Wharton’s Joseph Gyourko on Escaping China’s ‘Unsustainable’ Property Boom Unscathed

Like the many months before it, July was a gloomy one for the U.S.'s housing sector. New results show a 3.5% month-on-month fall in existing home sales in July, to 4.67 million from 4.84 million. Meanwhile, more homeowners fell behind on their payments between April and June than between January and March, raising concerns that foreclosures might be on the rise once again.

Over in the world's other property hot spot — China — a different, but potentially no less perilous, story has been unfolding, according to Joseph Gyourko, director of Wharton's Zell/Lurie Real Estate Center. In a paper published last year with Yongheng Deng, director of the Institute of Real Estate Studies at the National University of Singapore, and Jing Wu, a visiting research fellow at the institute, Gyourko probed China's rising house prices, which in Beijing, in particular, have been "nothing short of extraordinary."

Since the publication of their paper titled, "Evaluating Conditions in Major Chinese Housing Markets[r1] ,"the three real estate experts have continued to monitor prices in China, while widening their scope beyond the major cities of their initial work. With their latest findings being prepared, Gyourko spoke with China Knowledge@Wharton about the risks China's property investments face and whether any lessons can be gleaned from the bursting of the U.S.'s property bubble.

In contrast to the U.S., news in recent weeks out of China is more positive. At the least, prices are not falling precipitously, according to the official data.  However, for the first time in three years, property prices in Beijing were flat month on month in July, while 30 other cities across China reported lower or flat prices, according to the National Bureau of Statistics. And some of the country's largest developers are reporting a slowdown in demand. While China's housing market seems to have escaped the same fate as the U.S.'s, is it too soon to cheer? Yes and no, according to Gyourko.

China Knowledge@Wharton: In the course of your research, have you seen any similarities in what's going on in the U.S. and in China?

Joseph Gyourko: I certainly have, although they are very different markets. The motivations for people buying homes are very different. There's a lot more speculation in China — a lot of the purchases are not for occupancy. That's one of the huge differences. It's hard to tell what's going to happen there.

But you see an extraordinary boom in China by any count. Real prices increased by about 225% between 2000 and 2010, with around 60% of the increase happening since the beginning of 2007. You certainly see a boom in land prices — in Beijing, they increased nearly 800% over seven years between the first quarter of 2003 and the first quarter of 2010, with half of the increase occurring over the last two years of the research. But one of the differences is that we haven't seen a bust on the housing side in China.

My worry is that people will begin to think that because the property boom in China has lasted for a long time, it will last forever. That is the big risk. People can become complacent about the risks of prices dropping. I fear that too many people think real estate has become risk-less, and it is obviously not.

Right now, what's fueling this is that there are a lot of people in China who don't have anything better to do with their money. In the U.S., you can put your money in a lot of different places, such as stocks and bonds. In China, you can only put your money in the bank and earn an absolutely guaranteed negative real rate of return on your bank deposits, since the Chinese government controls the interest rate. Many people who thought they would put their money in housing instead have seen a big appreciation over the last seven or so years.

China Knowledge@Wharton: But does the longevity of China's rising property prices play into the argument that the country isn't actually facing a property bubble? 

Gyourko: It's precisely because prices have been increasing for such a long time that I'm worried. One of the problems in the U.S. was that the good times lasted for a long time — we had a boom from 1996 to 2006-2007 — before things really started to crater. China has almost had that long of a period of rise.

The other big worry that I have with China, at least in the big coastal cities, is that middle-income families can no longer afford the typical housing unit. That is a similarity with the U.S. It's a clear warning sign and we should have seen it in the U.S. When a proper middle-class household cannot afford housing because it's simply too expensive relative to their income that tells you the market is being supported by some sort of speculation. That should worry everyone from Chinese regulators to you and me, because we all need China to grow.

What you can say is that their housing market has become incredibly risky. Is it a bubble? Economists don't have good models for bubbles. We couldn't predict the one in the U.S. All we know is that housing has become unaffordable to a big part of their middle class in a lot of cities. That's a danger sign.

China Knowledge@Wharton: Chinese households are in the thick of things. But as your paper points out, China's state-owned enterprises (SOEs) have had a part in influencing the price and quantity of housing. For example, you and your co-authors say there's a "statistically and economically strong positive correlation" between land auction prices in Beijing and winning bidders being SOEs, suggesting a moral hazard.

Gyourko: That's right. We looked at SOEs being acquirers in the land market, and they certainly appear to be playing a pretty big role in Beijing's land market. They may be relying on subsidized costs of capital and their true risk exposure is unclear. We found that central SOE developers tended to win the biggest parcels of land and paid the highest prices.

The land sales have been an important revenue stream for local governments. Their goal is to make money by essentially selling out to developers. We found that local governments earned RMB 542 billion [US$84.8 billion] of gross income from land sales in 2003, which increased to RMB 1.6 trillion by 2009.

There are risks when the prices drop — and they will — and whoever buys at the peak will lose a lot of money. That's just the way it goes. The question though is, does it cause any systemic risk that harms the economy? In the U.S., it did because the bubble was so big and widespread, and so many people had so little of their own equity tied up in these investments, and the banks couldn't tolerate the defaults.

In China, we don't know what will happen. If you look at the basic data, there seems to be enough equity. It looks like people have to put down real down payments to buy houses in China.

But we don't know whether there is any hidden leverage in China's system, which is not all that transparent. Not that ours in the U.S. was all that transparent. As we found out, there were a lot of hidden risks and a lot of hidden leverage. That’s the worry about China. At face value, it looks like they have more equity so when the downturn comes, they will be better cushioned, at least on paper, and we'll find out if that's the case.

China Knowledge@Wharton: China's central government has been responding in one way or another over the past year to dampen the market — such as reducing the funds banks have available for lending, piloting property taxes programs, restricting residents in major cities from buying second or third homes, and requiring higher down payments– up to 50% in some cases. Is the government responding in ways that you agree with? Have the measures been effective yet? Prices in cities like Beijing and Shanghai, for example, are flat or declining but it's hard to know whether that's the result of the government measures.

Gyourko: I would not presume enough knowledge about China or its regulatory system to be able to comment on whether the government is doing the right thing. However, I view it as a healthy sign that the government is willing to try to intervene, to stop what looks like a bubble. I also view it as quite sane and proper for the government to require more equity for purchasers. It's a very good policy and we should have had it in the U.S. If you really want to bet on this market, you need to put some of your own money in.

The things they've been doing in that regard will be useful when prices fall because equity cushions the downfall. Someone loses but it's not an immediate threat to the banking system.

How effective it's been is unclear at the moment, partly because we don't know whether people can get around these rules, and if they can, whether they actually are. Again, theirs is an opaque system so it's not easy to monitor. We do see a slowing, and in many cases, a drop in transaction volume — in the number of land sales, for sure. You see it on the quantity side first, which will translate into prices.

Real estate isn't like the stock market, and doesn't re-price every minute, so when a cycle turns in real estate, it takes a while. But I think we're seeing the beginning of a turn in China — the first sign of that is a drop in transaction volume. How much is due to the government policy, I couldn't tell you. It also could be that people are thinking that it's too risky and they're starting to slow down.

China Knowledge@Wharton: Did any of your research go into commercial real estate?

Gyourko: We don't have data on that. The housing and land sale data we used was due to the good efforts of my colleagues in Singapore. We're doing a new study now of 35 cities in China so we will be able to look at interior markets and the like, which we should have done this fall. Our strategy is to see if the "big eight" markets that we first looked at — Beijing, Shanghai, Chengdu, Hangzhou, Shenzhen, Tianjin, Wuhan, Xian — are abnormal, and compare them with the others.

China Knowledge@Wharton: For the business community sitting outside China, why should we care about its possible property bubble?

Gyourko: It's a big sector, in an economy that's a big driver of global growth. The estimates are that real estate in general is about 12% of China's GDP. In the U.S. at the height of the boom, it looked like it was about 6% to 7%.

There's the potential affect on the real economy to consider. Private housing accounts for around one-third of the buildings completed by China's construction industry. That industry constitutes around 5% of the country's GDP and consumes roughly 40% of all steel and lumber produced in China.

A lot of people are counting on China's growth to drive our export industries and so on. I have no doubt that prices are going to fall. It's just a question of what trouble that causes.

China Knowledge@Wharton: Were there any surprises in your research?

Gyourko: I was very surprised by how much land prices had increased, at nearly 800% in the case of Beijing. Price-to-rent ratios in eight large markets, including Beijing's, increased from 30% at the beginning of 2007 to 70% by early 2010. As for price-to-income ratios, our research found that they were at their highest-ever levels in cities like Beijing, Hangzhou, Shanghai and Shenzhen. Those are big numbers.

That's one of the reasons why I believe there is some type of bubble, or euphoria, that has developed in China. It's virtually impossible to see fundamentals growing that fast. We all had a sense that levels had become very high.

China Knowledge@Wharton: Are there any lessons that Chinese investors can take away from what you're observing in post-bubble U.S.?

Gyourko: The big part of the bubble bursting in the U.S. is over, but I think it will take a few years, not quarters, for the U.S. to recover. We still have a big supply/demand imbalance. We grossly overbuilt and we have unoccupied housing. We have this big backlog of foreclosures [since the sharp rise in 2009] clogging up the system. As long as that supply overhang exists, you should not expect any significant recovery in American housing. It will be a couple of years at least before that supply overhang is gone. We have got to get rid of the foreclosures and sell them, and you can expect downward pressure on prices until that process is done.

China Knowledge@Wharton: Do you see any momentum increasing in the foreclosure process?

Gyourko: No, we see a slowing because of all the court cases since the mortgage lenders got caught last year "robo signing" foreclosure cases. They — quite appropriately — are now judicially supervised. You certainly don't see a speeding up; it's dragging out the downturn.

China Knowledge@Wharton: Do you see any changes among any of the players — from the regulators to consumers — that give you confidence that the U.S. aren't repeating the same mistakes again and again?

Gyourko: You've certainly seen a huge drop in homeownership rates, which means that at least some people who were able to get credit in the past despite being weak borrowers aren't able to get it now.

But you still see the Federal Housing Administration has a 25% market share and is giving out 97.5% loan-to-value mortgages. So there is still an arm of the government that is actively propagating very risky mortgages with very little equity. We're a bit schizophrenic. The private markets have almost exited the mortgage market. But the government is still engaged in a policy that allows for highly leveraged home purchases. It's like Dr. Jekyll and Mr. Hyde.

China Knowledge@Wharton: What would be a best-case scenario for China at this stage then?

Gyourko: That the government intervention requiring more equity works and you see air coming out of the balloon in a controlled fashion over the long term so that households can handle it, and you see a long period of time when prices are down or flat. Borrowers won't be happy, but there won't be a financial crisis. What you fear is a precipitous drop very quickly, with defaults on the underling loans.

China Knowledge@Wharton: Has there been any similar bubbles in the past where we've seen that?

Gyourko: We didn't have any cases until recently. Statistically, you can't say anything. We haven't seen bubbles akin to what happened in America, Spain or Ireland — they just haven't happened in the last 30 or 40 years.

It's hard to imagine that you can escape such dramatic price rises completely unscathed. Either there's a fundamental story that would justify the prices or they will fall by a significant amount.  What would the fundamental story be? Incredibly high demand with limited supply.

To understand why bubbles can last a while look at the U.S., at cities like Phoenix or Las Vegas. Those markets grew like mad because there was huge demand. There was huge population growth and substantial income growth — real demand drivers. You see that in every major Chinese market. It's not like it's completely crazy. They've got real demand drivers. The question is, have they built enough homes so that prices aren't pushed up so much, and have prices become so high that the typical household can't afford it? My worry derives from the fact that the Chinese are building a lot of homes, and prices are unaffordable. At that point, I view it as unstable.

China Knowledge@Wharton: How are Vegas and Phoenix doing now?

Gyourko: Very badly. Prices continue to fall. The good news is that the biggest part of the bubble has now burst. But in those cases, we now know that a lot of those purchases were made with very little equity. There have been a huge number of defaults. Their economies are weak because of that and are very still depressed. That's where equity really matters.

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