A loyal reader forwarded me a 43-page law journal article by Professor Gregory M. Stein and asked me what I thought.  The article is entitled “Is China’s Housing Market Heading Toward a US-Style Crash?” and it was last revised in late September 2012.  Stein is a very esteemed professor of law (mostly real estate) at University of Tennesse.

This abstract of the article summarizes it beautifully:

This article aims to determine whether China is heading toward a U.S.-style market crash in its housing market. Rather than attempting to maintain any suspense, I will disclose here that my conclusion is, “Who knows?” China and the United States have dramatically different histories, cultures, governments, economies, and legal systems. Anyone who claims to have a definitive answer to this question is overly confident.

My more modest goals in this article are to examine the available evidence and see which way it seems to point. The article begins by listing and describing several different ways in which the American housing market failed. It then evaluates the consequences of these failures for the U.S. housing market. Next, the article demonstrates some of the key respects in which the Chinese market differs from the market in the United States. This central portion of the article emphasizes just how difficult it is to make predictions about what might happen in one nation’s housing market based on the experiences of another nation that differs in so many significant ways. Finally, the article provides a description of some of the worrisome similarities between the Chinese and American housing markets. To the extent the previous analysis may have comforted the reader into believing that the Chinese market is unlikely to experience a downturn anytime soon, this last discussion will create some apprehension by highlighting some of the ways in which China might, in fact, be heading down the same path as the United States.

Though I was a bit disappointed that Professor Stein reached no strong conclusion (remember he is a lawyer), the article’s analysis struck me as very sound and very thorough and I highly recommend his article for anyone interested in China’s real estate market.

What do you think?

I had dinner last night with two Chinese from Nanjing and two Americans.  The two Americans are both fluent in Chinese and have each spent well over a decade living and doing business in China.  The same is true of the two Chinese.  I greatly respect all four of these people.

The topic of China real estate came up during our dinner and, and I found myself in the more bullish camp. The two Americans both argued that China’s real estate bubble has already popped and that it is only going to get much worse.  I, along with the two Chinese, argued that China’s real estate had not really “crashed” and that I did not think it was going to crash in the same way it had in the United States. The two Americans kept making fun of me and saying that I sounded “just like the realtors who try to sell property.”  I responded by pointing out that I have been pretty bearish on China real estate for a long time but that there is a big difference between being bearish and believing there will be a crash, which to me means a plunge in real estate prices so deep that properties pretty much cease selling at any price and the rest of the economy is deeply impacted.

I then talked about how China’s real estate market is different from that in the United States, mostly due to the following:

  • Urbanization
  • The Chinese government’s close ties to its banks
  • The typical Chinese mortgagee being less leveraged than the typical American mortgagee was right before the crash in the United States.  I admit to not having solid evidence to support this.
  • Real estate demand in China is due in large part to there being a lack of other investments. This alone creates and props up demand.

I hate making the “it’s different this time” argument as I do think past performance is one of the view ways on which we can judge future performance, but at the same time, Shanghai isn’t Sacramento — heck, Sacramento isn’t even San Fransisco.

As I thought more about our discussion, I started thinking about how it has all of a sudden become almost too fashionable to paint China as finished economically. When it comes to investing, I think of myself of as a bit of a contrarian, and so I am now wondering if the recent onslaught of negative news on China might actually end up being a good thing. Does the fact that just about everyone (or at least it feels like just about everyone) is negative on China’s economy and real estate mean that we should be expecting an upswing soon?  Has the China is going to fall bandwagon gotten too big or is it justified?

What do you think?

This is part II of a series of an occasional series of posts we will be running here on what our lead China lawyer, Steve Dickinson, is seeing of China’s real estate market, based on his living “on the ground” in Qingdao. Here it is:

By: Steve Dickinson

There are two types of real estate investor in China. The first are pure speculators who treat residential real estate as a source of value, far removed from its original residential use. These investors purchase multiple properties without bothering even to remodel the units for actual use. They are responsible for the spooky flats of empty condo buildings that have become so common in all of China’s cities.

The second are the normal citizens who purchase real estate as their primary residence. The high prices of the real estate bubble created by the speculators have created much pain for these normal home-buyers. Recent policies of the central government designed to contain the real estate bubble have been designed to benefit this segment of “normal” home buyers. However, it is probable that the recent collapse in real estate values has damaged these normal home buyers as much as, or even more than, the speculators.

A recent story in the local Qingdao newspaper illustrates the situation very well. The article is about Mr. Li (age 31) and Ms. Zhao (age 28), both of whom are successful young professionals. Both are college graduates. Both work in good jobs in the visual design sector. Mr. Li earns RMB 6,000 per month and Ms. Zhao earns RMB 2,000 per month. These are good salaries for young professionals in Qingdao.

For three years, this couple has been planning to marry. The obstacle has been that they have not been able to purchase a home. Their families do not have the resources and they have not had the savings. Mr. Li proposed that they forget about owning a home and just live in a rented apartment after marriage. As is typical in this region, Ms. Zhao refused: no home ownership, no marriage. With great reluctance, Mr. Li agreed to work on purchasing a condo.

In April of this year, they found a suitable unit in Li Cang. Li Cang is a village to the north of Qingdao city. Services there are bad and transportation is inconvenient. However, they determined that a 90 square meter unit on the 15th floor of a sprawling condo project was just about the only thing they could afford in the Qingdao area.

They completed the purchase in April on the following terms:

  • The price of the unit was RMB 9,300 per square meter. Compared to the 20,000 to 40,000 RMB per square meter price in Qingdao, this seemed reasonable to them.
  • The total price was RMB 830,000. Of this, RMB 350,000 was required as a down payment.

The couple was able to come up with the down payment by using their savings, by Mr. Li moonlighting, and with a contribution from their parents. The down payment was accumulated from the struggles of the couple and both their families over the past 10 years. For payment of the remaining RMB 480,000 of the purchase price, the couple obtained a 20 year bank loan. Payments on this loan will be RMB 4,700 per month for the life of the loan, over half of their combined total income, before taxes.

Consider the following:

  • Their down payment was actually a deposit on an uncompleted unit. The project is far from completion. At best, the project will be complete at the end of 2012. Thus the down payment money is tied up and yet the couple still have to pay rent until the project is complete. If the project is not completed there is a substantial risk that the down payment will never be returned. This risk is never discussed in China, but the risk is substantial in a declining market as we know from our experience in the real estate markets around the world.
  • This young couple has now joined the ranks of the Chinese “house slaves” 房奴”, or what we call “mortgage slaves” in the U.S. The total household income of this couple is RMB 8,000 per month, before taxes and their mortgage payment consitutes more than one half of their monthly income. They are in their early thirties. How will they save for their child’s education? How will they save for retirement? How will they save for medical emergencies? How will they save for the care of their four parents? How will they even live a normal life with about RMB 3,000 per month in disposable income? No one knows other than to say that they will suffer.
  • The total price of this 90 square meter unit is RMB 830,000. This is ten times the annual income of this young professional couple. Most economists believe that the cost of housing should not exceed 3 to 5 times annual income. The unit is therefore about twice as expensive as recommended. All of this for a condo in a not particularly nice exburb of a second tier city. 

In October, the couple became uneasy when they heard rumors that units in their project were being offered at a 90% discount. At the end of November, the couple was shocked to see advertisements in the local newspaper offering units in their same project at the price of RMB 6,300 per square meter, a 30% discount off the price they had already agreed to pay. A group of buyers formed and demanded that their purchase price be reduced to the new price or they would cancel their purchase contracts. Some members of the group picketed the sales office. The developer refused their requests. Mr. Li states that he has reviewed the purchase contract carefully and concluded that none of the buyers have the right to a refund or cancellation. He is therefore resigned to his fate and sees no reason to participate in the protests.

Ms. Zhao calculates that over the life of the loan, the couple will pay RMB 400,000 in mortgage interest that is in excess of that amount that would be paid if the unit were re-valued at the new, lower price. This makes her sad. It makes her husband resentful that she insisted on purchasing the condo unit when he had proposed that they just rent a unit. Their excitement at becoming new homeowners is now drowned
by the sorrow of the economic disaster they face. The prospect of 20 years of “home slavery” is not a good way to start a marriage. The couple has not even considered the two additional disasaters that may
be waiting for them:

  • The price drop has only just started. The couple hopes that prices will recover over time. The more likely scenario is that prices will continue to fall next year after buyers truly face the fact that the bubble has burst.
  • Once it is clear the bubble has burst, the developer of their uncompleted unit will not be able to sell units at any price. This means the project will fail, and the units will not be completed. What will happen to the substantial deposit this couple has already paid? No one knows. Chinese law provides that it must be returned. However, there are no good controls in place to guarantee that will actually occur.

Our couple and their fellow buyers are already upset with the fall in price. What will happen if the project fails and their deposits are not returned? What will happen to their bank when their mortgage loans turn out to be worthless? What will happen to the development lender when the project fails and the development loan is not repaid?

The story above is being repeated in every city in the coastal provinces in China. The impact is personal and direct. Every person in China knows at least one person who has been impacted. The effect on the economy is incalculable. Just when the government is promoting a new program to increase domestic consumption, the collapse of the residential real estate market is pushing Chinese consumers in the opposite direction. The extreme uncertainty likely means that they will freeze up, greatly reduce their spending and move into an even more intense savings mode. The result will be to freeze up the economy for a considerable period.

I must emphasize again that what I have described has already happened. It is not a projection. The situation is China’s current reality. A government cannot prevent what has already happened. It is too late. All we can do is wait and see what will be done about the situation. Current indications are that nothing will be done at all. Given the way governments work, that may be the best possible result.

What will you do to adjust to this new reality?

UPDATE: China Bystander has a really good post on China’s real estate market and its likely impacts, entitled, “China’s Property Bubble: Bursting or Deflating?