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China’s Real Estate Riddle

June 11, 2009

This article of mine appeared in the Far Eastern Economic Review in June 2009.  The direct link is here.

China’s Real Estate Riddle
by Patrick Chovanec
“The end is near!” That was the message top government expert Cao Jianhai delivered in April when he predicted that residential property prices in China will plunge by half in the next two years. He reasons that China’s recent run-up in housing—average prices have tripled over the past five years—is unsustainable given the huge volume of new apartments sitting empty throughout the country.
Mr. Cao’s forecast is pretty scary, and not just for homeowners. China’s banks may not have invested in risky mortgage securities like CDOs, but they make most of their business loans based on collateral in companies’ real estate assets, which frequently are pegged to the going price of nearby residential developments. If that collateral were suddenly cut in half, China could face a banking meltdown that makes the West’s financial crisis look like a walk in the park.
The problem with such predictions, as sensible as they may be, is that informed observers have been making them for over a decade, yet the “bubble” never seems to pop. Pessimists point out that, according to official figures, China’s inventory of unsold apartments hit 91 million square meters at the end of last year, up 32% from the previous year. But this number pales in comparison to the 587 million square meters that investors happily purchased over the past five years, only to leave empty. Not only do the Chinese seem to have a voracious appetite for homes they never intend to live in, this appetite has persisted for a remarkably long time, almost defying economic gravity. So when housing prices dipped 1.3% in March (compared to the prior March) on concerns over a supply glut, buyers poured into the market, sending sales volumes to their highest levels in two years.
As a Beijing homeowner myself, I’ve experienced this puzzling phenomenon firsthand. We have been told that the value of the condo we bought last year has gone up 30% based on sales of new nearby developments, but it’s impossible to confirm since there is no secondary market. Originally we tried to rent the place, but we couldn’t find takers at any price that could remotely cover the mortgage, despite a prime location. When we decided to move in instead, we discovered that while the building was sold out long ago, hardly anyone actually lives there. Same with another 800-unit project down the street: every unit went for top dollar well before completion, but now the lights are off and nobody’s home.
The most common explanation, in Beijing at least, is that provincials who struck it rich are buying addresses in the capital to secure hukou (residency permits) for their children, which offer access to better schools and jobs. Fair enough, but that hardly explains the seemingly endless rows of luxury megaliths you can see sprouting up in every provincial capital or third-tier Chinese city worth its salt, with nary a resident in sight. Beijing has no monopoly on ghost-condos.
One possible key to this riddle occurred to me after I heard about the Chinese tour group that recently (and famously) traveled to the United States hunting for post-bubble real estate bargains. I heard that one of the reasons they returned empty-handed was that they were shocked—shocked!—to discover that in the U.S., property is taxed annually on its value. China has taxes on real estate transactions, but no recurring tax on holdings. The group’s discovery, and their disappointment, got me thinking.

The average property tax in the U.S. is 0.95% of assessed value, which for serious real estate investors represents a relatively modest cost of doing business. But for a typical homeowner, such taxes amount to roughly 3% of their income, a not-insignificant cash outlay, especially if they are not getting full use out of the property. This and other aspects of the U.S. tax system—including the home mortgage interest deduction and passive loss rules—create strong incentives for residential property owners to either use it to live in or to generate income by renting it to others to live in, and penalize them for letting it stand idle. The effect is to keep housing prices closely tethered to real end-use demand for livable space, by driving owners to find such uses. Investor sentiment can push those prices too high or too low for a time, but the need to find actual occupants eventually forces a correction.
In China, there is no cost to holding property indefinitely. In fact, it can be relatively attractive option. Unless they already possess offshore funds, Chinese citizens have limited investment choices: they can gamble on an unstable domestic stock market, buy low-yielding government bonds, or stash their cash in even lower-yielding bank deposits. By contrast, real estate—occupied or not—offers them a visibly reassuring place to park their money, sheltered from inflation. Americans have long been familiar with this advantage to owning a home, but with little or no holding costs, Chinese owners are unconstrained by the need to make the property “pay” in cash or in kind. For them, an empty condo is a store of value, much like gold, another asset that performs no practical function besides retaining its worth.
A modest annual tax may not be the only factor shaping these behaviors, but it’s emblematic of an important difference in outlook. There’s an old story reported by an American journalist in Shanghai after the end of World War II. Ravaged by hyperinflation, locals had turned to using tins of sardines as an alternative currency. One recent arrival opened his “proceeds” from a sale only to find the sardines inside were spoiled. He complained to the other trader, who cried, “You opened them? My God, man! Those sardines aren’t for eating, they’re for buying and selling.” Apartments in China aren’t for living in, they’re for investing. That is the real source of demand.
One problem is that using luxury condos as currency is immensely wasteful, compared to sardine tins or tiny amounts of gold. Construction of all these useless high-end units consumes huge quantities of labor and materials that could go into creating, rather than merely representing, useable wealth. And without adequate maintenance (recall the need to minimize holding costs), any practical utility these units might have had as residences will deteriorate rapidly.
The other challenge is psychological. A useless asset like gold or vacant apartments can only serve as a store of value so long as people have collective confidence it will continue to perform that function and thus retain its value. China’s property market may well crash. The point is that if it does, it won’t be because the supply of apartments outstrips the practical need for affordable living space, as it has for many years now. It will be because the Chinese lost faith in real estate as a form of tangible savings, or found a better alternative.

33 Comments leave one →
  1. September 2, 2009 3:58 am

    I think untill we get the credit mess fixed we are in for along road and so is China

  2. kenny permalink
    November 15, 2009 1:01 am

    don’t get it. if there is no secondary market, why is there a primary market for investing?

    • bam permalink
      December 20, 2009 7:27 pm

      I think a fair number of owners are waiting for the yuan to strenghen in hopes of unloading the property in a more mature market. I’m not sure if that makes much sense, but that’s what I’ve been told from other owners here (in China). Not only that, Chinese property has a max 70 year lease. What happens after that is anyone’s guess. … a technicality perhaps…?

    • February 15, 2010 12:56 pm

      there actually is secondary market… I am a Chinese…But I am not sure those luxury condos have active secondary market

    • martin permalink
      March 4, 2010 10:13 am


      Your right, it doesn’t make sense. That is why this whole thing is scary in China. People continue to build and buy new condos rather than purchase the perfectly fine vacant condos next store.
      In actuality, there is a secondary market, condos are sold by their owners at times, but not nearly to the degree that one would expect from a typical functioning housing market.

  3. Peter KT Chew permalink
    November 20, 2009 4:32 pm

    Hi Patrick,

    Are these empty buildings being properly maintained? Meaning these investment assets would begin to fall-apart (literally) unlike gold or money in the bank.


  4. Karen permalink
    December 21, 2009 7:53 am

    How does homeowners’ insurance work in China? I assume they have it; is it unusually inexpensive?

    I have heard that most Chinese make very low wages. So I suppose the cost of ongoing maintenance and security at these condo buildings might be much lower than what we’re used to in the developed world?

    Also, don’t homes become dated after a while, like they do here? Shouldn’t these investors expect tastes to change after a while, so if they try to sell after a number of years they will have to either accept a lower price or pay for a big remodel?

    Or are they expecting to sell in only a few months?

    • Shannon permalink
      December 21, 2009 1:18 pm

      Regarding ongoing maintenance the usual Chinese home is what in the USA we’d call an apartment. When sold it’s little more than an unfinished concrete shell. Bare walls, zero flooring. VERY basic toilet and sink in the bathroom(s) more suitable for the renovation crew to use while they are putting in an interior than for any proper family use. As a rule the crews live inside the apartment they are working on, and depending on the level of occupation/ newness of the building may bang / paint / saw for > 12 hours a day. In the USA you buy a new house in a nice development you move in your furniture, perhaps pick out a new fridge or stove, and you are good to go.

      In China you buy a new home (for cultural reasons they prefer new over secondhand) you’ll spend many thousand additional dollars and perhaps several months before it’s fit to live in.

      Buy in a new building? Enjoy the sound of ongoing construction for the next year or so, and the structure is concrete so the sound of someone using a jackhammer to chisel out (concrete/ brick, remember?) a channel in a wall for some conduit can be heard some distance away.

      For those who live in China, can anyone explain why the developers don’t include enclosed patios when they build the apartments? Because 97% of them will be enclosed by the occupants anyway seems it would go far to ensure a uniform look to just have it done from the get-go anyway.

      • prchovanec permalink*
        December 21, 2009 1:25 pm

        What you say is oh so true. My building is at least 2 years old now and I still hear construction going on above and below us, although it’s less now than a year ago (when it was almost constant).

        The other thing worth noting is that, although most buildings have provisions in their sales contracts for the formation of a condo association, they usually require a quota of residents. It can take quite a while for that quota to be reached, and even then the interest in actually starting and participating in one is low (most residents probably don’t know what it is, since they’ve never seen one actually set up). Instead, the building is run by what’s called a wuye, or management office, operated by the developer. Of course, the developer has long since moved on to a new project, so the wuye is just a cost-center to them.

      • February 15, 2010 1:01 pm

        I think culturally Chinese like our own home to be decorated according to our own taste from scratch, so we are very willing to design and decorate everything, including the “patios” by ourselves. This culture influence is enormous, although it may start to change as more fully-furnished apartments are available for sale.

    • May 8, 2010 9:52 am

      The situation where there are people in a position to invest in a speculative property market is such a recent development that people likely haven’t thought that far ahead. The emergence of a middle class in China happened very quickly, and at this point it’s not clear just how big it will become.

  5. Vincent911 permalink
    January 4, 2010 1:38 am

    China’s property market may well crash.
    The point is that if it does,
    I have invested in 10 apartments in Shenzhen and Hong Kong with some of my retirement cash and very nervous.
    *) 3 in a small town center and next to the town seat – Tripled in value & earning small renting income.
    *) 3 near county seat, above Tesco supermarket, next to subway station exit current being built (2010-10 completion) – still vacant & lost 10% in value.
    *) 3 in Hong Kong, rented earning reasonable income & remain the same in value.
    *) 1 450-square-meter, 30 miles from Shenzhen city center, near the exit of a highway, still vacant & lost 5% in value.
    I have been searching for the answer whether or not the property market in China will crash.
    I have found some answers from the last paragraph of this blog (above).

    Please someone help me!
    Under what circumstances would the Chinese loose faith in real estate as a form of tangible savings ?


  6. January 6, 2010 9:08 am

    I am hearing more and more about a China bubble and the potential impact on US market that i am startign to watch closely

  7. martin permalink
    March 4, 2010 10:19 am

    Dear Chovenec,
    In regard to your statement,
    “China’s property market may well crash. The point is that if it does, it won’t be because the supply of apartments outstrips the practical need for affordable living space, as it has for many years now. It will be because the Chinese lost faith in real estate as a form of tangible savings, or found a better alternative.”

    I couldn’t agree with you more. But I think there is another catalyst that might come sooner than a psychological change. Chinese purchase real estate here as a form of long term savings. There is a huge older working population in china, who have placed their savings in real estate. When they retire, in the very near future, what happens when they want to liquidate their savings? Is there really a large enough pool of buyers to aquire their properties in a sea of vacant secondary market homes and new construction properties? The only way they will be able to sell is to lower their prices……… I see this as the tipping point of the housing crash.

    Its not when the pyschology changes as much as it is when the chinese working man retires, stops working, and starts reaching into his savings. Am I missing something or would you agree?

  8. ADH permalink
    March 25, 2010 2:02 am

    In regard to your comment:

    “In China, there is no cost to holding property indefinitely.”

    Does the concept of opportunity cost not apply in China? (As in the opportunity cost of forgone rent). Why not rent it out and get some more ROI ?

    The price for these new apartments is very high relative to the average wage – and that suggests unsustainablity.


    • prchovanec permalink*
      March 25, 2010 10:49 pm

      Perhaps what I should have said is that there is no (or minimal) out of pocket cost to holding property indefinitely.

  9. October 29, 2010 4:43 am

    And that will have a massive impact on the economic situations on many countries in trade agreemants with China all around the world!

  10. September 14, 2011 6:00 am

    Very instructive professor. After all the time passed, would yo say the situation and the reasons are still the same?

    Miguel Arca

  11. July 25, 2012 10:37 pm

    Hey there excellent blog! Does running a blog similar to this
    require a massive amount work? I’ve very little understanding of computer programming however I had been hoping to start my own blog in the near future. Anyway, if you have any recommendations or techniques for new blog owners please share. I know this is off subject nevertheless I just needed to ask. Thank you!

  12. September 20, 2012 6:47 pm

    Great blog and good post……………very informative…….

    Jeffrey T. Angley


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