We put up a post in late December which keyed off a discussion by Patrick Chovanec . Chovanec argued that real estate was increasingly serving as a vehicle for speculation, with many units kept vacant by investors:
In China, however, “flipping” is not the problem. Some people may be engaged in short-term ”flipping,” but as I’ve described in my FEER article “China’s Real Estate Riddle,” a lot more are buying residences — in many cases multiple units — and holding them vacant indefinitely as an unproductive ”store of value,” like gold. As I mentioned in my article, the Financial Times estimates that there are 587 million meters of apartment space that buyers have purchased over the past five years only to leave lying empty (for a concrete notion of what this statistic means, take a look at Al Jazeera’s report on Ordos). This puzzling phenomemon is due to the fact that Chinese citizens have relatively few investment options, and China’s real estate sector (unlike its stock market) has never experienced a sustained downturn since the country converted to private home ownership in the mid-1990s. The fact that China has no annual holding tax on property means there is little penalty for letting property lie idle, in the hope that it will appreciate or at least retain its value. The result is an inflated market where the demand for property as a pure investment vehicle far outstrips the demand for affordable, usable space.
If people were trying to “flip” their properties, that might actually be a good thing. At the very least, it would mean those residences would have to be brought onto the secondary market and priced. What we see in China, though, is an extremely weak secondary market. In the U.S., the ratio of secondary to primary residential property transactions for the first half of 2009 was 13.45; in Hong Kong it was 7.25. In China as a whole, that ratio was 0.26 (four times as many new home purchases as secondary sales). Even in China’s most developed markets the ratios were just 1.30 for Beijing, 1.56 for Shanghai, and 1.35 for Shenzhen. [Keep in mind that an immense quantity of existing housing stock was privatized in the 1990s, at nominal prices, so the explanation cannot be simply that China is a “new” market — China actually has a higher rate of established home ownership (80%) than the U.S. (70%)].
Chovanec got some pushback, and has offered some further commentary on his blog (hat tip reader Michael):
One of the comments posted on SeekingAlpha framed the first argument, about leverage (or lack thereof), quite well:
If they are buying and holding long term without using it (as a store of value), then they must not be taking on loans to do so.
If that is the case, then it is not an asset bubble. Bubbles are fueled by cheap debt. If they are paying in full, then they can just sit on them forever without problem, if that is their preference. They aren’t hurting anyone by doing so. Eventually, their economy will grow to the point that they will sell their holdings (so long as their government continues to liberalize their economy). Until then, there isn’t really a problem.
I don’t mean to pick on the reader by citing him here — quite the contrary, he offered a very succinct and articulate summation of an argument I hear quite a lot, both outside and inside China.
Yves here. The idea that asset bubbles depend on leverage is inaccurate. In the dot-com mania in the US, borrowing played a trivial role (there was an increase in margin debt, which occurs in most bull markets, but it remained a very small percentage of market capitalization). Cheap lending makes asset bubbles more likely, and also makes their unwind fare more destructive (as in not only does the investor/borrower lose, but in many cases the lender loses too, and since most lenders are pretty highly geared, the damage can blow back and impair the banking sector. Chovanec, addresses this longer-form, with more examples and more detail, but the premise hold. His discussion of how leverage works in the Chinese real estate market was very interesting:
China’s property markets are leveraged….
Chinese developers must use their own capital to secure land. Once they do so, banks will lend them 65% of the money they need for construction and related development costs, with the land pledged as collateral. But saying developers must use “their own capital” to buy the land is a bit misleading…. By taking on loans at multiple layers of holding companies, a developer can leverage up considerably to cover his “capital” commitment to the banks.
In today’s hot residential property market, developers usually pre-sell all their units well before they complete the project. …..there’s a huge pipeline of residential projects for which land has been purchased or construction is underway but pre-sale proceeds have yet to exceed construction loans. If a crash were to take place, the junior creditors would be left holding the bag. It’s very hard to quantify the extent of this exposure, due to the indirect way many of these loans were raised and channeled into real estate.
According to the latest statistics I’ve seen, approximately 50% of all residential purchases in China today are financed with mortgages, which are mainly provided by the big state banks. That’s a sharp increase from just a few years ago, when nearly all such purchases were made in cash. In theory, the rules allow 30-year mortgages, but anything longer than 20 years is rare, and the presence of high prepayment penalties tend to push buyers towards mortgages with even shorter terms (our own mortgage was, believe it or not, 3 years, which is more like an installment plan!). The terms for buying a second or third place are much steeper than buying a first home, and my impression is that the vast majority of mortgages being issued are going to people who actually intend to live in their unit, whereas people buying multiple units as investments are mostly paying cash. And by the way, the banks don’t securitize the mortgages (at least not yet, there’s some talk of pilot projects in this regard), but hold them on their balance sheets.
Obviously the investors paying cash don’t present a credit risk — in that sense, the people using real estate as a store of value, a place to stash their cash, are helping to deleverage the developers. And to the extent they’re buying units pre-sale, it’s a pretty rapid deleveraging process (of course, in this market, the developers are just releveraging back up again to build the next project). So what about the mortgaged buyers? Well, the fact that they live in their units reduces the risk — they’re likely to pay up to avoid losing their homes. But the fact that they’re stretching themselves so thin to buy into such a high-flying market, in competition with investors, on accelerated repayment terms is some cause for concern. In the TV show “Dwelling Narrowness” — which encapsulated middle-class distress at rising housing prices in China — the main characters’ mortgage payments end up amounting to 2/3 of their combined monthly income. That may be on the high side, but it’s not too far outside the mainstream. ….The good news, however, is that China’s mortgage market is relatively small — about 10% of GDP, compared to 48% for Hong Kong. But it is growing rapidly, and the second half of 2009 saw a big push in mortgage lending from the banks, as part of the stimulus effort.
Ahem, this does not look pretty….