Introducing EO's China's Future Investment Watch series: first, how the property sector still has signs of health.
Antitrust reform, reform in education, real estate and medical care policies, the Common Prosperity policy... all of these show that China is undergoing earth-shaking change. These changes have brought large uncertainty, making many investors afraid to invest in Chinese projects and companies. However, over the next decade, China will surely become the world's largest economy. How to better understand the opportunities and risks of the Chinese market and deal with certainty and uncertainty is a crucial problem. EqualOcean has launched a series of research pieces, China's Future Investment Watch, hoping to provide clues for global investors.
Wang Shi, the founder of the property developer Vanke, said in 2014 that "The 'golden age' of Chinese real estate has ended. Investors in China’s real estate space would be wise to adopt a new mindset to evaluate the current 'silver age'. " What Wang said could not be more correct today. According to the Balassa-Samuelson effect, economies' labor productivity is higher than that of developing economies in sectors engaged in international trade, while the labor productivity differential in the non-tradeable sector between advanced and developing economies is marginal. China's growth can be attributed to large-scale capital investment, financed by domestic savings and foreign investments, and productivity growth. Reforms that decentralized economic production accelerated growth in household savings, which enabled China to support a high level of investment. Real estate is in the non-tradeable sector that was boosted by China's activities in the tradeable sectors. Thus, the slowdown in the industry due to Evergrande's crisis should not lead to a total collapse of the entire economy but will instead act as a warning to the fragile structure of real estate development in China that is in need of reform. As more defaults and missed payments transpire, China urgently needs to take a step back and fix its problems from their roots.
The real estate sector made up approximately a quarter of China's GDP in 2020. With an average of 900 million square meters of new apartment construction each year in the past decade, China's economy could face an extended period of stagnation as the real estate sector shrinks. However, the determination of Beijing not to use the property sector to stimulate the economy during downturns bodes well for the future of the industry. Although devastating to home sales and housing starts, the engineered recession will benefit the sector in the long run. China's real estate sector should begin to heat up again after around five to seven years of adjustment.
Why Evergrande will not be the new Lehman
The Evergrande Group's fiasco is unlikely to spiral into an event like the collapse of Lehman Brothers in the US in 2008. China has more control over its real estate sector than the US federal government did during the financial crisis. NINJA loans, which were prevalent in the US before the housing crisis, could never fly in China as lenders heavily scrutinize borrowers. Officials in China did not rush into saving Evergrande to set an example. However, Evergrande owes money to around 171 domestic banks and 121 other financial firms. The developer's default would mean these lenders will be unable to lend money at their normal levels, leading to a possible credit crunch. But Evergrande is not 'too big to fail' as some media have suggested. China has let state-owned enterprises' loans default so that the market can play a more significant role in the economy. In Evergrande's case, China will look to restructure the developer's debt as was the case with Baoshang Bank, HNA Group, and Anbang Insurance. Unlike Lehman Brothers, Evergrande holds physical assets, while land prices are also more resilient than financial derivatives since local governments monopolize land supply. The Evergrande crisis will undoubtedly have a massive impact on the real estate market in China, but it will not be China's 'Lehman Moment.'
The unemployment rate in the US reached 10% following the financial crisis in 2008, breaking double-digits for the first time since 1982, while over 8.7 million jobs were lost. Lehman's debt of USD 619 billion sent the US into years of recovery. The economy in the US grew 19% from 2010 to 2017, and the employment rate was down to 4% at the end of 2017. Should Evergrande default, it would collapse in a more controlled fashion as the company would be pulled apart by local governments and other developers. The collapse of Lehman and the burst of the housing bubble in 2008 caused American households to lose over USD 16 trillion in net worth. But the combination of Evergrande's physical assets and the government's determination to complete unfinished construction projects will protect households in China from the large-scale bankruptcy and defaults that happened in the US. The Chinese households are also not losing as much value in their net worth as the households did in the US. As a result, the recovery process for the Chinese real estate sector should be faster than many expect. Within five to seven years the sector should start to gain traction as it becomes more versatile and less leveraged. Currently, there are a few risks that investors and policymakers should recognize.
China's real estate sector flourished behind waves of urbanization, but the industry's growth is no longer congruent with the country's broader economic development. From 2000 to 2015, China's home prices rose at an 8.30% compound annual growth rate (CAGR) while real GDP grew by 9.70% CAGR. Since then, however, the growth in housing prices outpaced the growth in China's real GDP. From 2015 to 2019, housing prices increased by 9.40% CAGR while real GDP growth fell to 6.60% CAGR. The CAGR of total productivity and urban population also fell to 2.70% and 2.80%, respectively. This means that homeownership has become increasingly expensive due to uncontrolled development activities and land use transfers. The widening gap between the growth of the industry and the nation's growth should be a warning sign for investors in China’s real estate sector.
Another risk comes from the potential rise in unemployment due to the decreased activities of the real estate industry under-tightening measures. China's unemployment rate has been reasonably steady for the last few years. It reached 6.20% in February 2020 due to the pandemic. As of October 2021, the unemployment rate had dropped to 4.90%, remaining flat from the previous month. The unemployment rate in urban China was 4.30% in 2020 and is expected to be even lower in 2021 due to ongoing construction projects. With fewer building activities, the building construction industry, China's third-largest industry by number of employees, will likely see a dip in its productivity and profits. The unemployment rate in urban China could rise again to around 4.4% for a brief period in 2022 after the current construction projects are finished. But the unemployment rate will return to a normal level in the next two to three years, given the time needed to adjust.
A history of 'land finance'
Local governments have relied on the sale of land rights as their primary source of fiscal revenue, which became a problem as officials' indulgence in developers' greed resulted in crippling debt. The total government funds of China, provincial and central governments combined, reached CNY 6.10 trillion as of the end of Q3 2021, which is an increase of 10.5% from the same period in 2020. Funds generated from land use transfer reached CNY5.36 trillion, an increase of 8.7% from the same period in 2020. Funds from land-use transfer constituted 94.79% of total government funds, an extremely unhealthy portion that showcases local governments' reliance on generating revenue from land transfers, a phenomenon called 'land finance.' Furthermore, local officials are judged based on their ability to create economic growth. Land use transfer that leads to construction activities is the simplest yet most effective way to increase economic output.
As officials continued to promote construction activities, housing prices skyrocketed, and homebuying gradually became similar to buying a stock. The tax-sharing reform of 1994 also contributes to the distortion of the housing market in China. The reform demanded that local governments give percentages of their fiscal revenue to China's central government, which spurred the adaptation of 'land finance.' Local governments are left with no other option other than to generate an even larger portion of revenue from the land use transfer department to make up for the revenue loss incurred by the tax-sharing system. Two focal points need to be highlighted for China’s property sector to achieve a speedy recovery and sustainable growth in the future.
1. Suppressing home prices through real estate tax
In October, the Chinese Parliament announced the plan to roll out a pilot real estate tax in some regions with the hope of limiting home prices that have soared over 2,000% since the implementation of privatization policies in 1982. The pilot scheme will include residential and non-residential properties, excluding residences in rural areas, and last for five years. The proposition of a real estate tax first surfaced in China in 2003, but its implementation was halted due to concerns over the potential impact on home prices, demand, and future construction projects. Local government officials were also not fond of the levy on homeowners, as they worried that the tax will vastly reduce governments' ability to seize revenue in land use transfer. However, with a real estate tax in place, government officials are less likely to depend on land use transfer as their sole method for promoting local economic growth. The real estate tax will include new tier-one cities like Hangzhou, which is home to the headquarters of tech giant Alibaba.
The real estate tax will help in suppressing home prices, but its effectiveness is uncertain. Many countries depend on real estate taxes as their primary source of fiscal revenue. Revenue from real estate taxes makes up 99.50% of total revenue in some local governments in the UK and 71.60% in the US. The overall effect of imposing a real estate tax is negative to home prices. A study done by Weida Kuang, a professor at Renmin Business School, shows that every 1% increase in the real estate tax will result in the home price index falling by 0.69%. According to a paper published by Sami Alpanda and Sarah Zubairy, an increase of property tax from 1.40% to 1.63% will result in a lower return on investment for home purchases, thus reducing the demand for residential investment. Home prices will fall by 0.5% as a result; however, home prices, given the time to adjust, will return to an average level within five years. Although real estate taxes are popular in many countries, especially those in OECD, it is not a means to regulate home prices for the long term. There is a negative correlation between the strength of real estate taxes and home prices, but China should change its home prices growth expectation and limit investment opportunities in housing to better control the soaring prices.
2. Additional investment instruments to deleverage the industry
China's first nine REITs (Real Estate Investment Trusts) debuted in June and raised over USD 4.70 billion. The nine REITs will provide liquidity to the market and capital towards infrastructure projects to boost China's economy. Unlike the equity REITs in the US, these REITs act more like public funds that invest in asset-backed securities. 90% of core earnings from these REITs will be paid out to investors through dividends, with a projected dividend yield of between 4% and 12%. These REITs only include industrial and infrastructure-type assets. However, the types of REITs will eventually expand to include a variety of asset classes as China loosens rules on REITs. Goldman Sachs estimates that the value of China's REITs market could reach over USD 3 trillion, surpassing the US as the world's largest, if China's full REIT potential is realized.
Establishing REITs, especially apartment REITs, can help stabilize and deleverage the domestic economy. The most indebted property developer, Evergrande Group, is struggling to deal with the crushing weight of USD 300 billion in debt as it sits on the brink of collapse. The company's crisis represents the shaky ground that many property developers in China built their wealth on. REITs uses an equity financing business model, the opposite of debt financing, for today's real estate operations. The business model of a REIT depends on income-producing properties, but this type of property has yet to gain traction in China. Chinese developers have been unified in their business approach, relying on sales or pre-sales of their residential projects for fast cash for finance their next projects. Even most of the rental buildings in China cannot produce income as many of these buildings are owned by prominent companies that are state-owned or non-profit. These companies often rent the units to their employees at a discount or free. To make REITs a popular investment in China and get developers to abandon their current leverage-heavy business model and slow down China's rapid urbanization, which is a process that is already happening after the implementation of tightening measures in the real estate market.
In a culture where homeownership is almost a necessity, especially for young men looking to get married, housing became less of something to live in but rather an investment instrument to speculate on. As of 2019, more than 90% of the households in China own homes. More than 20% of these households own more than one home. Such emphasis on homeownership makes the installment of REITs difficult. In addition, the real estate development activities in China have not faltered. From January to October in 2021, China saw a 7.10% increase in construction activities compared to the same period in 2020. However, there has been a 6.80% decrease in new residential developments and an 11% decrease in land rights transfer.
Investability in the Chinese real estate market
China's GDP grew by 4.9% year-over-year in Q3 2021, one of the lowest growth rates since 2011. But a decrease in economic growth is a worthy price for the country to diminish its dependence on real estate. While 90% of renters in the US want to become homeowners, more than 90% of the population in China are homeowners. China's household debt level is lower than that of other developing countries, such as Thailand and Malaysia. Households in China also have an average of 40% of their money going into savings. Although the industry is profoundly leveraged, the rapid development of real estate led to an impressive number of homeowners and a respectable savings to income ratio within households. Investors should feel relieved at the lack of large-scale bankruptcy, since individual wealth won’t be as heavily affected as it was in the US during the housing crisis. The abundant wealth in Chinese households' savings and tightening controls over the real estate sector will allow the sector to make a healthy recovery within five to seven years.
The near-term investment outlook in the Chinese real estate market remains uncertain for 2022. On the one hand, there is too much volatility as the waves of defaults continue. On the other, China has significant untapped potential in the real estate industry, especially in the rental market. 70% to 80% of assets in Chinese households are tied to real estate. By stabilizing home prices through regulations and local government control, buying a home will become less of an investment opportunity and will give a chance for other investment instruments, like stocks and bonds, to mature within the mainstream. As housing becomes less of an attractive and sound investment, a good portion of individual wealth tied up with real estate will be freed up for use elsewhere, making up for the gap created by the decline in real estate activities. The unprecedented cycle of heavy tightening measures and regulation is not meant to create a friendlier environment for investors but rather to fix the unacceptable behaviors in the industry to achieve President Xi's agenda of 'Common Prosperity’. Real estate taxes and REITs are on the rise, but they are by no means a sign for immediate relief for the sector next year. Investors should tread carefully and give the Chinese real estate market time to settle into the new norms.
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