of financial help, please consider enlisting the service of any of the sponsors of this blog who I feel are part of the “good guys and gals of finance.”
Even a steadfast DIY’er can sometimes gain benefit from the occasional professional input.
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