Oct 24, 2013 06:58 PM

Deflating Property Bubble Fears


In economics, a so-called bubble is any deviation of an asset's market price from its intrinsic value. Such deviations can be driven by a range of irrationally exuberant and speculative behavior: overly confident views of the future, a herd mentality, or a misplaced faith in an investor.

Whether the Chinese property market represents a bubble of epic proportions hinges upon the nature of the demand. Do the country's sky-high property prices reflect genuine, realistic views on the future consumption of housing services?  Or are they speculative purchases driven solely by the overconfident expectation that house prices can go nowhere but up?

Since 2000, about 70 million apartments have been sold in China – less than 20 percent of the country's total housing stock, which is estimated at 442 million. The market remains extremely fragmented, although the biggest developers such as Vanke, Poly Real Estate and China Overseas Land and Investment have grown from scratch to US$ 10 billion companies just in the last decade.

"Ghost cities" similar to Ordos continue to crop up in China. However, the tier-one cities (the country's four most developed metropolises) and tier-two cities (10 high-growth cities with smaller economies and lower population density) that are property developers' major markets continue to grow, driven by consumption demand. Investment-driven purchases have fallen from about 50 percent of all home buys to 10 percent since the implementation of home purchase restrictions in 2011. Although affordability is always a major complaint in the country, developers are addressing the issue by building smaller units for the mass market.

What's commonly misunderstood is the perception of a home in China. Home ownership is perceived as a necessity, not a privilege or luxury. As such, owning a home is more important than owning a big home, especially for those young men eager to get married and start new families. The average home size in China is 310 square feet, compared with 850 square feet in the United States. In fact, the Chinese philosophy of feng shui dictates that a big house with few residents is unbalanced in energy. In Hong Kong, the average three-person household resides in an apartment as small as 360 square feet.

Analysts often use the ratio of average selling price (ASP) to per capita income as a measure of affordability, but this only tells part of the picture. First, personal income is often under-reported in China, either due to the presence of grey income or tax evasion. In addition, as purchases by owner occupants (real demand) outweigh speculative purchases this year, the product mix (for both sales and new construction) has shifted toward small housing units, rather than villa and luxury apartments. As a result, ASP per unit is declining, although ASP per square meter is still increasing in most cities.

Not All Bubbles Are Created Equal

Even assuming there is some level of a housing bubble in China, the bubble is very different from the most recent housing bubbles in the United States and in Japan before the land and real estate crash in 1991, in that the residential mortgage debt remains relatively low. Chinese residential mortgage debt was 15 percent of GDP as of 2009, compared to 81.4 percent in the United States, according to the Milken Institute.

The difference between a leveraged bubble and non-leveraged bubble is crucial both for the size of the bubble that will develop and for the economic damage when it bursts. In China, property buyers typically do not have to incur a lot of debt to buy property – cash, whether saved, borrowed, gifted or inherited from parents and grandparents, or found in the basement, has been the principal payment. In countries like the United States, where the practice of borrowing against real estate is highly developed (some argue overdeveloped), homeowners do not just borrow to purchase houses. They also borrow later against the value of the asset, often before the initial mortgage is paid off. Such home equity withdrawals during the subprime mortgage boom abruptly ended in 2008, landing a lot of American homeowners in the soup.

In the case of home equity withdrawal, the debt is either explicitly collateralized with property, or the owner's debt service ability hinges on the market value and cash flow from the property. If property is not leveraged, the bursting of a bubble and the resulting crash of the price of property merely has a negative wealth effect. Since the marginal propensity to consume out of wealth is small, the crash has a limited impact on the economy. This explains why the impact of the bursting of the tech bubble in the United States at the beginning of the previous decade was relatively isolated in comparison to the more recent mortgage crisis.

When the property is heavily mortgaged, however, an asset price collapse can cause a full-fledged financial crisis. The borrower has to breach his debt covenants and is unable to meet margin calls. Distressed sales of property further drive down property value. Not only is the owner in trouble, facing losses and eviction, but the bank that provided the mortgage loan is also at risk. This destructive chain of events describes the subprime mortgage crisis in the United States in 2008. Although the initial impact seemed to be concentrated in highly leveraged financial sectors, the damage quickly extended into the broader global economy, the recovery of which has been slow, anemic and is still ongoing five years later.

Unlike in the United States, the cash payments involved with owning a home in China typically happen in the early stages of a purchase. The official minimum down payment for a home is 30 percent, and the interest rate is set around 6.6 percent. Maintenance and management expenses are trivial, and a property tax, just being trialed in a few cities, is not yet applicable to most households. A typical residential mortgage in China is a variable rate 20-year repayment mortgage. The 30-year fixed rate instruments found in the United States, which shift interest rate risk comprehensively and exist only because of the guarantees provided by Fannie Mae and Freddie Mac, do not exist in China. Enticing, seductive and non-transparent financial constructs like adjustable-rate mortgages or interest-only mortgages are not available to most Chinese home buyers (yet).

Unlike in the United States, the Chinese government has not provided the same massive subsidy to borrowing against residential property created by the deductibility of home interest payments from federal income tax.

China is also embarking on a plethora of infrastructure construction projects that are likely to increase property values and mass housing demand in the future. Beijing plans to build a seventh ring road running 940 kilometers around the capital. Shanghai has four concentric ring roads, with the largest stretching 189 kilometers, and the southwestern city of Chongqing has two concentric ring roads.

When observing surging Chinese property prices and ever-declining affordability, many tend to draw comparisons to the inflation and bursting of Japan's housing bubble between 1986 and 1991. China is undoubtedly similar to Japan in 1980s in the formation and expansion of a credit bubble, which threatens the solvency of local governments, companies in the traditional sectors with excess capacity, and financial sector institutions including banks. On the other hand, Chinese households are not highly leveraged, and many trends have been set in motion that will continue to reinforce fundamental demand for residential housing in China.

The booming Chinese property market is largely supported by the non-stationary fundamentals of rapid real GDP growth, wage inflation, growth of private wealth and urbanization. Another fundamental driving this growth is the absence of attractive investment alternatives. Despite the growth of wealth management products (WMPs), the asset menu available to most Chinese investors is restricted. Most investors can access only WMPs, deposits with regulated rates, domestic stocks of companies with poor governance and transparency, and property. Should regulators decide to remove restrictions that prevent Chinese investors from accessing foreign markets, the Chinese property market would undoubtedly be hurt, especially if restrictions were to remain in place on foreign investment in China.

With thanks to Yifeng Mao at Goldpebble in Shanghai and Ana Swanson in Washington

Junheng Li is the founder and CEO of JL Warren Capital in New York, and the author of "Tiger Woman On Wall Street," to be released on November 8 by McGraw-Hill 

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