Is The China Real Estate Bubble Real?

by: Mark Bern, CFA

The answer depends upon to whom we listen for answers. I like comparing the average home prices to average household income to determine fair value. I have read several recommended guidelines for buying a home ranging from 2.5 to 3.3 times gross household income. In much of the U.S., house values produce a ratio that falls between 1.5 times and 4.0 times. Of course, we have places like Santa Barbara, CA, where the ratio is 10.45 according to the World Map of Price to Income for 2014 at Most of us mere mortals cannot afford to own a home that costs much more than three times our income and, chances are, we could not get a mortgage for one now anyway.

There are several places around the world with unsustainably high real estate prices: Indonesia, Brazil, Thailand and the Philippines look very pricey. Havana has a ratio over 48 times, but I suspect that results from a combination of foreign buying and extremely low local average incomes; and even if it is a bubble and pops, it would not affect the global economy. But prices in China combined with a huge overhang of inventory get me concerned especially since the China economy has become a significant factor in global trade and economic growth. If China experiences an economic contraction while economies in Europe and the U.S. are still fragile, the results could be far-reaching.

But how about home prices in China? I keep reading that there is a real estate bubble in China, so how high is the ratio there? Well, I find the answers staggering to believe myself. Again, my source is the World Map of Price to Income for 2014 (check out the link in the first paragraph) but I have seen similar reports elsewhere. In Beijing the average price of a home is 34.38 times the average household income. In Shanghai the ratio is 28.57 times; Hangzou, 27.7 times; Guangzhou is 26.74 times. Compare that to New York City where the ratio is 7.85 or San Francisco at 7.43 times. Or compare to London at 14.76 or Paris with a ratio of 15.87, cities where foreign money tends to prop prices higher.

For those who still believe that there is no real estate bubble in China, please consider this short article from TheStreet that includes reports about the recent China PMI report (hitting a seven month low down to 48.3 from 49.5 reported in January; where below 50 means contraction), reports of real estate prices declining in some Chinese cities and as many available properties for sale as the total sold in all of last year. This is a quote from the article that tells a story that seems to be missed by much of the media: "A recent study sponsored by Shanghai's Tongji University said real estate markets have been especially shaky in the northeastern city of Harbin, the eastern commercial center of Wenzhou, and the resort town Sanya. New-home prices in Wenzhou have fallen monthly for more than two years."

An interesting article from Australia Network News about how the ultra-rich Chinese are moving money out of China by purchasing real estate in Australia (as well as the U.S. and other developed nations). Chinese investment may be creating more bubbles in other parts of the world. As wealthy Chinese find ways of moving their money out of China seeking more safety (both legally and illegally, according to the article), who will be left to sustain rising home prices in China?

This article is from CNN's One Square Meter site and was published somewhat earlier than the other articles (November 2013). It is more in line with what we normally read coming out of China: everything is still fine as prices and growth continue to rise. I like this quote from the article, "The problem is Chinese people have very few investment vehicles. They've lost trust in the stock market so they turn to real estate," says Xu Si Tao, China Director of the Economist Intelligence Unit." That sounds familiar. After stocks tumbled in 2001-03, the rate at which real estate prices in the U.S. rose seemed to increase and investors were flipping houses in hot markets making huge profits.

Here is an article from Bloomberg about a study by a college professor teaching at both Texas A&M and in China who calculates that as much as 90 percent of household in China already own a home and that 65 percent of China's household wealth is in real estate. "The Chinese housing market is clearly oversupplied," Gan told Tom Orlik, a Bloomberg economist based in Beijing. "Existing housing stock is sufficient for every household to own one home, and we are supplying about 15 million new units a year. The housing bubble has to burst. No one knows when." If the study alluded to is even close to being accurate, it means that home ownership is much higher than in the U.S. That seems to imply that there just is not much demand left to fill all the new houses being built.

This article from The Economist puts a different spin on the Chinese real estate bubble. Sure, we have a bubble and sure, it has to burst; but the answer to when is either not yet or only within manageable, less significant cities while values in the cities that count, like Beijing and Shanghai can continue on for the foreseeable future because it is different there. At least that seems to be the message still being proffered by many believers in Chinese real estate.

Much of what I have read about China real estate lately is beginning to sound more and more like what I read during 2006 and 2007 in the U.S. Back then, most pundits were stating that the problems in U.S. real estate were akin to a speed bump in the road and would only cause a temporary slowdown. Is not this the sort of talk that generally takes place at the top of a bubble? This time is different! I do not think so.

I am not saying that a bursting of the bubble is imminent. It may yet take years since the leaders in China have a great incentive to keep the real estate market from falling. They may be able to prop prices up for now. Some say that the air will be let out slowly. I have a hard time picturing how to accomplish that, even with the great power of the central government in China. My suspicion is that once prices begin to fall, especially in the major cities, that the process will gain speed as prices tumble. The reason I pay attention to such things is that I believe that a bubble of the size of China real estate could be the catalyst that sends the global economy back into recession mode.

If the Chinese economy contracts, which is likely should the real estate bubble pop because it will have significant effects on capital flows, there would be a direct impact on several resource exporting economies around the globe such as Australia, Canada, Brazil, Russia, and South Africa (among others). It will also indirectly impact most developed economies because demand in China for foreign products and services will fall. We will feel the effects here in the U.S., not just because of the direct linkages our U.S. based multinational companies have with the Chinese economy, but also because our other trading partners will experience slowing growth; and demand from Europe for U.S. goods and services will also contract. The global interconnectivity of the economies of the world has become complex and delicate. When one of the major players such as the U.S., Europe, Japan or China contracts, the rest of the world feels the pain.

China may have been able to fill the gap for lack of growth in Japan and Europe, but where is the engine that can keep the world growing if China becomes a drag rather than an engine? The U.S. economy is still fragile, in my opinion, and will not be able to sustain growth without help from abroad. Emerging economies fates have become increasingly tied to the success of China. Again, I do not want to imply that anything is imminent, but rather that what happens in China is worth watching for clues as to our own economic well-being and that of U.S. equities. China just might be the next catalyst for recession if the government there loses control over the mess created by real estate valuations.

As always, I welcome comments and will try to address any concerns or questions either in the comments section or in a future article as soon as I can. The great thing about Seeking Alpha is that we can agree to disagree and, through respectful discussion, learn from each other's experience and knowledge.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.