To Henry: My thoughts on China’s Real Estate Market

[American Turtle]

Hi Henry, thank you for your insightful comments and some of my thoughts are following. I post this message separately solely to attract more readers’ attention and hopefully more inputs from them.

First of all, whenever I talk about China, I do not intend to include Hong Kong and Macau. Politically, they belong to China. Economically, they act as a separate entity with their own fiscal and monetary policies. Due to the rise of China’s economy power, their economy will become more and more a derivative of China but not the other way around. I encountered some bullish reports on Macau talking about its out-performance of Las Vegas and long-term prosperity. It is true that Macau benefited greatly from Asian economy recovery especially rise-up of China. But in my opinion, it is a matter of time that China will have its own Las Vegas built up in the inner China (The same logic of initial start of LV) to attract tourists and recoup its lost gambling profits. In this sense, any play on Macau could only be short-term. In long-term, Macau will lose it to the prospective China’s LV.

Looking at the real estate sector in China, let us first define some fundamental trends.

1. Urbanization. In this year, China’s urbanization ratio stays around 42% with $540 Mil urban residents. Korea stands as 81%. Looking forward, this ratio is expected to increase to 60% in the next 25 years. What this number means is in the next 25 years 250 Mil rural residents will move to the cities and buy their first-time property (low to mid-level) over there. Current number of persons per urban household is 2.98 which would denote 80 + Mil apartments in the next 25 years.

2. Upgrading needs of urban residents. Starting from the end of 1980s, China issued the policy to resell the once “free” apts. to their current residents with 5% to 20% of market price. This policy redistributes wealth back to urban working people and helps maintain social stability. Unfortunately, these old style apartments look quite xxx compared with currently developed one which sell with market price. The old residents tend to sell their olds ones (to rural migrants) and trade up when the price comes to their affordable range. Another upgrade is from inner-city rebuilding. Even the most developed city Shanghai still has a large percentage of crappy buildings which usually reside on high-value locations. The developers will cut a deal with local government to buy out old residents who will get compensated to buy their new home wherever they can afford in the same city. The price elasticity of this demand is almost zero.

3. Foreign demand. Foreign demand only taps into a few cities in China mainly Shanghai and Beijing. Pure speculators come and go. But the overseas Chinese which includes mainland Chinese who immigrated to other countries and people from HK and Taiwan have a tendency to purchase property either as their asset allocation strategy or just for personal use. This piece of high-end demand tends to stay for the long-term.

4. Government. Affordable housing is one key piece of social stability. It is a way government used to distribute wealth and currently only benefits few privileged ones. In the middle of this year, the government issued new policy towards real estate with the purpose to adjust the supply-mix and increase supply to middle and low-end housing. The entry barrier for property developers greatly increased which would be beneficial for a few public listed companies to consolidate the market.

Maro-economy Trends

1. With negative real interest rate, closed capital market and under-performing stock market, where can the money go? The over-capacity will keep the inflation low and in the near future China would face deflation pressure instead of inflation. The domestic stock market is still hovering around their 8-year low. Real estate becomes one of a few channels to park the money. Even when the people’s expectation for the future real estate price is neutral, as long as rental yield is greater than inflation, they may still be willing to buy just to keep the purchasing power.

2. The current market does not expect to see another appreciation of RMB soon. The hot money leaving China did not cause the collapse of Shanghai real estate market. I have never found any data which tracks hot money flowing into real estate. My intuition is that the major speculators are domestic players. Even the expectation for RMB appreciation changes, we are going to see a big inflow of capital into this area.

Current Market Situation

The bubble area is solely Yangzi River Delta area which typified three cities, Shanghai, Nanjing and Hangzhou. Just 3 years ago, Beijing’s apt. price is highest in China while Shanghai is ranked second. Now, Beijing’s average transaction price is 6K while Shanghai has 11K. So you can see Beijing lagged far behind Shanghai in this real estate boom. In the country overall, the growth of property price is less than the increase of disposable income. It is a good sign for the property price in Shanghai to soften. But I can hardly imagine the weakness will spread over to the whole country unless the economy tumbles dramatically.

In terms of your comments on increase of US capital cost, I think the effect would be minimal. On average, the developers finance their projects with 30% equity, 20% bank loans, 45% presale proceeds and 5% others. The US denominated financing only comprises of a tiny percentage. With the low inflation environment, the cost of borrowing will stay low for a while. One interesting thing is when the market cools down, it would be much harder for developers to use presale proceeds and bank loans to finance their new projects. Only financially strong developers could survive a cool market.

Henry, could you please give me the source of your commercial building 1 billion square feet every four months. Thanks.

[American Turtle]

To: Henry

Thanks for your posted article. Shanghai is a booming city which sucks in both domestic and foreign capital into its real estate. Personally, I can not time or even do not know how to time the cycle of Shanghai's real estate market. Anyone has any ideas please share.

[HenryTo]

AT - check out the following NY Times article. Quote: "But since the early 1990's, Shanghai and other cities have been making up for lost time. And this year the building boom is at a frenzy, with the nation expected to lay down the finishing blocks on 4.7 billion square feet or more of construction, a record, up from 2 billion in 1998."

No doubt this includes residential as well. I am actually getting my commerical numbers from somewhere else.
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October 18, 2005
China Builds Its Dreams, and Some Fear a Bubble
By DAVID BARBOZA
Correction Appended

SHANGHAI, Oct. 16 - Move over, New York. This year alone, Shanghai will complete towers with more space for living and working than there is in all the office buildings in New York City.

That is in a city that already has 4,000 skyscrapers, almost double the number in New York. And there are designs to build 1,000 more by the end of this decade.

China's real estate market is so hot that miniature cities are being created with artificial lakes, and the country's nouveau riche suddenly seem eager to put down as much as $5.3 million for a luxury apartment in skyscrapers with names like the Skyline Mansion.

For decades after the Communists took over in 1949, there was relatively little housing construction or office building under central planning. But since the early 1990's, Shanghai and other cities have been making up for lost time. And this year the building boom is at a frenzy, with the nation expected to lay down the finishing blocks on 4.7 billion square feet or more of construction, a record, up from 2 billion in 1998.

"There's no doubt what is happening in parts of China is on a scale we've never seen before," said Richard Burdett, professor of architecture and urbanism at the London School of Economics. "But more importantly, it's the fastest pace of development in the past 50 or 100 years."

In Beijing, the remains of an old Taoist temple now stand in the middle of the parking lot of a new mall more than twice the size of the Mall of America. Big developers are acquiring huge swaths of prime land in the largest cities to build huge residential campuses with kitschy names like Cloudland Water Manor, Eastern Venice, Palais de Fortune and Skyway Oasis Garden.

Such developments dwarf anything being built today in the West. "I'm working on a master plan for a 46-kilometer riverfront area," said Robert Egan, who runs a landscape architecture firm in Beijing called PlaceMakers. "Scale like that doesn't happen in the U.S."

It is not uncommon to see a residential development with 10, 20 or even 30 identical high-rise apartment buildings clustered around sculpted green spaces and artificial waterways.

For increasingly wealthy Chinese, the American dream of a home and a yard has become more like a French villa with a community lake, a town square, a post office, a hospital, a cinema, a church, a hotel, a shopping mall and, of course, a power plant.

A top-of-the-line unit at one development project has a 25-acre palm-shaped artificial lake, which brochures say will feature docks with berths for private yachts.

Prices are soaring. Luxury apartments in Shanghai and Beijing with names like Home of the Tycoons now sell for prices comparable to some high-end properties in New York.

Rising prices have created a circus-like atmosphere in parts of China. Real estate fairs are mobbed, land speculation is rampant and some poor farmers dream about converting their wheat fields into the next Beverly Hills.

Indeed, prices have risen so fast over the last few years and the pace of building has been so furious here and in other large cities that the government and some leading economists have been warning about a huge property bubble in China.

The building boom is a principal reason that China is searching around the world for energy and natural resources: it needs the raw material to build new cities, and the energy to power them. That is helping drive up world commodity prices and threatening global environmental damage .

China's heavy reliance on coal to power its overcharged economy has already made it the world's second-largest producer of greenhouse gases, after the United States. And the World Health Organization says China has 7 of the world's 10 most-polluted cities.

The construction boom is also beginning to wipe out what little is left of the old China, alarming historic preservationists. Indeed, as the world's most-populous country, at 1.3 billion, rapidly modernizes and urbanizes, producing millions of new homeowners, its social and economic fabric is being fundamentally altered.

China's housing rush is being fueled by mortgage rates around 5 percent and huge inflows of foreign capital. But the boom is also driven by landmark government housing reforms from the 1990's that for the first time since the Communist revolution of the late 1940's allowed Chinese to acquire their own homes rather than live in government housing.

As a result of this privatization, thousands of new residential projects are rising in the bustling coastal provinces. And sprawling satellite towns and luxury villa developments are sprouting in what was once farmland.

This may just a suggestion of what is ahead. China expects 75 million more farmers to move to cities over the next five years, amounting to one of the biggest mass migrations in history, according to CLSA, a brokerage house specializing in the Asia-Pacific region.

"China's demand for housing is just getting going," says Andy Rothman, a CLSA analyst in Shanghai.

The boom is most evident in the largest cities like Beijing, which will be host for the 2008 Olympics and is now draped in construction projects that are straining water and power supplies. Every big city seems to have plans for a central business district. And every big housing project seems to have a Phase 1, 2 and 3.

"Everyone wants to build a Manhattan," said Jun Xia, a principal in the Shanghai office of Gensler, a global architecture and design firm. "In China, I say 'smaller, smaller' and the clients say 'wider, wider.' "

Some of the greatest financial rewards have been going to the country's new real estate tycoons - people like Pan Shiyi and Zhang Xin in Beijing, and Wang Shi in Shenzhen. A property tycoon in Tianjin, Sun Hongbin, once served a two-year prison term for embezzlement but now graces the cover of magazines like China Entrepreneur.

It is not surprising that in a country where 170 metropolitan areas have more than a million people, according to government figures, everyone seems to want to be a developer. State-owned oil and steel giants, automobile companies, shipbuilders and even Communist Party newspapers are creating real estate subsidiaries.

The developer of the Fortune Residence in Shanghai, a high-end property, is a subsidiary of People's Daily, the leading newspaper of the Communist Party. And China Central Place in Beijing is being developed by Guohua Electric, a power company that for 50 years has occupied land in an area the city recently designated as its new central business district.

Guohua's real estate arm is now building a $1.2 billion complex that consists of three high-rise office buildings, a 1.8-million-square-foot shopping mall, 1,300 luxury apartments, two five-star hotels and a man-made lake and river walk.

Foreigners are also scrambling to enter the Chinese real estate market. Goldman Sachs and Merrill Lynch have invested in property. And Morgan Stanley has acquired about $700 million worth of commercial real estate this year in Shanghai. The city says it now has more than 4,000 skyscrapers - buildings 18 stories or higher - far more than New York, according to Emporis, a global real estate research group based in Germany.

Also considering investments here are Simon Property, one of the world's biggest retail developers; Triple Five Group, developer of the Mall of America; and a Japanese real estate tycoon, Minoru Mori, who is spending nearly $1 billion to build one of the world's tallest buildings - the 1,614-foot Shanghai World Financial Center in the Pudong district.

There is, of course, a dark side to this real estate boom. In the scramble to reallocate land and create boomtowns, China has spent much of the last decade demolishing millions of old homes and buildings and relocating tens of millions of people, many against their will.

And there are broader risks. The Chinese government is concerned that soaring prices might overheat the nation's economy and even threaten social stability. It moved this year to impose new taxes and other tough administrative measures aimed at cooling off the property sector.

Housing sales have slowed since June. But in recent months, real estate construction has picked up steam again, according to UBS. And that growth is bolstering new demand for energy and raw material. China is already the world's largest producer and consumer of steel, cement and coal.

In his report, "China Eats the World," Mr. Rothman of CLSA predicted that in coming years, "the Chinese dragon will stay very, very hungry."

Many Chinese are acting as if the housing boom will not fizzle any time soon. The economy is soaring, income is rising, Ikeas and Wal-Marts are popping up in second-tier cities and tens of millions of people are giddy about the prospects of owning their own homes, driving their own cars and adopting a more modern lifestyle.

"You know for a half-century, nothing was built in China," Mr. Jun of Gensler said. "Now there's a lot of excitement and demand for new houses, and excitement about a new way to live."