China's real estate industry had a great year in 2012, with total industry sales close to $1 trillion, a historical high. As a result, China-based real estate companies such as Xinyuan Real Estate Co., Ltd. (NYSE:XIN), SouFun Holdings Ltd. (NYSE:SFUN) and China HGS Real Estate Inc. (NASDAQ:HGSH) have been doing well lately. This is not at all surprising to me. I have held such a belief all long that China's real estate industry will do just fine. You can see an article I wrote late last year arguing that China's real estate industry would definitely not crash and burn.
The more important question is whether the industry will continue to carry the momentum in 2013 and beyond, given the fact that housing prices in China are already quite high. In the following paragraphs, I will explain why China's housing prices are so high and will continue to be high for the next three to five years.
Home Cost Components
The biggest driver for China's high housing prices is escalating land prices. According to China's Statistics Bureau, land prices increased from $70 per square meter in 2000 to $331 in 2010, or an increase of 17% per year. This is astonishing given that inflation was at low-single digits during that time period. The Chinese government reaped huge benefits from these rising land prices. For example, in 2011 alone, the government received more than $532 billion from land sales, or more than 50% of China's total real estate industry sales.
The Chinese government also levies heavy taxes and fees on real estate developers. Eventually, those costs would be passed over to homebuyers. There are more than 50 different kinds of taxes and fees that developers have to pay when developing a real estate project in China. These taxes and fees are so large that they constitute about 20-30% of the final sales price.
According to several research firms, for a typical housing project, land price constitutes 30-40% of the final sales price and taxes and fees paid to the government constitute another 20-30%. In other words, suppose a house is sold for $1 million, 50-70% of that money goes to the government.
Of course, developers also have to incur construction costs, which can amount to 15-25% of the final sales price. So net profit margins for developers in China are about 5-15%.
Since land prices and taxes and fees paid to the government constitute 50-70% of the final sales price, housing prices won't go down unless the government voluntarily lowers land prices or cuts the tax burden for developers. This is not likely to happen because these incomes are the main source for the Chinese government to fund its investment projects and keep the economy humming.
I believe China's real estate industry will continue to do well in 2013 and beyond. This industry will remain attractive during the next three to five years. In 2013, China's housing prices will increase by 5-10% and total industry sales will grow at a similar pace.
Because of the supply constraint, housing prices in most Tier I and some Tier II cities with population inflow will continue to be strong. However, in most Tier III and Tier IV cities, housing prices may struggle because of the abundant housing supply and population outflow.
Right now, there are way too many real estate developers in China. With the government's curbing policies still firmly in place, a lot of small developers may disappear. However, large developers with deep pockets or easy access to financing should continue to prosper.
Disclosure: I am long XIN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.