The Chinese Housing Market's Outrageous Price-To-Income Ratio

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Includes: FXI, XIN
by: Dividend Investor 101

Summary

In many Chinese cities, the price-to-income ratio for buying a house is between 20:1 and 35:1.

To put this in perspective, in most areas of the U.S., the price-to-income ratio for buying a house ranges from as little as 0.5:1 to 3:1.

Migration from countryside villages to the city has driven up housing prices.

Investors have also driven up property prices, in some cases buying hundreds of empty homes, as they believe housing is a great investment, preferable to bonds or stocks.

Who in the U.S. making $50,000 a year would ever consider buying a house for $1.5 million? Obviously no one would. Maybe in their dreams, as they think about what they would do if they won the lottery, but it would only be a dream. A bank wouldn't even consider giving this type of loan out. In fact, a person wanting to get that kind of outrageous loan wouldn't even go to a bank, as there would be no hope of getting a loan that large when only making so little.

Yet this is what is happening every day in China. Families are betting the farm on the housing market, trying to buy a home, to fulfill their dreams and feel like they have made it in the world.

My family and I lived in China for six years, from 2008 to 2014, until recently moving back to the United States. We lived in Yunnan Province, in a large city called Kunming, and then moved to a smaller city near the Laos/Myanmar border. When we moved back to the U.S., we ended up in Naples, Florida, of all places. Talk about culture shock. We moved from the U.S. to China, adjusted to the Chinese culture in one of the poorer places in China, and then moved back to one of the wealthiest places on the planet. I usually see two or three Maseratis a day (most cost between $100,000 to $180,000), along with the "poorer man's" cars -- Audis, Porches, and BMWs.

When my wife and I were looking at buying a house in Naples, we were looking at homes around 2 to 3 times our expected annual income. In fact, I thought buying something 3 times our annual income was stretching our budget a little too far.

Yet in China, the average person has been shut out of the housing market, and those who do try to get in, are stretching their budgets by far more than 3 times their annual income.

Here are some statistics from where we lived in China, in the smaller city near the border. (Note: RMB stands for renminbi, or yuan, the official currency of China. The exchange rate is currently about 1 USD for 6.2 RMB.):

  • We worked at a nonprofit organization. Our Chinese colleagues made 1200 to 1500 RMB per month as new hires or lower-level employees. Those in management roles made around 2,000 RMB per month.
  • People working in the fields doing general labor made about 60-80 RMB per day, which might average 1,500 RMB per month if they could find work most days.
  • Teachers made 1,500 to 2,500 RMB a month, depending on what kind of school they were in. It's important to note that their housing was typically provided for them.

The Housing Situation

We lived in an apartment that was about 1,100 square feet. It was a nice sized apartment for China. Apartments that size were going for about 1,300 to 1,800 RMB per month on the outskirts of the city, and more downtown. If we would have bought an apartment that size outright on the open market, we would have had to pay around 400,000 to 600,000 RMB, depending on what floor it was on and the location of the apartment in relation to downtown.

Now, let's do the math. Let's say the average wage in our city was 1,800 RMB per person per month. Most of that salary would then go to food and rent costs. Even a 1 bedroom apartment cost around 600 to 800 RMB per month, so not much would be left over for savings.

The yearly income for an average person in that city was about 21,600 RMB. So what kind of house (most "houses" are apartments) could a person buy? Nothing. The cheapest houses started out around 200,000 RMB. That is about a 9:1 ratio. And that was for the bottom-of-the-barrel housing. If a person making 21,600 RMB per year, with a spouse and one child, wanted to buy a 3-bedroom, 1-bath apartment, he or she would have to spend around 400,000 to 600,000 RMB to buy the house. To buy that 3-bedroom apartment for 500,000 RMB (mid-range, and a very "normal) price) that would be a price to income ratio of 23:1. Ouch!

Yet families are desperately scraping together the needed amount for a down payment, before housing prices rise even further. And the common consensus among our friends was that they will continue to go up in the future. Obviously prices will not go up forever without some kind of correction. But people don't always understand this. They just see prices going up and up and think they always will.

So how are these people buying houses? Most of them are not buying them. That privilege is reserved for the wealthier people in China. Instead of investing in stocks or bonds, many wealthy people, or developers, buy houses. And they buy lots of them, hoping to someday sell them for a large profit. In fact, many of these "investments" are empty cement apartments that have not been finished yet. And they will remain empty until the investor decides to sell them. There are estimates that say there are between 50 and 70 million empty apartments in China. Wow!

For the middle-class families that do try to buy houses, while their incomes may be higher, especially with two adults working, they still are buying houses at price-to-income ratios that are extremely high. Many people we know had to borrow money from family members and from the bank in order to buy a house. Even then, they had maxed themselves out and had to keep borrowing money as unexpected things came up, like medical bills. Unfortunately, many times this hurt their family relations as they had to keep on asking to borrow money.

Let's say a middle-class person working makes 40,000 RMB per year. With two adult incomes, you get 80,000 RMB per year. Let's say Grandma and Grandpa also live with them, as is often the case in China, and they contribute 20,000 RMB a year in retirement income. That's a total of 100,000 RMB per year. With that many people in a house, though, they will want to go for the 3-bedroom option. So they buy a 3-bedroom house for 500,000 RMB. That is still a 5:1 price to income ratio, and that is with two working adults' incomes, and their parents' too.

The average house-price-to-income ratio in the U.S. varies from 0.5:1 to 3:1 in most areas. Compare that with China, which varies from 20:1 up to 35:1, and you see a pretty scary picture. The average lower- and even middle-class person can't buy a house. Only when both adults are working, and Grandma and Grandpa are living with them too, can an average middle-class family try to buy a house. (You can get a complete world listing of house prices to income ratios here.)

When I look at this kind of situation, housing prices need to come down in order for the average person to buy a house in China, otherwise the housing situation is just a giant game of speculation by the middle class and rich elite that are gobbling up houses for the profits they hope they can make in the future as housing prices continue to rise.

In both cities that we lived in during our time in China, developers were building like crazy. Kunming added an entire new city, called ChengGong. During our time there, hardly anyone was living there.

Then, in the smaller city that we lived in, investors and speculators were also building many new developments -- so many that they actually doubled the size of the city in the four years that we lived there. Most of the housing they built remained empty after it was completed.

Below is a picture I took one day as I was walking along the muddy banks of the Mekong River. Rumor has it that this development cost around UDS $10 billion, and to this day, most of the house are empty, even though it was completed about two years ago. In fact, many of the houses are very large mansions that not even the middle class can afford (you can see some of them on the far right of the picture, next to the more "affordable" skyscrapers). I would venture to say that this new development alone added about 20,000 new apartments to the city. Let's hope some more peasants from the countryside move to the city to live in them (catch my sarcasm?).

China's economy is overly dependent on the property market, especially construction of new buildings and the things that are tied to new houses. Estimates are that up to 25% of China's GDP is tied to the housing and construction market. If things do go downhill in the housing market, GDP will get clobbered.

The government is between a rock and a hard place. They don't want the economy to slow down, yet a large chunk of GDP is tied to housing in some way or another, and that housing has become extremely expensive for the average person. More housing needs to be built to drive GDP forward, yet almost every city in China, both large and small, has been adding housing projects over the past six or seven years that have literally doubled the size of these cities. Way too many houses are empty, with no intention of anyone living in them, because they are just investments waiting to be sold. But to whom? Eventually prices will need to come down so the average buyer can afford one, unless multiple migrant families will continue to live together in rented houses.

We had around 10 people living above us in a 3-bedroom apartment; they turned it into a 5-bedroom apartment by putting bunk beds in the living and dining rooms. But that is life in China. You do what you need to do to get by, even if that means being cramped together in an apartment, because that is all you can afford after you spend most of your salary on food and housing.

Concluding thoughts

It will be hard for the Chinese consumer to drive the economy forward, as the government hopes, when most of the income of the lower and even middle class is drained by high housing prices. For those who already owned housing 10 or 20 years ago, the situation is not as grim, because their house has appreciated in value, so they can sell it and use the proceeds when buying a new house. However, for the hundreds of millions of migrant workers coming to the cities for work and a better life, the dream of owning a home remains just that, a dream -- and certainly a far-off one.

The Chinese government will try everything it can to make sure housing prices never go down too much, as that could discredit them in the eyes of the people, and the government hates social instability and unrest. Peace, prosperity, and harmony are the motto. The government will pull out all the stops and keep on stimulating the economy, like it just announced a while ago with a USD $1 trillion spending package. But how long can this go on?

In the meantime, housing remains out of reach for many people. In my opinion, there is no lack of supply of housing. Speculation is the problem. Someday the price-to-income ratio for housing will come back to normal, which means a day of reckoning will come. I just don't know when that will be. Nor does anyone, really, as people have been sounding the alarm for a few years now. As I mentioned above, the government will continue to pour as much money into the economy as they need to in order to keep it humming along at the rate at which they want it to. If you are invested in China, let's just hope the music doesn't stop and leave you without a chair.

Will there be a lot of defaults on loans? Maybe -- but since many Chinese families have their entire life savings (and other family members' savings) tied up in the housing market, I doubt many of them will want to walk away from their loans, even if they are underwater. That doesn't mean housing prices can't come down, though. It just means there might not be as many defaults as there were in the U.S., because of a higher down payment requirement in China.

In fact, lower housing prices might even mean the Chinese consumer has more disposable income if less of their paycheck is going to a mortgage. This, in turn, could spur the economy. However, there are too many unknowns, especially when talking about an economy driven by a Communist government.

How to invest in China

First off, I would suggest staying away from real estate in general, especially housing developers. Xinyuan Real Estate Company (NYSE:XIN) is one company that I know of that has shares listed in the U.S., and the stock price has cratered in the past year. Real estate developers could be left with lots of inventory that needs to be sold at high prices in order to make a profit, so if prices come down a lot, bankruptcy will be a problem. For the speculative investor, XIN might offer a very attractive return from its current lows, but the risks are also very high.

Chinese banks are also another sector that I would not want to be invested in. I don't think there are any banks you can buy into on U.S. exchanges, but on China and Hong Kong's exchanges, there are plenty of them. You will also get exposure to them through ETF's that track large Chinese companies. Bad loans could affect earnings for some time to come. There has been lots of talk of "shadow banking" and also bad loans packaged up as "investment products" that banks sell with a 10% to 13% rate of return. Investors in China love these high returns, but are misled as to what they are really buying into. Having lived there, I can tell you shadow banking is real and that there are lots of small micro loan businesses going on, as I saw them all around. These companies also can charge exuberant rates and don't always care about the credit worthiness of their borrowers.

FXI is an ETF that provides exposure to 25 large cap stocks in China. This may be a better route for the investor that wants exposure to China, but it will still go up and down with the Chinese economy, and will have exposure to real estate and banks. In fact, from 2010 until now, the stock price has not gone up at all. So an investor has basically just collected some small dividends along the way the past 5 years. Not the best return on your money, especially since China's stock exchanges have soared higher in the past year by nearly 50%, yet FXI has lagged behind them and only increased by about 16% over the past year. However if things do get a lot better for the Chinese economy (I don't see this happening), this ETF could be a good play on that.

Another way to gain exposure to China is to buy into large multinational U.S. companies like McDonald's (NYSE:MCD) or Yum! Brands (NYSE:YUM). YUM is the owner of KFC and Pizza Hut, among other restaurants. Western food is still popular in China and MCD and YUM still have great growth opportunities there as they open new restaurants. You can read an article I wrote about MCD's tremendous growth prospects in China here. I personally prefer this method of gaining exposure to China, as it is less risky yet still offers exposure through good, solid companies.

While the middle class and economy are still growing in China, the dangers are also ever present and growing. I hope this article has increased your awareness of the price of housing in china and helps you invest accordingly.

Disclosure: The author is long MCD.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

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