A View of China Real Estate with 2020 Lens
In our latest Perspective, we explore some of the long-term structural reasons as to why the China real estate sector has been resilient and why we expect this resilience to continue going forward.
With the U.S. and much of the developed world still struggling from the once in a lifetime Global Pandemic Crisis (GPC), it is worth noting how much the China real estate sector has recovered. Despite the severe drop in economic activity, the China real estate high yield index1 is down a mere 1% year to date through May 11, 2020. China real estate equities2 are down 14.6%, compared to U.S. real estate equities3, which is down 20.6% over the same period. Despite being generally perceived as a risky sector, China high yield real estate sector has served as a relative anchor of stability. In our latest Perspective, we explore some of the long-term structural reasons as to why the China real estate sector has been resilient and why we expect this resilience to continue going forward.
What differentiates the Chinese real estate from any other asset class or any other real estate? We asked this exact question to a mid-level People's Bank of China (PBOC) official during one of our research trips to China a few years back. At first glance, China's real estate is a puzzling market. Despite very low affordability in some of China's largest and most developed cities, home prices have continued to rise. In fact, for some investors, China's real estate market is a bubble that is waiting to burst. While we believe a bubble is a bit of an over-extrapolation, the question that remains despite the low affordability is, why do people in China continue to buy real estate?
Not all cities in China has low housing affordability
China's Tier 1 cities (Beijing, Shanghai, Guangzhou, Shenzhen)—the largest and the wealthiest—are the ones that receive all the reporting on low housing affordability. However, a deeper look at China's real estate market reveals that only less than 10% of total areas sold in the last five year comes from the Tier 1 cities. The vast majority of real estate sold occurred in more affordable Tier 2- 4 cities which are less developed and less urbanized. Affordability,--defined as average house price divided by average household income—is around 13 for Shanghai. For comparison, San Francisco has housing affordability at around 10. However, affordability of a Tier 2 city such as Changsha (provincial capital of Hunan province) is only about 6, which is similar to that of Seattle. China is a vast economy and disparities between regions of China are significant—looking only at the developed Tier 1 cities would be analogous to just extrapolating New York City, San Francisco and Los Angeles prices to the rest of the United States.
Urbanization drives demand for new homes
China's urbanization rate is currently about 60%, with the country urbanizing at a rate of about 1% per year. On a population base of 1.4 billion people, that is about 14 million going into various cities and townships. To put some perspective around the magnitude of 14 million people, let's assume that only a third of this population purchase a new home, which put the demand at 4.7 million people. For reference, the population of Los Angeles is about 4 million. So every year, China will effectively have to meet the housing demand of an additional Los Angeles, give or take. Imagining a new Los Angeles added every year is sometimes mind-boggling, but this is the reality that is China.
Housing ownership seen as a pre-requisite for independence
Having one's home is seen as a pre-requisite in China—in part a result of China's command economy legacy where effectively everyone has their own homes. Until the 1990s, housing was provided by the government and the concept of renting didn't exist. A major factor of independence in China is having your own home. For someone, particularly the male, looking to build a family, one of the main pre-requisite is that the new family has to have his own home to live in. Otherwise, it is seen as lack of independence and chances of finding a suitable partner dramatically decreases. This is a cultural phenomenon and the mindset could shift in the future, but as it stands today, this cultural value makes housing purchases less sensitive to prices (lower price elasticity).
Disposable income increase
China urban household income grew at more than 10% per year for the last 20 years. Against this larger backdrop economic increase, the roughly 8% increase in residential homes over the last 20 years seems reasonable. This is not to say that in certain cities, home prices have increased far more than disposable income, but those are only in certain large cities. On a macro basis, we would be remiss if we looked at the Chinese real estate market in a vacuum without taking into account of the overall economic picture.
This last point on general macro-economic growth relates back to the answer we received from the PBOC official. The answer was surprisingly candid: think about it from the perspective of an average Chinese person with some savings due to decades of economic growth. They effectively have only three options for investment:
- Deposit it at a bank which earns about 3% - 4% interest per year
- Invest in the stock market, which over the last ten year period, the Shanghai Composite Index (SHCOMP) returned roughly 1.5% per year
- Buy a property which historically returned on 8% per year, or more depending on the city that you live in
“Which one would you choose?” PBOC official rhetorically asked, highlighting the compelling attractiveness of real estate to the average Chinese.
To be sure, investing in China real estate is more nuanced than implied by the PBOC official for three key reasons. First, consolidation in this industry over the next decade will mean that many companies will cease to exist through being acquired, orderly wind-down of operations, or bankruptcy. As such, understanding which companies will likely be the winners and losers from the upcoming consolidation is critical to generating returns in the future. Secondly, the perception amongst some investors that the Chinese real estate sector is highly leveraged is true amongst a segment of companies. For example, some acquirers might choose to take on substantial debt to finance an acquisition, increasing the riskiness of the company's credit profile. Some acquirees might offer better returns as being acquired would trigger a change of control put which might enable investors to put the bonds back to the company at a higher price. Finally, the specifics of a security, such as covenants, seniority, and the position within a company's capital structure, can often determine ultimate returns of securities, even if issued from the same company.
In summary, Chinese real estate bonds have risks like any other investments. Maximizing returns and minimizing risks requires substantial knowledge of the market, the industry, the company, as well as detailed analysis of the specific security covenants. While we expect China real estate market to benefit from sound long-term structural factors, we believe investing with an active manager with deep local knowledge, understanding of competitive dynamics, and diligence to handpick each security may be the most prudent way to take advantage of the opportunities in China real estate bonds and to limit downside risks.
Teresa Kong, CFA
Sources: Matthews Asia, Matthews Asia, Bloomberg, CICC, The Economist, Demographia
1 MarkIt iBoxx USD Asia ex-Japan China Real Estate High Yield Index
2 MSCI China A Onshore Real Estate Index
3 Dow Jones U.S. Real Estate Index