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The Tangled Web of China’s Property Market is Only Getting Worse

News of Evergrande’s default was the shot heard ‘round the property world back in December of 2021, resulting in a cascade of financial woes that continue to threaten China’s entire economy. For context, the country’s real estate sector contributes more than 25 percent of its GDP, so the debris from Evergrande’s financial fiasco has a wide reach. While it’s possible the ensuing debt bomb has yet to truly suffocate the commercial property industry, the property crisis has already dismantled several steel producers, state-controlled asset managers, and privately-owned banks. But this could only be the beginning.

Cracks in China’s economy have been appearing after Evergrande’s initial collapse followed by a parade of postponements to a debt restructuring plan. Then, the rest of the dominoes began to tip. Other major property developers started folding. More than 30 Chinese real estate firms, including China Evergrande Group and Sunac China Holdings, have defaulted on their foreign debts.

Investors have grown frustrated with the insistence from defaulting developers, regulators, and even the Bank of China that everything is fine and the property market will sort itself out. Yet try as censors might, the people of China are beyond fed up, and so are Evergrande’s lenders. After nearly a year’s worth of promises to pay back its loans, the world’s most indebted property developer just had its Hong Kong headquarters, a 26-floor office building that just so happened to be one of the developer’s most valuable assets, seized.

As easy as it may be to pin all of China’s property problems on Evergrande’s mismanagement, the truth is that the ongoing debt saga is the result of systemic problems from Chinese financial institutions and the propensity for excessive risk-taking in real estate transactions. China’s government has been trying to yank the sector back to its feet, but solving a $7 trillion real estate bubble simply won’t happen overnight. A staggering amount of China’s money is caught up in its real estate, so every day that millions of square feet of unfinished buildings continue to sit abandoned prevents very necessary cash-flow. Policy makers in China are absolutely feeling the pressure to craft a silver bullet for its current crisis.

If Evergrande’s fallout isn’t pushing the Chinese government to forge a silver bullet for the property crisis fast enough, a nationwide boycott stemming from a much-abused property practice will.

Pre-sale pressure

If you’re wondering why so many news outlets are referring to China’s real estate market as “Ponzi-like,” then this is why. In China, real estate makes up over 70 percent of individual wealth, and property buyers frequently make upfront payments for unfinished construction. This practice, known as “pre-sales,” accounts for more than 85 percent of all new home sales in China. One of the many reasons Evergrande and other developers had gotten so out of control was because developers eagerly accepted pre-sale cash and used it to simultaneously fund numerous projects, and therein lies the problem.

Pre-sales are so widely accepted in China that they’ve become one of the most important sources of liquidity for homebuilders. By 2021, nearly 90 percent of newly built residences in China had been pre-sold. The funds are practically interest-free and are used to pay for construction. Up until this year, 50-70 percent of pre-sale funds had to be kept in escrow accounts under the local government’s management, since each city has its own set of rules. But again, this has led to opportunities for abuse, and some governments have utilized the pre-payment money to fund their own initiatives in exchange for developer favors. 

As China is one of the fastest growing real estate markets in the world, pre-sales certainly had its upsides for buyers. Home prices in China have more than quadrupled since the year 2000. The income to price ratio for a building in China is at 1:34.9, which means that it would take 34.9 years for an individual earning an average salary to pay for a home. In comparison, the income to price ratio in the notoriously expensive New York region is 5.4. 

The entire pre-sale system is at a crossroads. China is expected to amp up pre-sale oversight in lieu of abolishing the practice altogether, at least in the short-term. Hopefully, regulators push for a shift away from this model. Using money collected from new investors in order to pay existing investors or fund other projects in the long run is eerily similar to Bernie Madoff’s infamous scheme.

Mortgage boycotts 

Unfortunately, the pre-sale model has caused multiple Chinese developers to go bust, which means that people in China are effectively seeing their wealth evaporate right before their very eyes. As the housing crisis worsens, an increasing number of developers may find themselves unable to deliver on already pre-sold properties, potentially disappointing even more homebuyers. Frustrated, tens of thousands of buyers in China are outright refusing to pay their mortgages for their unfinished properties.

For Chinese buyers, after forking over an exorbitant amount of money to purchase a property only to be stuck waiting for months on end for the developer to even show up has them throwing their hands in the air and marching in the streets. In a country that does not tolerate dissent, the fact that over 300 developments are not receiving their cash flow, even if construction has yet to break ground, is nothing for the government to balk at. The boycott has, so far, spread to over 90 cities, and regulators have to act fast before the boycotts gain enough momentum to drag down other sectors. 

Policymakers in China have mulled over a mortgage payment grace period in order to calm the streets. Officials in Beijing gave the impression that local governments and banks would determine a homeowner’s eligibility and the duration of the time between payments. At the same time, local governments were also asked to take steps to nudge their incomplete construction projects along, but the nudging was left to the local government’s discretion, so there wasn’t a cohesive solution to pacify the boycotts. The mortgage boycott is still ongoing as jilted homebuyers increasingly believe that they are victims of a widespread scam. 

China’s property crisis is a woefully complex ordeal that could potentially wreak havoc on a global scale, and unfortunately, the crisis appears to be worsening. The rapid speed of home construction was formerly symbolic of China’s growth. Now, trust in the real estate model has dwindled. Buyers are leaving the market, debtors are striking over mortgage payments, and developers are struggling with liquidity.

The effect of a collapse in the Chinese real estate market would be felt far beyond its borders. Currently, China accounts for around 18.8 percent of the world GDP. That isn’t too far behind the U.S., which accounts for 24.4 percent. A systematic failure of the financial system in the country could erase enough wealth to throw the world into another recession, much like what we saw with the mortgage debt crisis of 2008. The difference is, there is much less foreign ownership of China’s property, meaning that the pain would be felt most by Chinese firms and citizens. Evergrande might have been the first domino to fall or could have just been an outlier, either way, investors in Chinese property are cautiously awaiting what will happen to the mess that the Chinese property industry has become.

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