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What Drives Chinese Real Estate? - Outside View by Nitin Gregory
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What Drives Chinese Real Estate?
Apr 18, 2016

A great way to benchmark house prices is the house-price-to-per-capita-GDP ratio. This ratio looks at the price of an average house and compares it to the average person's earnings per year. It gives a sense of how many years of income are required to pay for a house.

The problem with averages is that they mask the extreme variations within a country. Real estate prices are impacted by many local factors. For example, the ratio in Mumbai or Shanghai will be outliers compared to the national average.

In my previous post, I drew comparisons between Chennai and Nanjing. Sticking to the same comparison - the average 2-bedroom house in Chennai city is around $225,000 and the GDP per capita for India is $1,500 per person. This means that it takes about 150 years for the average Indian to pay off a house in Chennai. In Nanjing, it would take around 108 (broad estimates). Does that mean housing is cheap in China?

Definitely not. The same ratio for a tier 2 city in the US like Chicago is 5 (New York is 13). When you compare house prices relative to income levels- emerging market are definitely not cheap. India is no exception.

Our focus here will be the Chinese housing market. What are the key supply and demand drivers? What are the next steps?

Supply

The most powerful factor is the government. Real estate development is a key tax source (30-40%) for the local government.

In China you cannot own land. Land is leased from the government, typically for 70 years when it is for residential purposes. An apartment is owned by an individual; however the land is still on lease. This means that at the end of the lease term - it will have to be renewed. Real estate firms have to lease land for new constructions, which result in a stream of revenue for the local government. A stable or rising property market will ensure new developments.

The government recently took measures to cool the overheated market. Now measures are being taken to help stimulate prices. Taxes on property transactions have been reduced. The minimum down-payment for first time home buyers has also been lowered.

Given the importance of this sector, government regulations and incentives are a key determinant of supply and transaction prices.

Demand

Urbanization is the prime source of demand. There is strong drive to move from villages to cities like Shanghai and Beijing. This is associated with the desire for a better lifestyle. Forecasts have estimated that 100 million Chinese will be moving to cities in the next five years!

Relative to the US, the financial system in China is still shallow. The Chinese stock market is heavily regulated and is has very low household participation (by value). Bank deposits are considered safe but have very low yields. Investment options are limited. This means that for the average Chinese, real estate is the most accessible and popular investment option. Large portions of the household savings are being directed into the real estate market.

Last but not least is the cultural factor. The Chinese consider owning multiple houses a matter of pride. Renting to live is almost unheard of. A young boy, who wants to marry his sweetheart, can only think about it after he has acquired a house and a car. I reckon, irrespective of the house prices, this will be a dominant factor in the household market of China.

Rebalancing

There are some strong and legitimate demand factors that are driving the housing market. Urbanization is a long-term 'megatrend' that will be a common theme across many countries, not just China.

Despite this demand, there is indication of an oversupply. It is estimated that there are one billion square meters of empty real estate. The government is keenly watching this sector and enacting reforms to help rebalance.

The first key step is to reduce the local government dependence on land revenues. A 'recurring property tax' on an annual basis has been recommended as a possible solution. A recurring tax will ensure that the local governments don't have to continue leasing new land to fund its budgets.

The second step (connected) is to provide some financing relief for the existing debts taken by local governments. In recent months, the central government has allowed the issuance of municipal bonds. This was followed by allowing foreign investors to invest in local bond markets. This opens the way for foreign funds to flow into Chinese real estate.

The real estate market is a key driver of the Chinese economy. It employs a large number of people and is also a source of bank debt exposure. While the demand factors will continue to grow, the supply situation has to be addressed (rebalancing supply). In the short term, financial stress will be managed through alternate funding sources. In the long term, dependence on this sector will have to be reduced.

How is real estate connected to the debt situation? What impact will this have on commodity prices? We will explore this in future discussions...

This column is authored by Nitin Gregory. Nitin, who graduated from IIM-Calcutta, is currently pursuing a finance role with an automotive major. He has a deep interest in Macroeconomics and pens a blog at Gregonomics.

Disclaimer:

The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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