The Unprecedented Real Estate Bubble In China by Gary D. Halbert
FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
April 19, 2016
IN THIS ISSUE:
Vanguard’s move into PE may change the landscape forever
Private equity has been growing in popularity in recent years as more and more big-name funds and institutional investors dive in. Now even indexing giant Vanguard is out to take a piece of the PE pie. During a panel at the Morningstar Investment Conference this year, Fran Kinniry of Vanguard, John Rekenthaler of Morningstar and Read More
1. China Posts Slowest Economic Growth in Seven Years
2. China’s Dangerous & Growing Real Estate Bubble
3. Purchasing a Home in China is Usually a Family Affair
4. When the Real Estate Bubble Bursts, Look Out Below!
Most economists and financial writers agree that the US has the strongest economy among the developed nations, even though we’re only growing at about 2%. Despite the slow growth, most don’t believe we are facing a recession anytime soon. However, most economists and financial writers also agree that a serious external shock could quickly throw the US economy into a recession and take most of the rest of the world with it.
The question is, what kind of a shock might it be? Some point to Greece, others to Brazil, both of which have flirted with bankruptcy. Others worry about a hard landing for China’s economy, which some fear would be enough to throw the US economy into a recession.
Yet there is another totally different risk in China that most Americans know nothing about. It’s the bubble in Chinese real estate. Chinese citizens are up to their eyeballs in real estate and almost nothing else. Prices have skyrocketed in recent years into what some are calling a giant bubble.
If that bubble bursts and home prices plummet, millions of Chinese would see their net worth evaporate.
This problem is much larger and potentially more devastating than most economists and forecasters realize. My clients and readers need to know about this, so that’s what we will talk about today. But before we do, let’s take a look at the latest economic news out of China from last Friday.
China Posts Slowest Economic Growth in Seven Years
China is getting a slow start out of the gate this year, growing at its slowest quarterly pace in seven years during the 1Q. Gross Domestic Product expanded by 6.7% (annual rate) in the three months ended March, following 6.8% in the 4Q of last year, according to China’s National Bureau of Statistics. That was a tick above the 6.6% growth economists expected ahead of the report, according to the median pre-report consensus.
While this represents China’s weakest quarter since the dark days of the financial crisis in early 2009, it is still “a milder deceleration than many had feared until recently,” said Louis Kuijs of Oxford Economics. For all of 2015, the world’s second largest economy grew at a 6.9% pace, the slowest annual rate in 25 years.
The government reported that fixed asset investment (a measure of capital spending) rose 10.7% year-over-year (y/y), and industrial output rose 6.8% y/y. Both of these measures were slightly stronger than expected. Housing and infrastructure gains offset a slowdown in financial services in the 1Q.
Friday’s growth report suggests that China’s aggressive monetary stimulus is finally bearing fruit, according to Jing Ulrich, managing director and vice chairman for Asia Pacific at JPMorgan Chase. But Ulrich cautioned that she does not expect the People’s Bank of China (PBOC) to unleash more stimulus anytime soon, and is awaiting the GDP data for the 2Q.
The PBOC has lowered interest rates six times since November 2014, as well as slashing the reserve requirement ratio (RRR) for banks. The central bank’s last action was in February, when it reduced the RRR by 50 basis points.
China’s shrinking economy has long been a focus for global markets, as President Xi Jinping tries to engineer a structural slowdown to re-orient the country away from manufacturing and exports towards domestic consumption and services. The government is targeting growth of 6.5% to 7% for 2016, but it remains to be seen if the deceleration since 2010 has stabilized.
China’s Dangerous & Growing Real Estate Bubble
In order to explain this potentially scary development, we must start by looking at China’s incredible savings rates. Compared to the US savings rate of 2-3%, the Chinese on average save about 30% of their income. Only a handful of countries around the world save 30% on average. Affluent Chinese save more than double that amount!
The other thing to know about the Chinese who live in the largest cities (Beijing, Shanghai, Shenzen and other Tier I cities) is that owning your home is paramount. It is said that Chinese men have zero chance of getting a date if they don’t own their home. But as we’ll see below, home, apartment and condo prices have skyrocketed in recent years.
While the Chinese are to be applauded for saving, the problem arises when we look at what they do with their savings. The Chinese on average have almost 75% of their wealth invested in real estate. This includes their primary residence and in many cases a second residence and/or investments in high-rise condo developments (more on that below).
With almost three-fourths of their net worth invested in real estate (and the other 25% mostly in cash), Chinese investors have no diversification. They have overinvested in illiquid and overpriced assets that they wrongly believe can only go higher. In doing so, they have created what some call the greatest real estate bubble in history.
And just how expensive and overpriced is Chinese real estate? Relative to income, China has seven of the 10 most expensive cities in the world!
Home price to income ratios in the largest cities are off the charts. Beijing is 33.5 times income, Shanghai is 30.2 times and Shenzen is 30.0. In the US, by comparison, the home price to income ratio in cities is only about 6 times income on average. That’s a HUGE difference!
The average condo in most Tier I cities in China is only 650 square feet and would go for $460 per square foot, or about $300,000. In preferred locations, the prices for the same size condo can be double that or more!
If tiny condos in Tier I cities are selling for $300,000 at 30 times income, that suggests that many buyers are only making about $10,000 a year in income, which is borne out by government statistics. This raises the question: How in the world can they do it?
All through the country’s Tier I, Tier II and even some Tier III cities, housing prices are severely out of proportion with the incomes of the people who live there. However, the people of China can afford to buy these extremely expensive properties.
In fact, 90% of families in the country own their home, giving China one of the highest home ownership rates in the world. What’s more is that over two-thirds of these homes are owned outright, without mortgages or any other liens. On top of this, north of 20% of urban households own more than one home. How can this be?
Purchasing a Home in China is Usually a Family Affair
Before we can understand how people in China can afford its over-inflated housing market, we must look at where this market came from. Hardly 20 years ago China’s real estate market didn’t exist. It wasn’t until the mid-90s that a series of reforms allowed urban residents to own and sell real estate.
People were then given the option to purchase their previously government-owned homes at extremely favorable rates, and that’s how most of them made the transition to being property owners. With a population provisioned with houses that they could sell at their discretion and the ability to buy the homes of their choice, China’s real estate market was set to boom. By 2010, a little over a decade later, it would be the largest such market in the world.
When we talk about how people afford houses in China today, more often than not we’re not talking about individuals going out and buying property on their own – as is the general custom in the West. No, we’re talking about entire family and friends networks that financially assist each other in the pursuit of housing.
At the inner-circle of this social network is often the home buyer’s parents. When a young individual strikes out on his/her own, lands a decent job and begins looking to pursue marriage, getting a house is often an essential part of the conversation. Owning a home is virtually a social necessity for an adult in China, and is often a major part of the criteria for evaluating a potential spouse.
Since many parents tend to move into their children’s homes in old age, this truly is a multi-generational affair. So parents will often fork over a large portion of their savings to provision their children with an adequate house – often times buying it years in advance. If the parents are not financially able to buy their kids a house outright, they will generally help with the down payment, or at the very least provide access to their social network to borrow the required funds from friends.
So, it’s the family and friends network that helps younger people buy such massively expensive homes – typically without a mortgage. Only 18% of homes have a traditional mortgage, compared to half of all homes in the US. Minimum down payments on first homes is 30%; for second homes, it’s 60%. For investments like condos, there is no mortgage financing available.
When the Real Estate Bubble Bursts, Look Out Below!
This all sounds well and good but the consequence is a huge real estate bubble in China. As noted above, most home owners have a large equity stake in their home, so the odds of a foreclosure crisis, like we saw here in the Great Recession when millions of home owners were “under water” on their mortgages, is very unlikely in China.
However, that doesn’t mean home prices cannot fall! In China’s largest cities, real estate prices have exploded between five and seven times since 2000. It’s even greater than the unprecedented housing bubble in Japan in the 1980s, which suffered a 60% collapse that it has yet to recover from – even decades later.
A 60% collapse would be devastating to the Chinese and their economy. It is estimated that household wealth in China is over $27 trillion, or about three times its annual GDP. With 75% in real estate, that comes out to over $20 trillion. If real estate falls 60%, as it did in Japan, that means over $12 trillion in household wealth would disappear!
How would Chinese consumers react if their rapidly-built wealth was suddenly cut in half or more? Naturally, that means they are going to spend a lot less money and China’s economy almost certainly goes into a deep recession.
And it may be even worse. The Chinese not only invest in homes – they often buy empty properties and condos as a pure investment play in the hopes of even higher prices. An independent firm in China monitored homes, apartment and condos that were using no electricity and found a 27% vacancy rate across the large cities. Some of China’s so-called “ghost towns” were far worse.
Question: How can a country’s real estate values continue to soar with such a high vacancy rate?
In conclusion, I bring you this information today because most economists and forecasters (and your Editor) believe it would not take much of a negative surprise to throw our feeble economic recovery into a recession. If the world’s second largest economy experiences a decline of 50% or more in its real estate market, that will mean a serious financial crisis in China.
I don’t pretend to know if or when it will happen. What I do know is that most (if not all) large bubbles get popped. Many believe that China’s real estate bubble is unprecedented in history, and when it pops, it will be ugly for all the world.
Wishing you well,
Gary D. Halbert