China’s real estate sector has a long track record of defying its naysayers. For at least the past decade, land and property values have time and again faced down a raft of apocalyptic predictions as they broke one record after another. Pricing may have wobbled at times as credit dried up and speculators ran for the hills, only for sentiment to quickly reverse and lift the market to new highs.
Today, after three years of outsized gains, mainland real estate markets have again begun to wob-ble, and the naysayers are once again out in force predicting their imminent demise. Transactions are down. Housing prices that doubled or tripled in some places are now stalling, especially in the big cities. With inflation looming and Beijing’s attention focused increasingly on more pressing issues, many are now asking: is this time different?
While there are various reasons to think this time may indeed be different, the mere fact that property values in China have multiplied in the space of a few years does not necessarily mean the market is overvalued. Yes, rental yields are extremely compressed. Home affordability—at around 22 times annual household income in Beijing and 19 times in Shanghai—also appears unsustainable by Western standards.
These are false alarms, however. Rental returns have never been a big draw for Chinese homebuyers more concerned with capital growth than with yields. And affordability ratios are similarly misleading, partly because so many Chinese homebuyers are richer than they appear—either they misstate their incomes or they are existing homeowners looking to upgrade—and partly because incomes in China are growing so fast that purchasers can reasonably expect to grow into seemingly unaffordable mortgages.
That said, there are signs the government may no longer view the property sector with the same indulgence as before. In part, this is because Beijing currently has more important things to worry about. In particular, authorities are concerned with fighting inflation and addressing the vast pool of bad debts accumulated on local government balance sheets—both of which are the result of the same loose monetary policies that have pushed up real estate prices.
This is important because, ultimately, China remains a command economy where the government’s heavy hand has a major impact on dictating investment flows. In the past, property market reversals occurred precisely because authorities decided to target the sector for special treatment rather than as a result of market cycles. The last time this happened was in 2007, when prices had risen and seemed as frothy as they do today. Ironically, the property market then was saved by the onset of the global financial crisis, which provoked a rapid about-face by authorities who then flooded the economy with liquidity. Ominously, however, Beijing today is repeating its 2007 program—and throwing in a few new restrictions.
These include demand-side measures, which have become the standard tools used to manipulate the market. The current crop, phased in beginning as long ago as April 2010, includes higher mortgage downpayments, higher borrowing rates, and bans on nonresident purchasers and on multihome ownership in some cities. In July, these curbs were extended to China’s smaller cities, where prices continue to rise. Historically, however, demand-side rules often see limited success in China, if only because they are easily ignored by local governments that have a vested interest in high prices because they depend on land sales for such a large share of their revenues.
In reality, therefore, supply-side measures aimed at restricting bank credit have been far more effective at cooling off the markets. Because so much of China’s real estate is financed by bank lending, it is relatively easy for Beijing to starve deals of funding by ordering banks to comply. A recent survey conducted by Standard Chartered Bank found that although property sales were down only slightly as of midyear, Chinese developers were increasingly pessimistic of their prospects. The bank projected that inventories would rise from a current three months’ supply to seven months’ supply by the end of 2011. Smaller operators especially are now facing liquidity problems. As transactions slow, more developers will be forced to cut prices in order to sustain cash flow. Standard Chartered is forecasting price cuts of 10 to 20 percent in many cities.
While these short-term cooling measures can be turned off as quickly as they are turned on, there are also reasons to believe that Beijing is beginning to favor a more calculated approach to property sector regulation that will create a more orderly market over the longer term. This results from a need to address some fundamental distortions in both the real estate sector and the wider economy.
In particular, Beijing is now being forced to deal with a longstanding problem whereby provincial governments have become addicted to land sales as a means of financing their budgets. According to figures released by the China Real Estate Information Corp., land sales by local governments nationwide totaled Rmb2.7 trillion (US$419 billion) in 2010—the equivalent to almost a third of all central and local government revenues combined.
In the past, this practice was a convenient means of financing the huge spending needs of often cash-strapped provinces as they set about creating urban infrastructure. Today, however, the practice has become a liability because it means in reality that urban development is financed by evicting farmers from their ancestral holdings and selling their land to developers at a huge markup. Not only is this the root cause of some of China’s worst civil rights abuses, it also produces some perverse incentives. It means, for example, that local governments continue to promote high land and property prices irrespective of social or economic merit. It also has encouraged the creation of a top-heavy housing sector with too many high-end homes and not enough housing affordable for regular people. In addition, by encouraging local governments to sell off land as quickly as possible, the supply of land in many large cities is now drying up, creating a looming funding gap for the provinces.
All this has convinced Beijing of the need to introduce fundamental reforms to its property tax base by replacing the current system, which taxes only transactions, with a broad-based annual tax assessed on property values. This would bring China’s system into line with systems commonly used in the West, where annual property taxes constitute the lion’s share of revenues for many municipal governments. The new tax was introduced on a limited basis in two Chinese cities at the beginning of this year. Although widescale implementation is expected to be slow, the tax will eventually be rolled out nationwide.
China’s new property tax will serve to
Apart from securing a more stable and equitable source of revenue for provincial governments, this new property tax will also serve to discourage speculation, a major cause of property price inflation thought to account for as much as half of China’s real estate demand, according to a study by the Chinese Academy of Governance. As a result, tens of millions of homes currently stand empty across the country even as it endures a chronic shortage of housing. By taxing the ownership of the asset rather than just the sale transaction, owners are forced to recognize the carrying cost for holding property, encouraging them to put their assets to more productive use (e.g., by occupying them or renting them out).
Another radical departure from the status quo is the recent shift in political winds to focus on the low-cost housing sector—an area typically shunned by local developers in favor of more lucrative high-end projects. Low-cost housing first emerged as a target for Beijing in 2008, but only gained traction early this year when authorities announced they planned to build or renovate some 10 million low-cost housing units by the beginning of 2012, and a staggering 36 million units by 2015. At a proposed cost of Rmb1.3 trillion (US$202 billion), finding ways to finance construction of such a vast pool of new homes promises to be a serious problem. Furthermore, while China’s big developers have little choice but to pledge cooperation, they remain reluctant partners in a venture that will slash their margins and create unwanted competition for their own higher-priced projects. Progress can therefore be expected to be slow.
Nonetheless, with current plans calling for fully half the nation’s completed housing in 2011 and 2012 to be composed of different types of low-income housing, the initiative can be regarded as the new cornerstone of government property sector policy. Combined with other recent changes, does this signal a long-term shift in official strategy? Discerning new agendas through the fog of Chinese policy making is always a tough call. But shifts imposed as a result of social and financial imperatives—as is the case here—can be easier to make out. Recent reforms may therefore prove to be an inflection point where Beijing began to reel in China’s wild-west property markets.