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China's Housing Bubble: Mainly Hot Air, Part 1

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Popular perception is that the biggest problem for the Chinese economy is a real estate bubble that's sure to burst any minute. But the fact is, the bubble problem is overhyped.

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Editor's Note: This is Part 1 of a two-part series. Click here for Part 2.

Popular perception -- driven by bogus statistics and gimmicky YouTube videos filmed by prima donna perma-bear hedge fund managers -- is that the biggest problem for the Chinese economy is a real estate bubble that is sure to burst any minute now. It makes for a good story, but the truth is that the real estate "bubble" problem in China as it relates to both quantity and price is overhyped.

This is a complex subject, and it will require substantial effort to review it, even in summary form.

How Big Is the Oversupply Problem?

There are no reliable statistics on residential vacancies in China. The most extreme estimate bandied about in the popular press is that there are 65 million vacant residential units. However, this is no more than an urban myth that has its origin in a highly questionable inference made by an economist at the Chinese Academy of Social Sciences that reported that 64.5 million electricity meters in urban areas around the country registered zero consumption over a six-month period. The claim about the meters has been vigorously debunked by the pertinent officials and power company executives in China. Despite this, the figure is frequently cited as if it were authoritative.

The figure is ridiculous. Sixty-five million is more than all of the residential housing units constructed in the relevant areas since 2000! Furthermore, it implies an overall vacancy rate of around 40%. Such vacancy rates are plausible in the case of a few Chinese cities that some prima donna hedge fund managers have highlighted in gimmicky YouTube videos filmed at 6:00 a.m. in the morning. However, on a nationwide basis, the 40% figure is patently absurd.

Official data provided by the National Bureau of Statistics suggests an overhang of about 4 million units. This estimate is probably to low due to problems with data collection and methodological issues.

Based on various informal surveys and press reports, I think that 25 million units is an absolute upper-bound limit for residential vacancies in China. A lower-bound figure would be around 12 million.

For the purposes of this article, let us take the upper-bound estimate as our base case. 25 million residential units sounds like a big number. But how big is that number, really?

Let us start by estimating what a "normalized" inventory level for China should be. Given the sheer size and growth rate of new home sales in China, a reasonable inventory-to-sales ratio in China's residential real estate market implies a normalized inventory in the neighborhood of 5 million units. This means that an upper-bound estimate of residential oversupply is roughly 20 million units.

Now, place that 20 million figure in the following context: China has a population of roughly 1.35 billion people that comprise almost 300 million households.

Of China's households, upwards of 220 million of them are living in accommodations that citizens of any developed world nation would consider to be sub-standard. We can consider this as the starting point for estimating the potential demand for decent housing in China. On this initial basis, we can observe that, there is 11 times more demand for decent housing in China than the current supply available.

But the question that must be answered is: How many of the 220 million aforementioned households can afford to buy or rent the sort of apartment units that are being offered on the market?

Based on my review of World Bank, IMF and McKinsey studies on the size of China's middle class and its growth, I estimate that there should be roughly 40 million Chinese households that currently fall within the "upper middle-income" range that would qualify to buy or rent the sort of units that comprise the bulk of the market. By 2015, the number of upper middle-income households is estimated to rise to 80-90 million. Of these, 50 million are currently living in sub-standard accommodations and will be looking to soon purchase or rent decent housing.

As an aside, readers should note that there is a significant cohort – estimated at about 40-50 million households by 2015 -- of relatively wealthy Chinese that earn above the "upper middle income" range described above. I am not factoring this population cohort into this discussion on the assumption that they already own or rent decent housing. Therefore, even though relatively wealthy Chinese represent a major source of demand for housing, if they trade up, they will leave vacancies behind thereby not affecting the total number of vacant units in the "up-to-par" category.

I estimate that roughly 10 million Chinese upper middle-income families still live in sub-standard housing. This means that a total of 50-60 million Chinese already enjoy, or are projected to attain, upper middle class incomes that will allow them to become new homebuyers or renters within the next five years.

A final factor must be taken into account in assessing potential housing demand: If one expands the above analysis to include "lower middle income" Chinese, the demand pool would increase from 50-60 million to 140 million households by 2015. It must be noted that the vast majority of Chinese that fall into the lower middle-income category can probably not afford to purchase or rent housing on their own. However, government subsidies, particularly at the provincial level, already have brought some of these citizens into the demand pool and the government is talking about aggressively expanding these programs. Many companies also subsidize housing. Thus, it is reasonable to assume that a substantial portion of lower middle income households are potential buyers or renters of new residential units. I conservatively estimate this cohort of lower middle-income households that are or will be eligible for housing subsidies to be in the range of 20-30 million households.

Thus, by 2015, the potential effective demand for new housing units in China should be in the range of 70 to 90 million households. This compares to the upper-bound estimate of supply overhang comprising 20 million units.

The implication is that the current assumed supply overhang of residential units could be easily absorbed by 2015, while still allowing for a very fast rate of residential construction. Indeed, assuming effective demand of 70-90 million units, and given current rates of construction, China may not be able to build housing fast enough to meet the potential effective demand. In this respect, the 20 million estimate of excess inventory may not be an excess at all if viewed from a medium term perspective.

Have Chinese Home Prices and Rents Risen Out of Reach?

I think that it should be clear by now that China has a sufficient number of households that not only aspire to decent housing, but that have a level of disposable income (with or without government assistance) to enable the nation to fairly quickly absorb any residential supply overhang.

But the question is: Have the prices of available residential units risen so much that they are now out of reach for ordinary Chinese households, even in the upper middle-income segments? This is precisely the claim of many bearish analysts.

The most authoritative study that I have seen on the matter was performed by IMF economists. After a thorough review of the data, and some sophisticated statistical analysis, the study concluded as follows: "We find that, for China as a whole, the current levels of house prices do not seem significantly higher than would be justified by underlying fundamentals."

This and other studies by the World Bank, The Economist Intelligence Unit, and UBS have noted that average home prices in China as a whole have risen by roughly 6%-7% per annum in the past decade. This is roughly in line with international averages. However, when compared to average personal income growth of 12% per annum, China's residential property price inflation seems tame on an international basis. China is, in fact, one of the few countries in the world in which the home price-to-income ratio (PE) has actually declined in the past decade. In fact, the Chinese PE ratio has declined by more than 30% in the past decade.

So, I think that it should be clear by now, that there is no generalized price or quantity bubble in the Chinese residential real estate market. Home prices have actually been getting substantially more affordable in China in the past decade relative to income levels. At the same time, projected demand through 2015 not only overwhelms current inventory, but also exceeds the current run rate of housing construction. These are not the sorts of circumstances that are indicative of a housing bubble, to say the least.

In Part 2 of this article, I wish to go even further than most previous studies have gone in debunking the notion that there is a residential real estate bubble in China.

A final note to Part 1: I am not encouraging anybody to load up on Chinese real estate stocks (Guggenheim China Real Estate (TAO)), stocks linked to the real estate sector (Guggenheim China All-Cap (YAO)) or Chinese stocks generally (iShares FTSE China 25 Index Fund (FXI), Guggenheim China Small Cap (HAO)). This is purely an analysis of the Chinese housing sector as it relates to the broader Chinese economy. Indeed, I am somewhat cautious on the prospects for Chinese stocks in the short to medium term for reasons that I will lay out in a future article.
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