China's Real Estate Riddle

Posted June 8, 2009

“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.

Patrick Chovanec is an associate professor at Tsinghua University’s School of Economics and Management in Beijing, China.