Bubble in Chinese Real Estate?
April 19, 2010
– Comments (13)
China's growing quite fast. In fact, China's GDP went up 11.9% in the 1st quarter of this year. I believe China will continue to be a growth story over the long haul, but I wonder if real estate prices have become frothy in the short-term.
Information has been quite hard to find in my Google searches, so this will unfortunately be an incomplete analysis based only on the numbers I could find.
Price-to-rent
I started looking at residential real estate both as an investment and as a nice place to live starting in 2008. I learned that a good price-to-rent ratio is 100:1. Rent in this case is monthly rent. For example, if you rent a place for $2500 a month, a good price for that property is $250k. Depending on whom you ask, the ratio starts becoming too high at 200:1 or even higher, in some cases.
I've found the price-to-rent numbers for 3 of China's largest cities as of December 2009:
Beijing: 546:1
Shanghai: 500:1
Shenzhen: 450:1
These ratios are astronomical. Based on the simple rule of thumb stating that 200:1 is too high, I'd say that 450:1 and higher is a ridiculous ratio indicating a very, very high price.
Price-to-income
I've found urban price-to-income numbers seem to be between 15 and 20. Income in this case is annual income. To me, a conservative price-to-income is 2.5, maybe 3. A ratio of 4 is doable, but only if you have an incredibly stable job and not many other debts and obligations. The recent economic collapse should've shown that few jobs are stable today.
Let's calculate a sample scenario based on these numbers. I'll use 17.5, the middle number in the 15 to 20 range. Let's say the home price is $175k. That means the income based on that ratio is $10k. Using a conservative 20% tax rate, this person takes home $8k a year in net pay per year. I'll use 5% interest rate, 30 year amortization schedule, and a 30% down payment.
Continuing with our example, this homebuyer who makes $8k after taxes per year has saved 30% of the home price of $175k, which is $52.5k. After saving most of his income for 10-15 years, he's finally buying that house. The mortgage will be for $122.5k. Using the 5% interest rate and 30 year amortization, monthly payment is $657.61, according to hsh.com. He makes $8k after tax per year, which comes out to $667 a month. Oops, our homebuyer has less than $10 a month to spend on food, utilities, property tax, insurance, and other necessities. I guess he can't afford that house unless he saves way more than 30%. I guess those 10-15 years of saving most of his net pay weren't enough.
Numbers from Homebuyer example:
Home price: $175k
30% Down payment: $52.5k
Mortgage Amount: $122.5k
Monthly Payment Based on 30 Years and 5% Fixed Rate: $657.61
Homebuyer Pre-tax Annual Income: $10k
Homebuyer After-tax Annual Income: $8k
Homebuyer Monthly Net Pay: $667
Homebuyer Net Pay Minus Mortgage Payment: <$10
Using $150k instead for the house price and the same 30% down payment, the monthly payment is $563.66. Our fellow making $667 a month would still struggle to live a normal life.
The price-to-income number is the one that stands out most to me. This example shows that people buying houses at these ridiculous ratios have either saved money for an incredibly long time or are simply rich. Due to higher saving rates and whatnot, I believe a higher price-to-income is justified in China, but not as high as 15 to 20. I could see a ratio of 5 or 6 being okay if supplemented by a high savings rate, but 15 to 20? Ridiculous.
Snippets of Anecdotal Evidence
I've read that much real estate is bought and just held. People seem to like to move in if the place is new, so many investors just buy places and hold them, even if they can be rented out for profit. This little story sounds like the greater fool theory that bubbles are made of.
Chinese hold homes longer and do not bail at the first sight of negative equity. Given the amount of money they have to save for a very long time, I'd say that seems like a big possibility. I'd also venture to say that homebuyers do not run into negative equity situations very often based on the large down payments.
Arguments Against Bubble
City populations are growing very rapidly, so demand for housing is steady or growing.
Savings rate is much, much higher in China than in the US. A very high percentage of real estate in the US, 90% or so, is debt financed. In China, 50% of real estate is bought with cash. Also, down payment requirements are very high. The requirement has been recently raised to 30% for all people, not just some. Even a sizeable drop in housing prices would not result in negative equity. Also, personal balance sheets look much better in China than in the US.
The government plays a big role in real estate prices. I also don't fully understand the impact of state-owned-enterprises and such. I'll look at that in the future.
Conclusion
House prices are very high in comparison to rent prices and to incomes, but I'm not sure it's a bubble about to burst. I will, however, be cautious about financials and basic materials companies in China and also those that do a significant amount of business selling into the Chinese growth (Brazil, Australia, whatever). I'm not necessarily bearish on China at this point, but I'm a lot less bullish than before.
I recommend further research before taking anything in my post seriously. Remember, this was an incomplete post and I'm lacking big-time in the "arguments against bubble" section.
As always, I look forward to comments. I'd especially like those that fill in many of the blanks that I didn't fill myself.
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