This edition of CIO Insights is authored by Jacqueline Zhang, winner of a blog contest held by Krishna Memani among his team of investment professionals.
Many observers have concluded that the Chinese real estate market is frothy.
They seem to be basing that assessment on the ratio between the average price of a residence and annual household income (or price-to-income ratio), a common measurement to gauge how high residential real estate valuations are. This ratio is generally considered to be “bearable” when it is in the range of 1.5 to 3. A ratio between 3 and 5 is considered “frothy,” and a ratio of more than 5 is deemed “highly unbearable.”
In China, for households with two breadwinners, the national average ratio stands at 6. This ratio is even higher in major cities (10.2) and premier metropolitan areas like Beijing and Shanghai (19). By common standards, it’s easy to conclude that China’s real estate market is prohibitively pricey.
But this conclusion would be remiss, since it neglects to consider the acute need in China—and in emerging markets in general—for modern housing. Most residences in those markets are currently inferior by western standards in that they lack such basic amenities as private bathrooms and kitchens, which are commonplace in developed markets. In China, for example, most apartments buildings constructed before 1998 offer only one communal kitchen and bathroom per floor, and the average space per urban resident is only 9.3 square meters (or 100 square feet), according to China’s Ministry of Housing and Urban Rural Development.
China’s Housing Market Is Driven by the Affluent—But Not Overvalued
In the early 1990s, 99% of urban residents in China lived, for the most part, in inferior housing provided by their employers at nominal cost, and private bathrooms and kitchens were considered luxuries. It was only after 1998 that the market for residential real estate in China started to take off and housing standards began to rise. As a large portion of the country’s population sought upgraded housing, the first decade of this millennium (2000-2010) witnessed a surge in the demand for—and prices of—modern residences.
As illustrated in Exhibit 1, in the early 1990s, the price-to-income ratio was 14.7 and the penetration rate (i.e., the total number of modern residences in China divided by the total number of households in China) was almost zero. As time went by, the price-to-income ratio decreased, but even today, penetration in urban areas is still at roughly 30%: For every three families, there is only about one available modern city apartment. This low penetration rate indicates insufficient supply in the face of large demand.
The national residential real estate penetration rate (accumulated number of modern residences since 1995 / number of families in China).
The urban residential real estate penetration rate (accumulated number of modern residences since 1995 / number of urban families in China).
The national average price of a modern residence / average household income.*
* We calculated the average household income by multiplying China’s per capita income by two, with the assumption that the average household has two earners.
To no surprise, most buyers of modern residences in China have been affluent. But looking at how the affluent rank in the national income could give us a sense of whether China’s residential real estate market is overvalued.
Up until the year 2004, China’s National Statistics Bureau used to publish the Gini Index, a measure of income distribution and a common gauge of inequality. That index stood at 0.47 in 2004, when the top 20% of Chinese householders earned 51.86% of the national income, and their average income was 2.6 times the national average. In 2007 the World Bank pegged China at 0.469, which indicated growing inequality. Drawing on this income distribution, we estimate that the current price-to-household-income ratio is two among affluent families, and three in major cities—both of which indicate that residential real estate prices are still within “bearable” range.
What’s more, the leverage ratio of China’s residential real estate market (i.e., the total amount of mortgaged money divided by the total value of residential real estate sales) was 45% in 2014. This figure is lower than the leverage ratio implied by China’s mandatory 40% down payment for a first apartment (which would be 60%) and the leverage ratio implied by a 50% down payment for a second apartment (which would be 50%).
In conclusion, China’s residential real estate market doesn’t appear to exhibit any signs of a bubble. Among the affluent there is high demand to upgrade inferior housing, yet penetration rates remain low and indicate that demand is far from being met. And since the leverage and price-to-household-income ratios are still reasonable among affluent households, we anticipate residential real estate prices to remain high in the foreseeable future.
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Unless otherwise specified, all data in this blog is sourced from the China National Statistics Bureau.
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