China Real Estate – What Bubble?

Inflows of foreign capital, low interest rates and a loose monetary policy have undeniably fueled the breathtaking real estate price increases in China over the last several months, however, as we argued in the past “while prices might be frothy in some Tier 1 cities, there is no systemic risk”. Nonetheless, concerns about the “bubble” in China's real-estate have continued increasing so we feel it is necessary to explain our thinking in more detail.

A “Bubble” That Everyone Knows Of
An asset bubble is an asset price that is supported by expectations of further price inflation and is not justified by fundamentals. A bubble usually forms due to a shift in the fundamentals which causes overconfidence to grow to extreme levels. During formation stage of the bubble, bearish voices are rare, and are overwhelmed by broad sense of euphoria. Explanations of tectonic shift in the fundamentals which have caused the asset price to reach a “permanently high plateau” start to emerge and full-fledged mania is created.

In the case of the Chinese real estate “bubble”, despite a significant price increase, there has been no sense of euphoria within investor, analyst, or policymaker community. Number of articles about the real estate bubble in China started to increase in the 2007 (from under 50 articles) and reached close to 150 articles in the 2009. Chinese authorities have a long standing policy of pre-empting price excesses in the real estate sector and various restrictive policies have been adopted in previous few years. There is a strong sense of price manipulation by developers and of unsustainably high prices within the investor community and in the household sector (however, although the desire of households to buy homes has been steadily decreasing since the 2004, the number of transactions has been steadily increasing, which might signal that structural forces have created demand inelasticity; more on this below). In other words, manic forces and herd mentality, which are critical elements leading to asset bubbles, are not present in the the Chinese real estate market.

A “Bubble” Without Lending Frenzy
Another important feature of asset bubbles is that they are typically accompanied with lending frenzies. As investors experience price appreciation, they typically lever up to increase returns and thus further massively inflate the bubble. As the mania eventually turns into a panic, deleveraging forces the speculators to liquidate which causes a total collapse in prices. Savings-driven bubbles are also possible, however, a collapse of savings driven bubble poses only minimal systemic risk as the price downside is much less dramatic, the increase in NPLs is not large, and the lack of deleveraging means that other asset classes are not significantly affected.

In the case of the Chinese real estate market, debt’s role is much less significant. Banks’ exposure to property developers stands at only 6% of the total outstanding bank lending and exposure to both developers and mortgage borrowers combined is currently at only 17% (compare that to 56% in the USA). Policymakers’ long-term worries of real estate excesses have made them impose very stringent rules on bank lending to the housing sector. Furthermore, banks' mortgage lending policies continue to be very inflexible; for example, mandatory down payment ratios are between 20% and 40%. The combination of these factors has caused total mortgage loans to be at mare 17% of the household deposits. In conclusion, the huge price increases in the Chinese real estate market over the last 10 years have primarily been fueled by the massive household savings and the retained earnings of developers. 

Supply And Demand Fundamentals
It is undeniable that the Chinese property prices have gone up tenfold over the past 20 years, but it is important to consider this data point in the context of greatly improved standards of living in China over the same period. Over the past 20 years, the disposable household income in China has been surging and the price-to-income ratio, a much better indicator of a bubble, has almost halved.

There also exists an increasing pent-up housing demand in China – although the per capita living space in China has increased almost fourth-fold in the last 30 years, the per capita real income increased sixth-fold over the same period. As the households get richer, they have been becoming increasingly dissatisfied with their living conditions (see http://www.gallup.com/poll/15082/Homeownership-Soars-China.aspx). Also, as we mentioned above, although the percentage of people that plan to buy a house in next three months has been in clear downtrend over the last 6 years, the actual floor space sold over the same period has been constantly increasing. All this indicates almost inelastic demand for housing due to the incredible growth China has been experiencing since opening up its economy.

The fundamentals on the supply side are almost equally bullish. Although the floor space in vacant residential buildings is at the all time high, the inventory-to-sales ratio is hovering at the all time low of around 2 months (compared to 8 months in the 1997, around 6 months before the 2005 in the the US, or above 10 months currently in the US).

It is also important to note that China is still in the early stages of urbanization and more than half of the population is still living in rural regions. Due to a huge income gap between the urban and the rural population, a huge number of rural dwellers are moving to the cities every year. Combine this with the mortgage borrowing policies which are slowly becoming more liberal (mortgage lending in China began only ten years ago), and you have a very tight supply-demand situation.

Investment Considerations
In summary, while the real-estate price gains over the last several months have been rampant and could become a cause of concern if they continue, we do not find classic features of an asset bubble in the Chinese real estate sector. In fact, for investors interested in finding a real estate bubble, we suggest taking a closer look at Hong Kong real estate, which is not in a bubble yet, but has all the necessary preconditions to become a huge bubble over the next few years (investors can easily gain exposure through REITs focused on the Hong Kong residential sector).

In other news, global equity markets bounced back in early February due to being technically oversold. However, we doubt that the current correction has run its course, and investors should avoid bottom-fishing at these levels. Staying in defensive sectors and countries, avoiding shorting government debt and dollars, and being overweight the US against the emerging markets is still advised.