China's Housing Bubble Spells Trouble

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by: Rob Abbanat

I am loath to rent. I just can’t stomach the idea of paying for someone else’s mortgage. When I first arrived in China back in 2006, I fully intended to buy property once I got the lay of the land. But when I started looking, I quickly realized that residential real estate was pricey, even by Boston standards.

And since then, it has only gone up. Conversely, rents are very reasonable and have increased only modestly. Renting here always seems to make more sense than buying. Anyway, after nearly four years in China, I spent the last two weeks looking for a new apartment to rent in a better part of town, which has opened my eyes to what appears to be a frighteningly large bubble. While I haven’t done any formal research, there is a tower of anecdotal evidence that suggests that the current market prices of residential real estate are unsustainably high, at least in Shanghai and other first-tier cities.

The most obvious sign is that middle-class housing seems to be priced well beyond the reach of the middle class. In Shanghai, asking prices start at about RMB20,000 (about $2,900) per square meter on the outskirts of town. But if you want to live with a tolerable commute to the main business centers, you are looking at RMB30,000 (about $4,390) per square meter with considerable remodeling (I’ve seen it as high as RMB85,000 per square meter for well-finished apartments).

That means that a middle-class family of three looking to buy a modest 80 square meter apartment will have to come up with RMB2.4 million, or about $350,000.

This is pretty startling considering that the average annual income of urban workers only reached about RMB29,000 ($4,250) in 2008, as reported by Xinhua News Agency. The median multiple, which measures the ratio of the median house price to the median annual household income, has historically hovered around 3.0 or less in the US, but rose dramatically prior to the recent housing bubble.

If my estimates above are right, then the typical middle-class family is looking at a median multiple of about 80 to slip into a modest Shanghai apartment.

Ok, maybe urbanites in Shanghai are much better off than the rest of the country, so let’s look from another angle: how do prices compare to rental income? In one of the places I considered renting, I asked the owner how much he paid for the place. I was then able to calculate the price-rent ratio (purchase price divided by annual rental income), which is another commonly-used tool to evaluate the relative value of residential property.

The ratio I came up with was 33, based on what he paid versus the price for which he was willing to rent to me. This is meaningless in and of itself until you compare it with the long-term sustainable price-rent ratio for the UK, which is 21 according to the Bureau of Labor Statistics.

The danger implied by this number is even more startling when one considers that the price-rent ratio for the UK peaked at about 27 just before the real estate bubble popped in mid-2006.

None of this bodes well for someone looking to invest in real estate in China. But it also raises some red flags regarding other seemingly very healthy parts of the economy. China’s resilience amidst the “Great Recession” has been fueled, in part, by a government stimulus program that “encouraged” banks to lend (in fact, it is probably more accurate to say that they were ordered to lend). Much of this lending has been collateralized by companies’ real estate, which is pegged to local residential rates.

So when the residential bubble pops, it will very quickly ripple through corporate balance sheets and directly to Chinese banks, which have recently ascended to become the world’s most highly-valued financial institutions.

Nonetheless, people have been predicting a collapse of China’s real estate bubble for years, but it continues to defy gravity. This situation begs two obvious questions: why have prices risen so astronomically, and can they sustain? Part of the first question can be accounted for by the fact that both incomes and the A-Share markets have risen dramatically in the last decade, creating lots of wealth to be invested.

Another factor is the absence of a tax on residential real estate. Combined with a high savings rate, availability of mortgages, and a dearth of investment alternatives, this inspires people to invest in real estate with a very long-term horizon.

But can it last? Honestly, with so many apartments sitting empty, and so many new ones under construction, I cannot imagine how the current prices can stay where they are, much less go up.

So for the time being, it looks like I’ll just have to get used to the idea of paying rent.