Chinese Property Market: A house of cards

Approximately a quarter of Chinese GDP revolves around real estate, and since China’s economy accounts for around 15 percent of global GDP, the health of Chinese real estate is of concern for investors worldwide. As so stated by the International Monetary Fund (IMF), “…a crisis in China’s housing market would be of considerable global concern.”

With this in mind, the recent performance of Chinese real estate has indeed been concerning and is estimated to continue to deteriorate. Furthermore, fears of an upcoming recession only grows concerns that this could well materialise. The Institute for International Finance estimated that China’s total debt exceeds 300 percent of GDP where much of the leverage is concentrated in real estate.

That being said, oddly enough, Chinese buyers have shown little concern about their real estate market – they are as excited as ever to buy. 69 percent of buyers in 2018 are purchasing their second or third home, compared to 70 percent buying their first home in 2008. Also, while a mere 19.6 percent of buyers in 2008 bought as an investment, a startling 50.1 percent 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 a safe haven to investors.

This has obviously increased prices to celestial levels and the major concern revolving around it is wages in China in comparison to current prices of real estate – a big mismatch not in the workers’ favour. How are workers making enough to sustain such elevated prices?

Chinese homeowners and landlords are due for a painful wake-up call – one that is already underway. For instance, in Hong Kong 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.

It is clear that China has an inflated 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 50 million apartments of China’s urban housing stock are vacant.

Unique Chinese Phenomenon

A trend of increasing prices alongside an increase in vacant supply is being sustained due to two reasons. The first being cultural; due to the longstanding one-child policy, China has an excess of young men and a scarcity in young women. Many women expect suitors to own at least one property before being considered as marriage material.

The other reason for the aforementioned continuous trend is due to 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 percent of their funding from the national government, but they must raise the rest themselves, either through taxation or otherwise. Only 20 percent 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. This means that 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, abandoned cities that attract more tourists than residents.

House of Cards

Considering that the U.S. saw a housing price decline of roughly 27 percent after its housing bubble popped, it would not be improbable to see a quarter of the value of Chinese real estate cut off if their housing bubble popped. If so, that would amount to 5.5 percent of Chinese GDP being erased. Since China’s true GDP growth is likely less than 6 percent, a possible housing crisis could eliminate nearly all of China’s GDP and possibly drag down other sectors and industries with it too.

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 waver.

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 into first, second, and third homes? Perhaps more relevantly, 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 and debt assets.

Many 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 we said China’s GDP is reliant on real estate.

Maybe a reasonable conclusion for investors would simply be to stand back and wait for a sufficiently strong breeze to pick up.