What's the Good of a House?

I'm in China until the 24th, seeing up-close and personal the economy I've spent so much time writing about.  I'll be blogging more about this in the days to come, but the most striking discussion I've had so far concerns China's real estate bubble.

You've probably read about it by now--the vast neighborhoods developed but entirely unoccupied.  As in our housing bubble, these homes have been sold to investors who expect to resell them to others down the road.

Sounds something like our housing bubble, right?  The condos with 40 or 50 lockboxes outside the front door?  Well, not quite.  There are a couple of things that make this rather different.

The first is leverage.  Until the last few years, almost all of these purchases were for cash.  Only recently have mortgages been introduced--a sign which sounds like the beginning of the end, as it's when buyers start looking for ways to massively increase their leverage that a bubble is usually hitting its frothiest point.  The fellow we spoke to yesterday indicated that at this point, about 2/3 of these purchases are being financed by mortgages.

On the other hand, those mortgages are considerably more conservative than our recent lunatic foray into new financing products, and as one of our hosts pointed out, the Japanese housing market went straight up for 48 years before it crashed.  There will always be a point in the development cycle where mortgage finance starts becoming common--one could argue that this is simply that point, not a sign of a market in a bubble.

The other interesting feature is that at the moment, no one is trying to sell these houses, or even rent them.  Even more than in the United States, I'm told, the Chinese put a high premium on new housing.  A renter would depreciate the asset by more than the value of the rent.

People are using those houses not as productive assets, but as a store of value--they're more like gold than like US real estate.  The capital markets in China are underdeveloped, and in key areas (like bank accounts) mostly controlled by the government, so people don't have a lot of good investment outlets for their extraordinarily high savings rate.  The answer is to plunge their money into real estate.

I'm not sure how this works out in the end.  Once you've got an entire development sitting empty, you've got a sort of collective action problem:  who wants to be the first person to move into twenty square blocks of empty apartment buildings?  In the US, condo fees and mortgage finance considerably mitigate this problem--people are not going to sit on an apartment in an empty building for ten years waiting for the thing to become more valuable.  Long before that, the whole building will revert to the bank, which will eventually redevelop it, or sell it to someone who can--or abandon it.  Ten years out, there's no one who thinks of an apartment that is, in some sense, unsellable, as a major asset.

Yet in China, that seems to be exactly what's happening.  Perhaps eventually population pressure will drive up the prices so high that even the first seller can get people to move in--and others will rapidly follow.  On the other hand, how much is a ten-year-old "new" apartment worth?   Of course, with leverage being added to the mix--I'm told that the 2/3 of these apartments being financed by leverage is up from approximately 0% three years ago--we may not have to find out.  Those people are going to be much more motivated to sell quickly than their all-cash predecessors, particularly if they get into some sort of financial trouble.

I've heard the argument that it's not really a bubble without a wild expansion of leverage.  This is not true--it's hard to tell a story about the stock market bubble where leverage is the primary culprit.  I think you can argue that a bubble isn't as damaging without leverage.  But while the lower levels of leverage may mean that Chinese economy would not be as devastated by a real estate bubble as ours was, if this is indeed a bubble, it will still wipe out the savings of a lot of people who have worked hard, and are counting on those assets to appreciate.  And, of course, the people who have taken out mortgages will find themselves in an ugly trap quite familiar to those of us on the other side of the pacific.