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May 20 2019

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House of real estate

The House Of Cards That Is Chinese Real Estate

Jan. 10, 2019 10:57 AM • tao

This article is exclusive for subscribers.

Summary

Approximately one quarter of Chinese GDP is tied to real estate, and that percentage is increasing.

China is in the midst of a unique and unsustainable housing bubble.

Here’s why it is imperative for Western investors to minimize exposure to most Chinese equities.

Roughly a quarter of Chinese GDP is tied to real estate, and since China’s economy accounts for around 15% of global GDP, the health of Chinese real estate concerns investors worldwide. As the International Monetary Fund noted in an April 2018 report, “a crisis in China’s housing market would be of considerable global concern.”

With this in mind, the recent performance of Chinese real estate (e.g. TAO) has indeed been concerning:

TAO data by YCharts

Moreover, fears of an upcoming global “big debt crisis,” to use hedge fund manager Ray Dalio’s phrase, only compounds concerns. A recent estimate by the Institute for International Finance suggests that China’s total debt exceeds 300% of GDP (moderately higher than the 260% estimated by economists surveyed by Bloomberg). Much of that leverage is concentrated in real estate developers, who are significantly more levered than other Chinese equities:

Oddly enough, however, Chinese buyers have shown little concern about their real estate market. They are as excited as ever to buy. 69% of buyers in 2018 are purchasing their second or third home, compared to 70% buying their first home in 2008. And while a mere 19.6% of buyers in 2008 bought as an investment, a startling 50.1% of buyers in 2018 bought as an investment. As capital outflows have become more difficult for Chinese investors (both due to government restrictions and international trade tensions) and the domestic stock market looks increasingly risky, real estate seems to be the perceived “safe haven.”

This has lifted housing prices to celestial levels. Let’s compare the American tech hub of San Jose to the Chinese tech hub of Shenzhen. In San Jose, the average price per square foot (PSF) is $636. In Shenzhen, the average PSF reaches $759. And even that is nothing compared to Hong Kong’s staggering $1,475 PSF – almost rivaling Manhattan’s $1,773 PSF.

The problem is the difference between real estate prices and the salaries that are supposed to support them. In San Jose, the average salary is $84,141, but in Shenzhen, the average salary is $15,456. In neighboring Hong Kong, the average salary is higher at $47,892, but still nearly half that of San Jose. How in the world are workers making that amount able to sustain such elevated real estate prices?

Chinese homeowners and landlords are due for a painful wake-up call – one that is already underway. In Hong Kong, for instance, after a 15-year bull market making the city one of the least affordable places to live on the planet, real estate prices have now fallen for 13 weeks straight. In Shanghai, the situation is not much better. One developer is giving away luxury cars to induce buyers to pull the trigger on three-bedroom townhouses. In Beijing, despite strong demand for housing, the vacancy rate is 10-20%.

According to Chinese real estate developer and the country’s richest man, Wang Jianlin, China has inflated a massive housing bubble that is unsustainable. No country has ever built so much real estate in so little time. Entire cities have been erected, and many of them sit vacant. Roughly 22% of China’s urban housing stock – more than 50 million apartments – are unoccupied. Replica cities of Paris, London, Jackson Hole, and other Western cities have been built, intended to become thriving urban centers but instead being transformed into wedding photo backdrops or cheap suburban housing.

You might object that there have been accusations of a Chinese housing bubble for years – at least five or six, at this point. And you’d be correct. There was a Dateline special in 2013, for instance, about China’s housing bubble and especially their “ghost cities” of unoccupied apartments and shopping malls. And in that year, a study showed the same percentage – 22.4% – of unoccupied housing. But just because we don’t know when the bubble will burst doesn’t mean there isn’t a bubble. Robert Shiller and Karl Case argued that the US was in a housing bubble as early as 2003. Just because they were early obviously didn’t mean they were wrong.

Perhaps Chinese property investors have been lulled into believing the same fantasy that fooled Americans in the early to mid-2000s: “Housing prices will never go down!”

A Uniquely Chinese Phenomenon

How, you might ask, could such a trend of higher and higher prices and rents be sustained alongside such elevated vacancy rates? Part of the reason is cultural. Due to the longstanding one-child policy, China has an excess of young men and a dearth of young women. Many women (and their mothers) expect suitors to own at least one property before being considered marriage material. If women expected men to own luxury cars in order to be marriageable, the cost of BMWs would surely rise, too.

The other reason that the trend of rising real estate prices has continued has to do with the centrally planned nature of the economy. All land in China is owned by the state, and only buildings or partitions of buildings can be owned privately. Local governments receive about 40% of their funding from the national government, but they must raise the rest themselves, either through taxation or otherwise. But only 20% of their funding actually comes from taxes, and the rest comes from land leases, mostly to real estate developers.

The Communist Party in Beijing incentivizes construction by rewarding local governments – and promoting local government officials – that carry out more of it. But in this competition for favor from the Party, localities require developers to build more or less immediately, whether the local economy supports these developments or not. This leads to the existence of massive, spooky “ghost cities” that attract more tourists than residents.

Source: David Gray / Reuters

Defenders of the unique arrangement which produces these ghost cities argue that detractors are ignoring just how fast China has urbanized. Yale professor and former chairman of Morgan Stanley Asia, Stephen Roach, for instance, points out that the Chinese population was only 20% urban in 1980 but surpassed 50% urban in 2011. The number is probably closer to 60% now. “China cannot afford to wait to build its new cities,” says Roach. “Instead, investment and construction must be aligned with the future influx of urban dwellers.”

Is Roach right? Can China’s growing economy and urbanization ensure that these 50 million or so empty apartments will eventually be filled? The answer to that question largely depends on the continued health and expansion of the now-fabled, KFC-eating Chinese middle class. There’s some reason to doubt that its growth can continue unabated.

The Chinese Class Divide

Much has been made of China’s middle class, now boasting 400 million or more members, but median income per capita in China is only around $2,750 (18,371.34 Yuan). The growing class divide between the urban haves and the rural have-nots calls into question the notion that the mass exodus from the countryside and into cities will continue at the same breathless clip as the last few decades. Income per capita in rural areas is 63% lower than in urban areas, and that includes the many poor urban areas that are rarely mentioned or noticed by Western media. This means that rents will need to come down dramatically in order to fill the tens of millions of vacant units, but a drop in rents large enough to fill the vacancies will also have a detrimental effect on housing prices.

Maybe that will be good for the few first-home buyers who haven’t already bought, but it will be very bad for the property owners who are underwater or selling at a loss.

And it will be very detrimental to China’s GDP. A Kansas City Fed study concluded that a 10% decline in demand for real estate would lead to a decline in GDP of 2.2%. This is because real estate is linked to the construction industry, which is linked to the industrial sector, and all three are tied to the financial sector. In short, fluctuations in real estate have deep economic ripple effects. If the rice farmers in Western China cannot be lured east into the cities at an adequate pace, the Chinese economy is in trouble.

A House of Cards

Considering that the US saw a housing price decline of roughly 27% after its housing bubble popped, it would not be implausible to see a quarter of the value of Chinese real estate lopped off if their housing bubble popped. If so, that would amount to 5.5% of Chinese GDP being erased. And since China’s true GDP growth is likely less than the officially reported 6%, according to DBS Group Research’s chief economist, Taimur Baig, it is possible that a Chinese housing crisis could eliminate nearly all of China’s GDP growth.

Granted, in the recent past, the government has intervened in the housing market to prevent price plunges through loosening restrictions and lowering mortgage rates for second and third homes, and they would likely do so again if the housing market began to falter. But what would happen if the Chinese middle class lost confidence in real estate as an investment? What if they decided to go back to saving rather than pouring their money (and their parents’ and grandparents’ money) into first, second, and third homes? Perhaps more pertinently, what happens when, despite whatever government interventions are tried, China simply runs out of middle-class buyers of real estate?

All of this leads to the unavoidable conclusion that there is a great deal of risk not yet priced into Chinese equities (especially those of highly levered real estate developers) and debt assets.

Much has been said recently about slowing Chinese GDP growth, but the fact is that China’s GDP growth has been slowing since at least 2010 – or, if you smooth out the dip and rebound during the Great Recession, since 2007.

And, as a friendly reminder, these official numbers (from the National Bureau of Statistics of China) are likely inflated.

Many smart people are bullish on China long-term because of its plans to lift hundreds of millions more people into the middle class, but that would require an ever-increasing GDP. And as the Kansas City Fed’s report noted, an increasing percentage of Chinese GDP is tied to the real estate market. In a country with roughly the same GDP per capita as the Dominican Republic, it’s difficult to see how this trend can continue indefinitely.

A reasonable conclusion for investors, then, would simply be to stand back, wait for a sufficiently strong breeze to pick up, and watch the house of cards topple. Maybe, once China’s newest cities are populated more by living beings than ghosts, Chinese equities might be worth considering again. But most Western investors whose only exposure to China is through broad-based ETFs or mutual funds ought to be wary. The nation may have embraced markets and privatization to some degree, but the old dragon of Communism still lives and breathes. Indeed, it never really went away.

Am I missing something? Have I overlooked an important point? Let me know in the comments below!

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