China's housing market is unbalanced

China’s housing market is a divisive topic. Housing bulls tend to point towards urbanisation, rising incomes and conservative mortgage lending. On the other hand, bears point towards high vacancy rates, low rental yields and over-construction.

I will cut through the noise and give you my own interpretation of what is going on.

The preconditions for the boom were set in 1998

First, it’s worth reviewing the history of China’s private housing market.

Before 1998, residential property was owned by the state. Individuals were allocated housing by their work units or municipal housing authorities and enjoyed highly subsidised rent.

Starting from 1998, employees were allowed to purchase their own property. The average discounts provided to them was about 70% compared to the market value of private property at the time. During this time period, individuals who purchased property made a fortune: buying property at an average price per square metre of roughly RMB 500 per square metre (RMB 45,000 for a median home of 90 square metres). Today, the average residential housing price in China is roughly 20x higher.

Coupled with rapidly rising incomes and rising property prices, the individuals who purchased homes were, therefore, able to accumulate household equity. Leverage was almost non-existent. That would change over the following twenty years.

A housing boom of epic proportions

So following the privatisation drive of the 1990s, a private housing market emerged. Floor space under construction rose from around half a million square metres to close to seven million in less than twenty years - an increase in construction activity of over 10x:

Much of this increase in floor space under construction was warranted, as the pre-1998 housing stock was dilapidated - even by emerging market standards.

Urbanisation was a key driver in the early years of the boom - but the argument has key flaws

Bulls are right in pointing out the importance of urbanisation in creating demand for housing. China’s urbanisation rate has been roughly 20 million individuals per year and has remained at this level since the late 1990s.

But there are several key flaws with this argument. Many of these newly urbanised residents are actually factory workers who are already provided bunk beds by their employers. They do not need and probably cannot afford separate commodity housing.

Another issue is that migrant workers typically don’t have permanent resident permits (“hukous”) in the cities they live in. For that reason, many will eventually move back to their hometowns to get access to school and government-sponsored healthcare. While the urbanisation rate of China’s permanent population is 59%, the urbanisation rate of the registered population is only 43%. Also, there are now signs that China’s “floating population” of migrant workers has peaked and is about to decline. And also worth mentioning is that China’s overall working-age population has also started to decline.

Another flaw with the urbanisation argument is that towns often become reclassified as urban once enough construction occurs. That makes the argument circular: construction causes urbanisation as much as urbanisation causes construction.

The market has become increasingly imbalanced

In the two decades following the reforms, the commodity market became increasingly imbalanced. Individuals purchased property for speculation rather than for living. This imbalance is best captured by the disparity between housing starts vs housing completions:

Why has this disparity emerged? Most likely because property developers cannot find buyers, so inventory is piling up. Another explanation is that speculators prefer to buy units that haven’t yet been completed, hoping to flip the housing to somebody else.

“Supply-side reform”

Around 2015, the new leadership in Beijing panicked and felt a need to address those building imbalances. Xi Jinping’s right-hand man Liu He jump-started his so-called “supply-side reform”, whose goal was to eliminate excess capacity through government regulation. In a way, it was a success. The government managed to reduce overall inventory to more comfortable levels.

But it didn’t solve the actual problem of over-construction. Even though the measures were marketed as being “supply-side” - what the government actually did was stimulate demand via cash hand-outs and an explosion in mortgage lending.

China’s central bank lent state development banks money that they, in turn, transferred to individuals via cash handouts related to shantytown redevelopment. Whenever a person had his house taken over by the government for redevelopment, that person would receive a cash handout. Such a person would often buy new homes with the compensation that he or she received.

As researcher Zhang Dawei of Centaline Property said:

“Over the past several years housing markets in third and fourth-tier cities had come to heavily depend upon monetary compensation provided for shantytown redevelopment.”

Another person quoted by Bloomberg who received compensation for her land said that the cash handouts saved her 10 years of hard work:

“This saved me 10 years of hard work… Where we lived before there were muddy roads outside with chickens and ducks running around. It was so dirty.”

So the government simply gave these displaced individuals free cash and free property, financed by its development banks. It was, in effect, fiscal spending in disguise in an effort to prop up the housing market.

Another way that the government dealt with excess inventory was a rapid increase in mortgage lending. The overall balance of mortgages in the banking sector doubled within just a few years:

So Liu He’s supply-side reform was really just a temporary measure to deal with excess inventory. The underlying problem of over-construction continues to be a problem for policymakers.

The market is not homogenous

Chinese cities are often divided into different tiers: first-tier cities are the richest and largest cities: Beijing, Shanghai, Guangzhou and Shenzhen. Lower-tier cities are not as rich and tend to have populations below 10 million people.

One key point about China’s housing market is that the floor space sold in tier 1 cities since 2006 has more or less stayed flat over the past decade.

Most of the excess construction, on the other hand, is in tier 3/4 cities where the purchasing power of individuals’ is weak. You can see that clearly in the below chart of tier 2 / tier 3 city floor space sold per person:

And in terms of prices, property prices have risen in line with incomes in lower-tier cities, while they have gone ballistic in tier 1 cities:

So China’s housing market is really a tale of two separate markets:

  1. Over-construction in lower-tier cities (that is, in most of the country)

  2. Over-pricing in first-tier cities

Too much housing being built in lower-tier cities

There are now signs that too much housing is being built. The number of housing starts per 100 population is today more than twice that of much richer South Korea and over three times that of Taiwan.

Other signs that there is too much property being built:

  • In developed economies, housing starts approximately equal household formation. In China, first-time marriages equal about 11 million. Further, the urbanisation rate of a maximum of 20 million people per year suggests a hypothetical underlying demand of 6-7 million apartments per year (3 persons per household). These numbers are far below the actual construction of 17-20 million dwellings per year.

  • Property construction / GDP is now about 13% vs 6% in the United States and 12% in Spain before their bubbles burst in 2006

  • Real estate and construction industries now account for 29% of China’s GDP, comparable to pre-crisis Spain and Ireland:

  • China’s property development industry revenue is about $1.5 trillion / year vs $186bn in the US, while their PPP-adjusted GDPs are roughly comparable.

  • Roughly 20% of urban non-private employment is in real estate, more than doubling in the past decade.

  • The percentage of bank loans going towards the property market (mortgages + development loans) is today 40% vs around 45% in Spain 2006

  • In 2018, the majority of purchasers of new property already owned at least one dwelling:

  • According to a Financial Times survey, 35.1% of respondents said they owned at least one empty property.

  • China’s average space per person was 6 sqm in 1985. Today, China’s per capita housing stock is 37sqm vs 42sqm in Sweden and 16sqm in Vietnam

  • 70% of Chinese millennials own property vs 35% in the US, 31% in the UK

  • The median age of urban housing in China is <10 years. When Japan's housing bubble burst in 1989, the average age of a housing unit was 12 years. In the US, the median age of a house is 37 years.

Tier 1 city housing prices are excessive

On the other hand, in tier 1 cities, there is plenty of evidence that property prices have reached unsustainable levels:

  • Rental yields of 1.5-2.0% in major cities are far lower than the cost of financing, with mortgage rates at around 5%, meaning that each buyer is facing negative carry on his or her purchase. This situation represents what economist Hyman Minsky referred to as “Ponzi Finance” - a clear-cut definition of an unsustainable financial bubble. Rental yields below 2% were last seen in late 1980s Japan.

  • The affordability rate (price-to-income) ratios of Beijing, Shanghai, Shenzhen property is over 40x, compared to 12x in New York and San Francisco.

But nationwide property prices have also reached unsustainable levels:

  • The average price for residential real estate in the 100 largest cities is about CNY 15,000 per sqm (or CNY 1.35 million for a 90sqm apartment). In the United States, the median price per sqft is US$119 or about CNY 8,300/sqm. It appears that Chinese home prices are, in fact, twice as high as in the United States, even though GDP per capita is 7x higher.

  • The total value of China’s housing stock/GDP is close to 500%, a very similar level to that of Japan in 1989.

  • The aggregate value of China’s housing stock is today worth more than 2x that of the United States and 3x that of Europe.

  • Chinese households save about 78% of their capital in real estate vs just 35% in the United States.

Major state-owned developers are growing but at the expense of private competitors

If you review the accounts of major Chinese developers, you get the impression that there is underlying growth in the market. This is a mirage. As mentioned earlier, overall completions have stayed flat since 2014.

What’s driving overall volume growth is really consolidation:

The drive behind this consolidation seems to be that state-owned enterprises (SOEs) have access to finance, while private companies don’t.

Numbers from the China Banking Society shows that the share of lending to state-owned enterprises (which dominate the list of the largest developers) has increased from around 32% to over 80% during the current administration. This data series has unfortunately been discontinued.

The bubble doesn’t necessarily have to burst

So you can probably tell that I am leaning towards the bearish side in the bull vs bear debate. Construction activity is above the norm, and property prices in most major cities are in bubble territory.

But that doesn’t necessarily mean that the bubble will burst. The government has great leeway in controlling property prices, including via fiscal deficit spending such as the cash hand-outs that were distributed from 2015 onwards. Eventually, of course, the currency will have to take a hit.

I believe that the government is hell-bent on trying to avoid a crash in the housing market. That means that prices will be controlled in some fashion or another. Perhaps through ever-rising budget deficits.

And who knows - perhaps the government will eventually decide to nationalise the housing market yet again. That would at least save the bubble from bursting.

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