S&P: Longfor Outlook Revised To Positive On Improving Debt Leverage, Growing Recurring Rental Income, 'BBB-' Rating Affirmed

S&P Global Ratings today revised the rating outlook on China-based property developer Longfor Properties Co. Ltd. to positive from stable. At the same time, we affirmed our 'BBB-' long-term corporate credit rating on Longfor and the 'BB+' issue rating on the company's outstanding senior unsecured notes.

The positive outlook reflects our view that Longfor's debt leverage will continue to improve and stabilize over the next two years. During the same period, we project that the company's recurring rental income will continue to strengthen, underpinned by new mall openings and positive rental reversion (or higher rents on expiry of leases).

In our view, Longfor's controlled expenditure and prudent financial management mean the steady growth in its property development and investment property segments should not put too much pressure on its leverage. Our base case therefore assumes that the company's debt-to-EBITDA ratio should strengthen towards 3x in 2018 and remain below 3.5x for 2019. The ratio was 3.5x in 2017, better than our forecast due to higher-than-expected revenue and margin.

While rental income may not fully cover Longfor's interest expenses in 2018, it should fully do so over the next two to three years; coverage was around 0.76x in 2017. We view this stream of income to be less volatile than that from property development, suggesting the company's earnings quality is improving.

Longfor is likely to continue to demonstrate balanced business growth and financial discipline. Through numerous cycles, the company has managed to control its financial leverage below 4x while growing its contracted sales to Chinese renminbi (RMB) 156 billion in 2017, from RMB55 billion in 2015. At the same time, its investment property portfolio has progressively expanded. Rental income steadily increased to RBM2.6 billion in 2017, from RMB1 billion in 2015. This is in contrast to many peers, which heavily relied on debt-funded scale expansion in the past few years.

Nevertheless, the fast expansion into rental apartments could increase Longfor's execution risk, in our view. The profitability of these apartments is considerably lower than for the other two property segments, and competition is intensifying as many developers are entering this market. We expect the cost of obtaining new sites will increase through higher lease expenses or land costs, thus compressing margins. Furthermore, occupancy and rental rates, and tenant retention have not yet stabilized, in our view. Nonetheless, these risks are tempered by Longfor's first-mover advantage, low funding costs, and higher economies of scale compared with peers.

We do not expect significant new capital to be tied up in the rental apartment expansion, given the company plans to expand through an asset-light model. Under this model, Longfor leases the premises, undertakes asset enhancements, and sublets the units. Favorable government policies towards rental apartments allows Longfor to obtain cheap funding and speedy approval for development plans. In March 2018, Longfor issued RMB3 billion in a special bond for its rental apartment business in China at a 5.6% coupon, despite tight credit conditions onshore. However, as Longfor commits to long-term lease agreements, its financial obligations will also increase. In our financial leverage calculations, we apply operating lease adjustments to the company's adjusted debt figures.

In our view, Longfor's target of increasing its rental income to RMB6 billion by 2020 is achievable given the high visibility of new pipelines. Longfor has 21 malls under development with land premiums fully paid. Among the project pipeline, 18 malls are scheduled to open in 2019 and 2020. Over the years, Longfor has shown its ability to achieve high occupancy and positive rental growth in its malls.

We expect stable growth in property development to continue in 2018 and 2019. Longfor has saleable resources of about RMB300 billion, compared with our projection of RMB185 billion in contracted sales for 2018. We also expect the booking gross profit to remain slightly above 30%, given rising selling prices in the past two years. However, the gross margin will likely decline to a long-term average of 27%-30% due to the Chinese government's market-cooling measures.

The positive outlook for the next 24 months reflects our view that Longfor will steadily increase its earnings quality through growing rental income. In addition, we expect its financial leverage to strengthen for the next two years as a result of revenue growth and cautious debt-funded expansion.

We may revise the outlook back to stable if: Longfor's debt-funded expansion is more aggressive than we expect or the growth and profitability is weaker than we estimate, such that its debt-to-EBITDA ratio exceeds 3.5x. Rental growth of the company's investment property portfolio falls short of our expectations such that its rental income cannot fully cover its interest in the near term. We may raise the rating if Longfor's rental income from investment properties can fully cover its interest expenses while the company reduces its debt leverage such that its debt-to-EBITDA ratio remains close to 3.0x. This could happen if Longfor continues to improve its operating scale and revenue diversity, shows steady execution in its new business segments, and maintains good financial discipline.

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