The Chinese political leadership announced the country would continue its priority of building up small and medium-sized cities first, while keeping strict control on the its largest cities to curb unbridled growth.

The Chinese government has restrictions on the movement of people from smaller towns to the large metropolises as it seeks to stave off the formation of shantytowns around these mega cities as well as avoid the strain on their infrastructure due to the influx.

China: Eerie ghost towns

Substantial infrastructure and housing were created in these small and medium sized towns, but the lack of jobs and opportunities led to their populations migrating away to the larger cities.

These mostly unoccupied towns soon became internationally notorious as China’s ‘ghost towns.’ At the same time, a real estate boom existed in other, more prosperous parts of China.

What is the reality of China’s property market?

Citi’s trek into the Chinese hinterland

Citi researchers Oscar Choi and Marco Sze visited 30 Chinese cities over two months to make their own assessment of the Chinese real estate market.

“We believe the reality is a complex mix: yes, bubbles in certain geographies, predominantly inland Tier 3/4 markets which will face painful and prolonged adjustments…but also cities with underlying resilience, where solutions are achievable and concerns overdone,” say the analysts in their research note last week.

The analysts rule out the risk of a nation-wide property bubble or bust, but call attention to more localized ‘bubbles’ that are likely to face painful adjustments.

Causes of these bubbles In China market

  • Explosion in domestic and global liquidity (see chart below of the routes into the Chinese property market)
  • Uneven economic development across various geographies in the country
  • A land-driven fiscal and revenue financing system that places inordinately high priority on GDP growth.
  • Traditional mentality of property preference
  • Disparity of incomes and wealth
  • Lack of adequate number of investment channels

1-liquidity-flow China

China property in Tier 1 and 2 markets

These cities see bubbles but the situation is not calamitous, according to Citi. These bubbles are seen across specific cities with ultra-strong demand, and are not a nationwide phenomenon. Sharp ASP rises and a high affordability ratio are major factors for the bubbles. Also, the problems stem from a skew in the supply patterns rather than demand. The high savings ratio in the country also means that many buyers remain one-off buyers using cash for their purchases. Loan leverage therefore remains low.

However, the analysts do not expect these bubbles to burst; instead, a vibrant outlook will see these gradually diminish as fresh demand emerges.

“The Tier 1/2 cities – with better job opportunities, faster economic development, higher living standards and education & healthcare resources – should continue capture population flows and generate housing demand. Thus, a bubble burst on demand shrinkage is unlikely,” say the analysts.

China property in Tier 3 and 4 markets

These markets are afflicted by oversupply, and this is particularly acute in inland cities, where most ghost towns are found. The problems are worsened due to weak local economies, falling populations, limited job opportunities due to global contraction and high existing home ownership.

“We are very cautious on these inland Tier 3/4 cities. There is no easy way out, no quick turnaround. After the likely eventual property market correction, these cities may need [to] take another long period (5-10 years) to recover,” warn the analysts.

2-tier3-4

Coastal cities are better positioned, however, though they too are afflicted by oversupply. According to the analysts, their problems are solvable in the long-term, and future urbanization should help the situation. These cities also benefit from the advantages shown in the green rectangle in the above illustration.

Investment outlook

Stable policies and increasing urbanization are likely to see a ‘catch-up rally’ in the first half of 2014. At the same time valuations are not inordinately expensive and Citi like developers that are focused on metro areas and have a solid land bank, good execution and brand value, such as COLI, Shimao Property Holdings Limited (HKG:0813) (OTCMKTS:SIOPF), Sunac China Holdings Ltd (HKG:1918), Vanke Property Overseas Ltd (HKG:1036) and CIFI Holdings (Group) Co Ltd (HKG:0884).