The real estate markets in China have been red hot for years, and we do not consider that to be a recommendation.  The rising prices have come from several motivations.  First, since China changed to a more market economy, several decades ago, people have been striving to own and invest.  In addition, everyone sees that some people have accumulated wealth, and they want a piece of it, too.

For the man (or woman) on the street, the most common and accessible object for ownership and investment is real assets, like housing.  In fact, by investing in housing, they also take care of another basic need: shelter, so it is a quite natural first investment for people all over the world.  In China, the novelty of business operation and wealth, combined with the ever increasing number of people who are earning enough to afford to buy a house had already set the stage for a pyramid scheme in housing prices.  The additional ingredients that have allowed the pyramid to build is envy and greed, as described in an earlier post on our redhillchinablog, entitled “Fear, Envy and Greed: the Chinese Business Model”.  In that regard, people are so envious of those who have accumulated wealth, and they believe that they can do the same just by starting a business or making an investment, that they give no forethought to the mechanics and realities of the situation.  Thus, people hear about how other people have made large returns on housing, then, later, in stocks, and they follow, blindly, into the market, expecting the same.However, as an arbitrageur.

I understand that all markets must, ultimately, be connected.  I even have experience in arbitrage, in the real estate markets.  In the late 1980’s, I bought an 18th century estate, in chic Bucks County, Pennsylvania.  A similar bubble had come into real estate markets, in the U.S., at that time, but the air was coming out of the bubble.  Indeed, the original price tag on the property had bee over $800,000, but I eventually bought it for $500,000.  My mortgage payments were over $4,000 per month, and, in the U.S., mortgage interest is tax deductible.  So, with the tax shield, my net payments were about $3,000 per month.  I had been involved in merger arbitrage, but that market, also, was having its own difficulties.  Thus, I had to find a way to make the real estate investment pay for itself.   I had a separate apartment, in an outbuilding, which I could rent out, and I had stables in the barn, which I could also rent out.  Still, my income from those rentals was only about half of my after tax mortgage payment, which was lessened slightly by depreciation deductions for the parts of the property that I could rent out.  Perhaps, I could have rented out the remainder of the property to break even.  Instead, though, I turned the property into a country inn, which had potential revenues from weekend-only rental of $8,000.  What I did, therefore, was to enhance my return by doing an arbitrage between the monthly and daily room rental markets, and I was able to, not only live on the property, but also to earn a profit from owning it.

In fact, we would always expect there to be a break even arbitrage between rental and purchase of residential or commercial real estate.  However, a simple example will reveal the state of the real estate market, in our home city, Guangzhou.  First, we must point out that there are no deductions for real estate, like those, in the U.S.  Our apartment costs Y3,000 per month for us to rent.  On the other hand, the owner of the apartment must pay mortgage payments of around Y8,000 per month on a purchase price in excess of one million Yuan.  That means that each year, the owner will make a loss of Y60,000, and without accounting for either the time value of money or increasing real estate prices, that is a loss of over half a million Yuan in ten years.  In fact, we have not had an increase in rent for over two years, and we even have a perpetual lease at the same price, if we choose to stay, and we see larger apartments, in our building, now, offered at even lower prices than we are paying for this one.Other people are also beginning to lift their heads above the frenzy to get rich, quick, in China.  The stock market bubble was partly fueled by the real estate bubble, both directly and indirectly.  Directly, because people who made money, in real estate, moved on th “play” the stock market.  Indirectly, because the envious who could not afford the buy-in price for the housing market saw an opportunity for a lower buy-in to “play” stocks.  After the bubble in stocks burst, and the stock market has come down two-thirds from its highs, real estate prices have also been backing off.  In Guangzhou, prices have declined by about ten percent in the last half year and forty percent, in parts of Shenzhen, for example.

The point is, real estate prices, in China, cannot continue with their current upward march, and even the downturn in prices over the last half year, still leave a huge gap between the rental market and the market for ownership, which must ultimately be connected, in the manner that we have described.  It is the reason that we continue to stay away from the real estate market as an area for investment, in China.