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Bubble in Chinese Real Estate?

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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.  

13 Comments – Post Your Own

#1) On April 19, 2010 at 7:55 AM, ayekappy (< 20) wrote:

Simple supply and demand.  I would need to find the numbers but I'm guessing China's are comparable to Japan right now, and Japan used to have much much more expensive real estate.

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#2) On April 19, 2010 at 9:53 AM, ChrisGraley (29.98) wrote:

You nailed it. No need to add anything.

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#3) On April 19, 2010 at 10:30 AM, JakilaTheHun (99.93) wrote:

Jim Chanos, the short-seller who has made the case against China, says that bubbles result from excess credit.  There is another famous short-seller (I can't remember who) that says bubbles develop when there's not a generally agreed upon pricing mechanism.  Both views are correct, in my view.

The tech bubble came about because people didn't know how to value these 'fast-growing' tech companies that grew revenues by insane amounts every year, but lacked profits.  

Obviously, the more recent crisis was a credit-driven bubble.  Maybe China's a bit of both. 

You alluded to unsure-valuation element when you mentioned the trend towards urbanization in China. The government of China is trying to urbanize the society rapidly (to be more like the US and Japan, essentially), but it creates this unsure valuation scenario. How do you value properties that have no cash flows, but that are projected to have tenants further-down-the-line in the future at uncertain prices? 

People buy properties because 'people will eventually move there', sort of in the same way that the tech companies would 'eventually turn a profit.'  Of course, some did, but a lot more went bust.  And even most of the ones that did, didn't really live up to their valuations.  

While the Chinese RE market is less credit-reliant than the American market, there is still credit involved.  I don't know much about Chinese banks, but I'm sure that a lot of their loans are backed by real property, and if the bubble bursts, those properties will suddenly be worth much less than before. 

One thing that's often missed here --- many of the people investing in these properties are not living in China --- they are essentially Chinese ex-patriates who have a bit more wealth living in developed nations like the US.  Which is one of the reasons why people can afford to buy these properties with a lot of cash.

There's another dangerous factor here --- the Chinese government is not the most open one out there.  Things have improved in the past few decades, but it's still far from an "open society."  What this means is that information flows less freely and bubbles can get even more out of hand in such an environment, because there is less skepticism floating in the air.  When you drown out critical voices, people are much more likely to develop one-sided views on things.  

 

So basically, in sum --- we have these giant, empty properties that are flipping hands every few months that generate no cash flows at all.  They are investment-only and the potential CFs are based on the belief that the Chinese government will relocate people there, who will then buy the housing.  The holes in this line of reasoning:

(1) The Chinese economy, which is heavily dependent on exports, might not sustain enough strength to create these new centers of activities, and 

(2) Even if people do start to relocate in some of these areas, can they actually afford these properties that are priced way out of their reach?  

It's difficult to say when everything will collapse, because the Chinese government can prolong the build-up for quite awhile.   But the whole thing doesn't really add up to me.

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#4) On April 19, 2010 at 6:58 PM, Bays (30.23) wrote:

Oops, our homebuyer has less than $10 a month to spend on food, utilities, property tax, insurance, and other necessities.

This is assuming there is only one wage earner in the house.   Isn't it safe to assume there is more than one wage earner paying for the house? 

Still, I see your point.  Well said.

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#5) On April 20, 2010 at 12:48 AM, bzhing (< 20) wrote:

Starting from April 15th, the central government have announced several polices trying to control the fast rising house price. All the house buyers have to use their own name instead of registering the house under somebody else's name. For the second house, the down payment has to be higher than 50%. The buyers have to provide tax evidence that they have stayed in the city where they are buying for more than one year. It is getting interesting. 

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#6) On April 20, 2010 at 10:45 AM, TigerPack1 (97.87) wrote:

Perhaps a large Chinese real estate bust leads the global economy down into a real deflationary recession in late-2010 and 2011.

No wonder the Chinese want nothing to do with U.S. Treasury auctions the last 4-5 months - they are bringing money and capital home to deal with their own significant economic issues now.

Europe is in the same boat, with the volcano and Greek issues slowing that large developed economy down.  They don't have the capital to invest and support U.S. bond prices either!

That leaves U.S. investors to finance the $3-4 trillion in annual deficit spending and debt rollover needs each year... The sad fact is that the FED and foreign central banks have accumulated a net $1.7 trillion in Treauries the last year, and the U.S. public and banks have purchased very little in the way of bonds to keep the government running... America's capital  flows have left bonds and cash, to be plowed into an over-valued and quite risky stock market bet, thanks to the insane ZERO short-term interest rate policy engineering by the idiots running the FED.

All the FED has accomplished with its free market manipulation and massive wealth transfer from savers to the banking system, is to encourage millions of investors to be in exactly the wrong place (risky assets) before another recession hits, while bringing about a total vacuum in long Treasury bond buying.  This is why the top stock and bond market minds in the world from Bill Gross, Munger and Buffett, Soros, Jim Rogers, and many more are freaking out about the U.S. intermediate stock and bond pricing future.

I have tried to explain the last 3-4 months in the economy to people as the "eye of the hurricane" where the storm looks to be over and a blue sky prevails for a short time... However, the second and perhaps most powerful part of the financial storm is about to hit!!!  The late-2010 and 2011 economy and market situation may make the 2008 and early 2009 experience look rather tame.

-TigerPack

 

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#7) On April 20, 2010 at 11:20 AM, TigerPack1 (97.87) wrote:

So far, the Motley Fool Independence Mutual Fund results have lagged a buy and hold, index fund of most any variety.  I don't know what kind of stocks they focus on, but the smaller capitalization indexes are crushing this "first try" by the Gardner boys>>> http://finance.yahoo.com/q/bc?s=FOOLX&t=6m&l=on&z=m&q=l&c=iwm,%5EGSPC,%5EIXIC

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#8) On April 21, 2010 at 6:45 AM, TMFBabo (100.00) wrote:

@ayekappy: That's true, but you can use supply and demand to also describe prices at the heights of bubbles and at ridiculous lows.  I guess I was looking for possible explanations on why demand is so high, since that's what seems to be driving prices up.

@JakilaTheHun: I agree that the Chinese situation is less credit-driven than the US situation, where we had ridiculous 0% down mortgages.  Much of the anecdotal evidence I've seen (various news articles) seem to suggest that these properties are often flipped without ever providing rental income to the temporary owners.

I've also heard of a mechanism by which the Chinese are paid by the government to leave certain properties and move elsewhere.  I'm very hazy on the details, but I'm aware at least that it exists.  This is one of those aspects of government involvement of which I'm unsure.

I'm not sure when the growth will slow and possibly collapse, but it worries me that a higher percentage of GDP seems to be going towards extravagant real estate with each passing quarter. 

I do believe that a collapse in real estate would not destroy China itself due to stronger consumer balance sheets, I do believe that commodity prices would suffer greatly.  I'm not convinced a crash is imminent, but it doesn't add up to me either.

@Bays: Yeah, dual income families would avoid the problem I posed quite nicely.

@bzhing: I agree it will be interesting.  I see that the Chinese government is realizing the potential dangers and is taking the right steps in requiring lots of cash up front.  I only hope it will be enough. 

@TigerPack: I believe the chances of major slowdown are real.  I've been worried about a possible crash since the Summer.  I've recently started to increase the percentage of cash in my investment accounts because safe and attractive investments are much harder to find than before.  I'm now having to research each buy more thoroughly, which takes a bit of time.

If we do crash worse than before, I will be doing anything I can to raise more capital to invest.  I found prices quite irresistible in late February and early March and I couldn't stay away for the life of me.

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#9) On April 21, 2010 at 4:40 PM, TigerPack1 (97.87) wrote:

Perhaps we can start the group hedge fund or mutual fund product near the bottom in late-2010 or early 2011?

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#10) On May 01, 2010 at 1:00 AM, Charlesriver (< 20) wrote:

Hi BB,

Thanks for the blog.

 I do not know if you ever went to China or lived in China for a time. My sense is that you do not know much of the pricing of Chinese real estate. Those number you gave only spoke part of the story, only apply to certain well developed cities at the best, not China as a whole, not most Chinese cities at all. The title implies you were talking about the whole Chinese real estate market.

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#11) On May 11, 2010 at 3:02 PM, naughtyguy (33.38) wrote:

Related to China, anyone have any idea if the CEO's involvement with the cash/stocks of CSR are above board or scary?

I noticed it on Bullish..'s stock pick list.

Nice intelligence reflected in these replies if you ask me!

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#12) On May 21, 2010 at 3:43 AM, reachmygoals1 (< 20) wrote:

So much talk about China real estate.  Any thoughts about XIN or CADC? 

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#13) On July 13, 2010 at 11:30 PM, rousseauhk (< 20) wrote:

A few comments:

Price to rent ratio is hugely dependent on where you live, prevailing interest rates etc. I lived for 7 years in central London, UK where price-to-rent was steadily around 200:1. I then spent the last 10 years in Hong Kong where it was (during the severe downterm during SARS in 2002) 300:1+ and is now up with shanghai at 500:1.

You dont state where you live, but if you're suggesting that ratios of 300:1+ are not sustainable in the long run, this is clearly not the case.

Income-to-price is also distorted in mainland China, due to the general prevalence of corruption & bribery. A guy might earn a declared salary of $10,000, but if he regularly gets another $20,000 a year from some dodgy dealings, a $200k property doesnt look so unreachable.

Add to this, near zero interest rates and I dont see the property bubble bursting until China drastically increases rates.

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