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In the last 10 years, China's housing prices have risen rapidly. In some tier one cities such as Beijing and Shanghai, prices have increased 600% or even 800%. Investors argued over whether this rise is a speculative bubble or a genuine increase in housing demand. Lately it seems that the former opinion has gained the upper hand and a lot of investors are increasingly concerned about the industry. Some even believe the industry will crash and burn soon. As a result, companies in China's real estate sector, such as Soufun Holding Ltd (NYSE:SFUN), Xinyuan Real Estate Co. (NYSE:XIN), and China HGS Real Estate Inc. (NASDAQ:HGSH) are all trading at somewhat depressed levels.

Will China's real estate industry crash any time soon? While doing macro economic forecasting is extremely difficult, it seems to me that this will not happen. The most likely scenario may be that housing prices won't go up as dramatically as they did in the past, but will remain stable and grow at a rate between inflation and income growth.

Demand Is Real

China's urbanization is the single most important driving force for housing price increases. As more and more people have moved into cities, demand for housing has exploded. The number of people moving into cities is simply staggering. For example, from 2002 to 2011, China's urbanization rate increased by 1.35% a year, which means that every year the urban population grew by 20 million. Suppose each household has three people, that means 6.7 million new housing units are needed every year. At the end of 2011, China's urbanization rate was 51%, while the rate was only 39% in 2002. This trend won't stop until the urbanization rate reaches 70-75%.

Prior to 2004, China's housing price increase was very mild. From 1998 to 2003, the average housing price increased at a rate of 3.5% a year, much lower than the per capita income growth of 9.5%. However, since the Chinese government implemented a land auction policy in late 2003, housing prices broke loose and went on a tremendous run. This is because the biggest cost in housing construction is land cost, and this increased dramatically in the public auction process. The Chinese government benefited tremendously from this auction policy. In 2010 alone, the total proceeds the government received from land sales were 2.7 trillion yuan, more than 50% of China's total commercial real estate transactions.

China's extremely loose monetary policy also helped to boost housing prices. As more liquidity was injected into the market place, the price of real assets such as property simply went up. The amount of money being pumped into the economy is mind-boggling. China's M2 was only 13.5 trillion yuan ($2.1 trillion) in 2000, and it increased to 85 trillion yuan ($13.5 trillion) in 2011, a cumulative increase of 530% in the last 11 years. At the end of 2011, China's M2/GDP ratio was 180%, compared to 60% in the US.

Finally, people living in China have a lack of investment alternatives. Because of currency control, they can only invest domestically. But China's domestic market has few attractive investment options. The stock market has been weak for years and most stock investors are simply speculators. The bond market is shallow and inactive and interest rates offered by banks are too low to offset inflation. So property investing has become the most attractive option. And the huge return it generated in the last couple of years also has reinforced this perception.

Monopolized Industry

One thing that is extremely important but most people don't realize is the fact that China's real estate industry is a monopolized one. It's not at all an industry with free competition. The Chinese government controls the most important input in the industry: land. By adjusting the supply of land, the government can effectively manipulate the land price and thus the housing price, since land cost constitutes 30% to 60% of the total cost to build a housing unit.

Once you understand the monopolistic nature of the industry, high housing prices are not a complete surprise.

Beach Ball Being Held Under Water

Over the last two years, the Chinese government has implemented purchase restrictions and loan restrictions in major cities in an effort to prevent housing prices from rising further, because sky-high housing prices further widen the income gap between the rich and the poor and may potentially endanger social stability. However, since most major forces behind high housing prices will not change any time soon, the demand for housing will continue to be strong. So the government's curbing measure is like pushing a beach ball under water. The government will make sure the beach ball won't escape its clutches and pop up too high again. It also realizes that there is not enough supply in the marketplace. So while the government does everything within its reach to keep the price steady, it also redoubles its effort to build more affordable housing to satisfy the market demand.

In summary, there is real demand behind the tremendous run in China's housing prices. The monopolistic nature of the industry accentuates the situation. With the government using administrative measures to suppress price increases, the golden age for China's real estate industry may be gone. But the industry will do just fine in the next five to ten years, with an average margin and return similar to other industries in China.

Those who hope for a spectacular crash in China's real estate industry are likely to be disappointed.

Source: China's Real Estate Industry - A Beach Ball Being Held Under Water?