While Chinese property sales have been somewhat sluggish for nearly a year now compared to their historical average, they took a definite turn for the worse in April according to recently released data.
Government figures show that real estate sales fell by 7.8 percent in the first four months of this year while new construction starts were off by 22.1 percent. That's is potentially very bad news in a country where nearly 23 percent of gross domestic product is somehow tied to the real estate market, whether it's the construction, sale or furnishing of new buildings. Most significantly though, the slowdown seems to be spreading from third- or fourth-tier cities – the largest non-capital cities in a given province – to second- and even first-tier cities such as provincial capitals and Shanghai, Guangzhou, and even Beijing.
There are two primary factors driving the sales slowdown; over-construction and over-investment, which are two distinctly different issues.
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Largely thanks to overzealous real estate developers, as recently as September, construction demand was slated to grow by about 8.5 percent annually through 2017. That demand was expected to be fairly evenly split between state-led programs to expand and modernize infrastructure such as roads and railways and residential buildings such as single-family homes and apartment buildings.
Much of that residential real estate boom has been justified by new household formation; a couple marrying, purchasing a home and striking out on their own. But for much of the past decade annual births in China have been holding steady at around 12 million, largely thanks to the country's one-child policy. As a result new household formation in the country has actually fallen by around 7 percent per year over the past two years ! as Chinese wait to get married (current average age at marriage is 25) thanks to both economic and social constraints.
At the same time, the argument that ongoing urbanization will drive property demand is falling short. While it is true that rural migration has helped boost property demand in lower-tier cities, in tier-one and tier-two cities rural migrants are essentially priced out of the market.
But while real demand has been slackening, investment demand has continued to run apace. It is estimated that about 15 percent of total commercial home transactions in China are driven purely by investment demand. Those investors have essentially been refusing to move their real estate at a loss, as demonstrated by the fact that while prices in select cities have been falling – down as much as 15 percent in Beijing – nationwide home prices are holding relatively steady. Sellers are unwilling to lower their asking prices to move the property and buyers are unwilling to pay the current asking price.
On top of that, it is widely expected that a new property tax will be rolled out sometime in the next 18 months even as the government continues cracking down on the shadow banking sector, a key source of funding for property purchases. That is putting further pressure on the estimated inventory of 10 million empty residential units in the country.
That combination of demographic factors, new taxes and lending pressures led many analysts to estimate that the number of unoccupied units could reach 18 million within the next two or three years, creating a significant drag on the Chinese economy and setting up a situation eerily reminiscent of our own property bust here in the US.
The real question, though, is whether or not this will finally result in a hard Chinese economic landing. I tend to think it won't.
For one thing, the property slowdown is largely being driven by government policy. Despite encouraging lenders to increase their activity in the real estate market, the ! governmen! t has begun requiring down payments of as much as 60 percent in top-tier cities in order to cool what had become clearly overheated prices.
It is also cracking down on the shadow lenders in an attempt to reduce the systemic risk they pose to the country's financial system as the government focuses on its transition from an export- and investment-led to a consumption-driven economy. As that transition occurs, by necessity the country will have to absorb slower economic growth as the face of industry changes and excess housing inventory is absorbed.
Over the long-term, the property slowdown as a result of those reform measures is actually bullish. Even if GDP growth slows down to around 5 percent over the next few years, a sustainable 5 percent is much more attractive than a doctored 7 percent.
In the meantime though, I would avoid betting on a hard Chinese landing, a bet that has cost many investors dearly over the past few years. I would, however, avoid most of the leading Chinese real estate developers such as China Vanke (OTC: CVKEF) and Xinyuan Real Estate (NYSE: XIN) which are almost entirely dependent on the domestic markets.
Otherwise, companies focused on Chinese consumers and infrastructure-focused plays should continue to do well despite the deflating property bubble in the country. By and large, in a country of more than 1 billion people, the average middle-class Chinese isn't heavily involved in the real estate market and should not not (?)be greatly impacted by declining real estate prices, particularly as the government is likely to intervene again to prevent a hard landing.
At the same time, infrastructure development is a key element of the most recent 5-year plan, particularly railroad construction. Spending on those programs will remain largely sacrosanct, if for no other reason than to continue shoring up growth.
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