It is a disaster. It is a sham. But I get excited about it. Despite the headlines, I see the Chinese housing market as fertile.
Most of the readers here are Americans, so we take for granted that we live in the largest, most-liquid, most-securitized, most-financed housing market in the world. It is easy to forget that, outside of China and the US, the number of countries with liquid, publicly-listed homebuilders is 3. While China may be a scary place to invest, it does have lots of public real estate companies, real estate finance businesses and even online brokers. All major categories of real estate investment are available, except for one. So it merits understanding where China is going and why.
Housing is best understood through what it is not. Housing markets are not like traditional markets in three important ways that will be relevant for knowing where China is going.
Heterogeneity – No one moves to Manhattan and asks to see the average-priced apartment and uses that as a benchmark to make decisions. Real estate is heterogeneous. There is no monolith “Chinese housing market”. The insights will lie in the differences between markets and sub-markets.
Giffen – Housing demand is often misunderstood because it does not behave like a normal market. Housing is not a normal good, but is a Giffen good– demand increases as prices increase and demand decreases as prices decrease. Homebuilders and Wall Street analysts rarely analyze the asset as a leveraged Giffen good, which is great because that is what it is.
Land – Homeowners think they are buying houses, but they are not. The purchase of a home is a leveraged position in land, with a depreciating house on top of it. The structure sitting on the land loses about 3% of its value per year. When you buy a home, you must pay cash now to offset the depreciation of the structure as well as taxes, insurance and financing costs – while hoping the appreciation in the illiquid land position offsets these upfront costs over time.
Now, where will there be opportunity in China?
China is a big country. There are roughly 170 cities with more than one million residents. Focusing on the differences between these cities reveals that the primary theme in Chinese housing over the past decade is a myth. The idea driving housing stock multiples was that China’s 700 million farmers would move to cities, so there should be endless demand for housing. Few asked – well, which cities? Despite hundreds of millions of people moving to cities in China, most Chinese cities have negative population growth. Only a handful of cities (that offer the most opportunity) are seeing consistently positive growth. This creates a structural demand problem that makes a broad housing “rebound” unlikely.
A demand problem makes a Giffen good problem. When homebuilders need to raise cash to pay their debts, they do what every business does– liquidate inventory by cutting price. The problem with homes is that meaningfully lowering the price in turn lowers demand. This is painful. My inbox is filled with research analyst reports from around the world projecting that price cuts will sell housing inventory and raise cash – stabilizing troubled homebuilders. It never happens. So what China is going through now, as lower prices beget lower demand, is not unique and is to be expected.
The land aspect of housing is where China gets interesting because individuals in China cannot own land; only the government can own land. Homeowners get a long-term lease, which can be renewed. Chinese housing investors often compare their market to housing in countries such as England, where there is a custom of signing 99-year leases rather than making outright land purchases. But that doesn’t quite get to the heart of the matter. Unlike England, China doesn’t have a functioning market for pricing land, whether it is bought or leased.
Here is why China has a land problem. Suppose you are a Chinese real estate developer. You want that spot by the river in Wuhan – what determines the price of the land/lease that you buy? It is called a “relocation cost”. There are a lot of people in China, so the price of land is driven by the cost to relocate the people living on it, plus a payment to the treasury of the local municipality. This becomes problematic because you can’t pay people less to move in an inflationary economy and you can’t pay municipalities less if their single primary source of revenue becomes land deals. So unlike England, where developers can respond to lower housing prices by paying landowners less, in China, the price of land is, practically, fixed. In a falling home price environment, it stops making sense to build anything because land prices can’t flex down hard enough. This spells trouble for the equities of builders if there is little worth building in the future.
It is not all bad. The land problem creates future opportunity for the right assets. If fewer buildings will get built due to the land problem and owning apartments is no longer a sure investment for Chinese savers, where will all of that money go to earn yield? At the moment, there are no liquid REITs through which to chase yield- yet. However, certain real estate developers see the writing on the wall and understand that future construction opportunities will be limited because of the land problem. This creates scarcity value for the quality assets that are still being developed. As a result, they are beginning to convert from real estate development to real estate ownership and management. This is a painful transition for an income statement to make – similar to moving from a license to a subscription model in software – with temporary, huge declines in net income and stock price. The pain is worth it because in China, savers are willing to accept 0% interest rates on bank deposits. So well-managed real estate assets in the few cities that are growing, with 6%-8% yields, which can be owned at the push of a button, will become an attractive home for money.
THIS ARTICLE REPRESENTS THE VIEWS OF BISHOP ROCK CAPITAL, L.P. AND SHOULD NOT BE CONSIDERED A RECOMMENDATION TO PURCHASE OR SELL A PARTICULAR SECURITY.