Bubble, Crisis, Bubble, Crisis – Debunking The Chinese Real Estate Sector

February 23, 2017

Bubble, Crisis, Bubble, Crisis – Debunking The Chinese Real Estate Sector

  • The Chinese government is controlling the real estate market and allowing short, two-year boom bust cycles.
  • Western investors don’t understand China and see either a bubble or a crash.
  • The best way to invest is to seize the wild market swings created by such erratic behavior.

Introduction

The question we would all like to know the answer to is this: is the Chinese real estate market in a bubble?

If it is, any kind of burst would create a credit crisis, lower economic growth, and quickly spill over first on global financial markets, and consequently onto the global economy.

There is no consensus on whether or not Chinese real estate is in a bubble. I’m going to describe both perspectives to give you the best information possible for China and Chinese real estate related investments.

Current Situation

To understand what’s going on in China, we first have to look at supply and demand, the level of inventories, and whether or not the real estate market is controllable by the government.

Price-Index

Many advocate that there is a real estate bubble in China but a look at year-over-year price increases shows that that isn’t the case for the whole of China. Prices have mostly increased in tier 1 cities while they have remained stable, and even declined, in tier 3 and 4 cities.


Figure 1: China residential property prices, year-over-year quarterly percentage changes. Source: Capital Economics.

Rising prices don’t immediately mean there’s a bubble. Figure 2 indicates that the Chinese real estate market evolves in two-year cycles. This short-term cyclical movement indicates two things: 1) there might be a supply issue behind surging prices and not a bubble issue, and 2) the government is tightly watching what’s going on in real estate and aiming for short-term cyclicality to keep the market hot, but not let it overheat.


Figure 2: Residential property sales, year-over-year quarterly percentage changes. Source: Capital Economics.

The two-year cycles are extremely clear and the result of government actions. As soon as the market started to shrink in 2015, the government loosened credit policies and increased financial stimulus, while as the market overheated toward the end of 2016, price regulation policies and selling restrictions were immediately implemented.

Limited price increases and increased required down payments will stabilize the market until the temporary restrictions are removed. We can expect more talk about bubbles when these restrictions are removed.

Demand, Inventory & Supply

Given that urbanization is expected to continue until 70% of the Chinese population lives in cities, up from the current 55%, there will be another 200 million home seekers fueling the real estate market in the future. Therefore, inventory is expected to shrink and turn around faster.


Figure 3: China property inventory. Source: Business Insider.

As inventory turnover rates fall below three years, we can expect another boom in prices, further government restrictions, and a continuation in the Chinese real estate cycle.

Government Policy

It’s extremely important for the government to keep real estate construction stable as it’s a huge part of the economy.

Karen C. Seto, a China expert and professor of geography and urbanization at the Yale School of Forestry and Environmental Studies, shares three things we have to know about China:

  • Urbanization in China is unprecedented and therefore impossible to measure with the tools we have. It cannot be compared to the U.S. housing bubble nor with any other historic example.
  • Urbanization is a process that’s still in transition with some cities in the latest stages of development while others are just at the beginnings.
  • Not all is black and white in China so the real estate environment can’t be put in one basket.

The long-term urbanization trend is clear and China is still far from developed urbanization levels.


Figure 4: China will reach 60% urban population by 2020, still 30% to go in order to reach Europe, Brazil and the U.S. Source: Dragon Star.

In 2016, the world’s best hedge fund managers expected China to enter a bust cycle. According to Ray Dalio, the unsustainable buildup of credit will lead to a typical boom and bust cycle but he also thinks that China will manage to get out of it because all the debt is in its home currency. Kyle Bass also advises against investing in China due to a credit bubble that is close to imploding.

However, housing is still a relatively small part of GDP debt.


Figure 5: Chinese debt to GDP per sector. Source: Bloomberg.

If people are so worried about Chinese debt, they should be more worried about the U.S. or UK as deposits in China almost cover all debts.


Figure 6: Global broad money and debt levels. Source: Bloomberg.

The asset perspective is also very important as asset values in China are much higher than the issued debt. Without a down payment, real estate can’t be bought in China.


Figure 7: Assets in relation to GDP. Source: Bloomberg.

The result of all of the above is short term cycles.


Figure 8: Three year cycles in the Chinese real estate sector. Source: Bloomberg.

When the government hits the brakes, we have a slowdown and prices decline. These declines are usually publicized by western media as “China going bust” events. But as the market stabilizes, the Chinese government continues to stimulate growth by removing restrictions.

As soon as the market comes close to bubble territory again, the government hits the brakes again. The latest government action was in the direction of tightening property purchase rules by increasing required down payments and by limiting prices.

As inventories grew, investments in real estate declined so we may see some sort of balance in the future.


Figure 9: Inventory buildup and investments in real estate. Source: Rabobank.

Investment Conclusion

We can’t analyze China through capitalist and democratic lenses because government intervention is direct and immediate when necessary. Putting a cap on prices is something unimaginable in the western world while largely accepted as normal in China.

Given all of the above data, I’m more convinced that the west just doesn’t understand China and our misperceptions should be used as investment opportunities.

The latest headlines indicate that the Chinese real estate sector is in a bubble with uncontrollable price increases.


Figure 10: End 2016 headlines. Source: Bloomberg, and WSJ.

On the other hand, just a year ago, headlines were indicating that we were in for a Chinese housing crash.


Figure 11: 2015 and beginning of 2016 headlines. Source: Financial Times and South China Morning Post.

The investment thesis is simple. Ride the cycles created by media misperception as it is the government’s goal to keep things sustainable but also allow for economic growth and development through real estate and higher prices. Don’t forget that another 200 million or more people will move to cities in the next few decades.

I’m following a few potential Chinese real estate investments and as soon as the market’s sentiment is at its lows, I’ll update readers. It’s much easier to work with and make money thanks to the Chinese government than to bet against it. The short term real estate cycles are a great investment opportunity as the urbanization trend will remain strong for the next few decades which limits the downside.