The deterioration of real estate lending conditions is forcing Chinese property market analysts to consider the prospect of serious declines in asset values and what economic impact this might have.

With an oversupply of offices in certain regions and a sharply rising number of bad loans, a price crash could put at risk many smaller banks’ survival, analysts say.

One scenario analysis of the impact on China’s banks of a 20% decline in property prices, released by Standard & Poor’s on March 5, forecasts that non-performing loan (NPL) ratios for property developers and construction companies may jump to 8%, from 0.5% at end 2013.

Official year-end 2014 NPL ratios have not yet been released, but all available data points to a serious downturn, at least in some areas.

An average 20% property price drop implies a more severe decline in some cities. Speaking during a panel discussion at the PERE Asia Summit in Hong Kong, Terence Loh, executive director at CDH Investments, remarked that cities like Tianjin and Chengdu “scare us a lot”.

Office oversupply, in particular, is “off the charts” in those cities, said Loh, adding that it will take many years for the existing supply to be absorbed.

China’s Premier Li Keqiang highlighted the chronic oversupply problems facing China in his opening speech to the National People’s Congress on March 5.

High property inventory levels in tier 2 and 3 cities are driving investors back towards tier 1 cities and core locations in tier 2 cities, posing challenges for developers – and the financial institutions which have lent to them – in the lower-tier cities.

But even then, Vivian Tsai, head of funds management at Tan-Eu Capital, pointed out that residential inventory levels – at 13-14 months – in China’s tier 2 cities  are so high there is no scope for price appreciation.

Property is central to China’s economy and since so much lending is linked to real estate, either directly or indirectly, the risk of contagion if the property market crashes is high.

According to Standard & Poor’s, borrowers pledge property and land for 30-40% of corporate loans; 13% of commercial bank loans go to real estate and construction companies, while 15% go to residential mortgages.

A 20% decline in property prices would see small and medium-sized banks “struggle for survival” said Liao Qiang, S&P’s senior director for financial institutions ratings.

But even a 30% decline in property prices would not see large-scale defaults on residential mortgages, predicted the rating agency, given that property buyers typically make a 30% down payment. Unemployment and household incomes – not property prices – drive the asset quality of mortgage portfolios, according to Standard & Poor’s.

S&P’s base case is a further 5% decline over the next 12 months. Its analysts did not conduct a scenario analysis on a nationwide property price decline in excess of 20%.

Liao said that a 30 or 40% nationwide decline is “beyond our imagination” as even a 10 or 20% nationwide decline has not been witnessed over the past decade.

Nevertheless, property price declines of more than 30% have already been witnessed in “quite a lot of places already” without leading to contagion in other markets, said Liao. China’s property market is highly fragmented and diversified, he said, underpinning the rationale for not considering a price correction of greater than 20% in its scenario analysis.

High-yield China property bonds now return 11.1% on average according to UBS, down from a peak of 13% in mid-January this year (and 8.5-9% in mid-2014), following default fears surrounding property developer Kaisa.

Those fears were re-kindled following Kaisa’s March 8 announcement of plans to restructure its offshore debt. If those plans are successful, credit rating agency Moody’s stated that the property developer could avoid a payment default.

But an unsuccessful restructuring of the property developer’s offshore debt could see Sunac’s proposed acquisition of Kaisa fall through. If that happens and no other buyers emerge, offshore creditors may end up recovering just 2.4% of the face value of their debt holdings according to an estimate of the property developer’s liquidation value undertaken by accounting firm Deloitte.

“Financing today is harder than it was a year ago” observed Tsai. She said that a publicly-listed property developer was offering 15% per annum for short-term [bridge] financing of a residential project in a tier 2 city, up from 10-11% less than a year ago.

Loh agreed that short-term debt financing costs for property developers have risen from around 12-13% one or two years ago to 15-18% today amid a funding gap – between acquiring land and pre-selling residential units.