Churchouse Letter
April 2011             by Peter Churchouse

Bubble Fever – A Question on Many Lips

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This newsletter is driven by an email from a reader – a Hong Kong-based fund manager – and out responses to his questions. We repeat his questions and comments verbatim, and our responses to them. His questions are familiar and reflect the concerns of many observers and participants in Asian real estate markets.

Q: “After reviewing lots of data, I am of the view that Hong Kong property is in a gigantic bubble and the party will end badly.”

I don’t necessarily agree that Hong Kong asset markets are in a bubble — at this point. But they have been pointing in that direction for the past year, particularly real estate assets.

First, how do you define a bubble?

A bubble is when a measure of value/valuation/measurement metric of an asset or an asset class is 1-3 standard deviations away from their long term average. For example, when valuations of ‘A’ shares in China were trading at a PE of 55x, vs the long term average of approximately 15x — that is well more than two standard deviations from the long term average and can therefore be called a bubble.

Housing Affordability is still in “normal range” – but getting worse.

Affordability can be a good metric of valuation in housing and in Hong Kong according to my affordability index for entry level mass market housing (not high end luxury) affordability is a little worse than the long term average but nowhere near one standard deviation worse — yet. Why? Because interest rates are at record low levels (one third or less of what they were in 1997) household incomes have gone up strongly over recent years and average low-end house prices are still roughly where they were in 1997. So, income up, interest rates down by 60% and prices the same as 1997. High end is well above 1997 levels, but high end is not so relevant for ‘social’ affordability and housing policy considerations.

Our affordability index tracks the change in cost of housing as reflected in the monthly mortgage repayment (see Figure 1 – which is dictated by the property price, mortgage rate and the down-payment percentage – which we take as 70%) in relation to the change in household incomes. When monthly payment is rising faster than income, affordability is getting worse and vice versa. This data series has proved volatile over the years in response to big moves in flat prices and interest rates. Household income changes have been steadier.

But it is correct that the affordability situation is getting worse with property price rises over the past 15-18 months and also the prospect that interest rates are inevitably going to rise from record low levels. Our analysis suggests that with a 200BP rise in rates and a further 20% rise in entry level housing prices the affordability index will be somewhat above the long term average, but still less than 1 standard deviation above that average. The risk of bubble conditions are there, but we are not there yet for the mass housing market.

Government measures to slow the market are going to be accompanied by higher interest rates, which together will likely slow the advance of property prices throughout 2011.

Also, bear in mind some basic fundamentals. Hong Kong is producing only about 50% of the numbers of flats per year as it did the 1990’s and about 35% of the average production of the 1980’s — supply is tight.

Also note that financial regulation in the West, and tsunami/nuclear fears in Japan are driving significant numbers of higher paid business people and professionals to Asia, particularly Hong Kong and Singapore, thereby underpinning demand even further. Expect upper end prices and rentals to keep moving upwards in response to this.

Q: “The value of Hong Kong ‘s residential real estate is now approximately 330% of GDP, which is higher than the peak of 1997 (300% of GDP). It is interesting to note that Japan’s property bubble popped when its ratio was at 370%. I know there is a lot of noise about the mainlanders buying real-estate here but even in China, this ratio is at 350%! In other words, China’s property is also in a massive bubble and when the music stops there, these mainlanders will stop buying in Hong Kong and may also start selling to raise cash.”

Value of Hong Kong real estate has always been a high percentage of GDP. So what! I do not know how that statistic is calculated anyway — does it, for example, include public housing and other social housing? A core factor here is that most Hong Kong families pay no tax, and even the wealthy pay a maximum of 15%. Many of the wealthiest people pay no income tax at all because they receive dividends from their companies and dividends are not taxed in the hands of the recipient.

In countries like Japan, US, UK and France, average taxes are more like 35%, plus huge VAT (now 20% in the case of the UK) plus state taxes, local taxes, sales taxes etc. Housing is bought on an after-tax basis, and given the low tax base in places like Hong Kong and Singapore it is likely that higher prices in absolute dollar terms for housing are going to be the norm. Households in Hong Kong and Singapore retain a far greater proportion of their earnings than folks in most other places, thereby making housing affordability inherently better.

Japan, as you correctly allude to, was a massive bubble, but mainly in Tokyo, not so much in the provinces. When mortgages are being taken out for 100 year repayment, and properties are being bought and sold on the basis of 0.5% rental yield; that is truly a bubble.

Rental yield vs cost of capital can be an indicator of unsustainable pricing.

It is worth noting that another indicator of potential bubble is when the rental yield (annual rental divided by purchase price) moves substantially below the mortgage rate/cost of capital. In markets like Hong Kong and Singapore, there is still a positive carry for most middle income types of housing. That is to say that the rental yield may be around 4% to as high as 5%, but that the cost of a mortgage can be around 1.5% (based on a HIBOR or SIBOR linked mortgage) or around 2.6% for a prime rate based mort-gage. There have been periods when the rental yield has fallen to say 4% in an environment of 8%-9% interest rates. That is a situation that suggests something has to give. Either prices have to come down or rentals have to rise substantially.

China Buyers of Hong Kong Real Estate:

It is easy to get swayed by the media hype, but mainland buyers of property in Hong Kong comprise less than 5% of total monthly transactions. It is not correct to assume that the Hong Kong market (or Singapore) is being swamped with mainland money. It may be true that mainland buyers comprise a higher proportion of high end purchases, say properties over HK$12 million, and it may be the case that mainland buyers have represented as much as 20%-30% of certain selected new releases of high end developments, but as a percentage of the overall sales, they are small potatoes. Also note that Class E residential properties (those over 170sq m) make up approximately 2.5% of the total private housing stock in Hong Kong. Some 85% of private housing in Hong Kong is less than 70 sq m. This is not the real target of the mainland buyers.

It is true that tightening measures in China may slow flows of cash to Hong Kong’s property markets, and there is some initial evidence that this is the case, but they have not been a big component of the mass markets. Any impact of a slowdown of China buyers is more likely to be felt at the high end of the markets, particularly in new releases.

Q: “According to the HKMA, for the luxury segment (1,000 sq feet or above), mortgage repayments already account for approximately 70% of household income. Bear in mind that this is when the mortgage rate is at 2% for most borrowers. Back in 1997, the mortgage rate was close to 10% and in those days, mortgage repayments accounted for 120-125% of household income. According to my calculations, when the mortgage rate increases to 5-6%, mortgage repayments will (once again) exceed household income and the game will be over.”

This analysis above assumes that the average home buyer is buying flats over 1000 sq ft. However as indicated some 85% of all private housing Hong Kong is less than 70 sq m (753 sq ft) and the average private sector flat size is approximately 50 sq m (548 sq ft) – note that approximately 50% of Hong Kong ’s population lives in subsided public housing. So the use of 1000 sq ft flat as a benchmark is very much at odds with reality of averages in Hong Kong. A flat of this size is in the ‘luxury’ category and no one in the ‘average’ or ‘median’ household income level is going to be in this sector of the market. The 1000 sq ft and above category is about 10% of the total private sector market and about 5% of the total housing market in Hong Kong.

About 53% of Hong Kong Households Can Afford Entry-level Apartments.

According to our estimates, based on current interest rates (using the prime-minus formula for mortgage rate and not the HIBOR-Plus formula — which gives a lower mortgage rate), and prices of entry level mass housing, for a 500-550 sq ft ‘average’ sized apartment, about 53% of households could afford such a unit, assuming that no more than 45% of household income is spent on mortgage repayment. If we look at Hong Kong’s average flat price (taking all sizes and quality) only about 22% could afford the average price apartment. For Singapore about 78% of households could afford the typical entry level apartment, but in Singapore more than 75% of apartments are provided by government.

Land Policy Destines Hong Kong Families to Poor Quality Housing Conditions.

I am not defending the Hong Kong government land policy that destines the Hong Kong population to a dreadful standard of housing in terms of size and quality. Far from it — I have long been a critic of housing and land policy that produces a living environment way worse than what is experienced in countries with a per capita GDP of a quarter of Hong Kong’s. Hong Kong’s housing conditions are lamentable, and a disgrace for a country that is so well off.

It is also worth noting that none of the affordability studies incorporate the issue of down-payment, my own work included. Saving up for 30% down-payment for lower income families is extremely difficult and has a big negative impact on affordability and home ownership. This was circumvented in many countries in the West by banks giving 90% or even 110% mortgages, so very little down-payment is needed. That is a recipe for problems for the banking system.

I have not figured a statistically rigorous way to include this in a single affordability measure, and certainly the very broad brush studies done by Demographia for instance, and others, do not incorporate this aspect of affordability. If someone has some ideas to do this, please feel free to let me know!

Q: “Finally, in terms of affordability, the latest survey from Demographia has clearly shown that Hong Kong’s real estate is the most unaffordable in the world at 11.4 times median income! The ratio is even higher for the more expensive properties.”

The studies by Demographia I have mentioned above (and in previous newsletters). They are undertaken by a US policy platform and are very much aimed at the US market. They use a flawed but understandable and simple methodology of looking at median (or average) house prices against median (or average) household income. This methodology has the advantage of simplicity, but like most simple things does not take account of the realities of each individual market.

Interest Rate Differentials Influence Affordability.

The studies do not take into account differences in interest rates which clearly have a big influence on the amount of monthly mortgage repayments — i.e., affordability. In some countries in Asia a mortgage can be obtained at around 1.5% or up to 2.5% vs more like 5% – 6% in many Western countries. This makes a huge difference to the monthly repayment amounts.

Low Asian Taxes Help Affordability.

Second, the studies make no allowance for tax differences. Housing is paid for out of after tax income. In the case of most Western societies income tax for middle class families are in the range of 35% to 45%, while for Hong Kong , hardly any households pay the maximum tax rate which is a mere 15%, and around 20% in Singapore. Moreover, households in many Western nations are saddled with high rates of VAT/GST of as much as 21%, sales taxes, state and local taxes, as well as payments for such taxes as national insurance.

Our studies indicate that a professional employee in London would have to earn about 50% more gross salary to be equally well off as the same employee in Hong Kong on an after tax and after monthly housing cost basis. For New York the figure is about 45%. For this study we assumed an apartment of about 1500sq ft in a good but not super-high end location.

Role of the Public Sector in Housing Provision.

Third, the studies do not take account of the role of the public sector in housing provision. In both Hong Kong and Singapore a very substantial amount of housing is provided by the government in subsidized platforms of one kind or other.

Affordability is less of an issue for higher end homes. These are typically bought by people who may have climbed up the property ladder and have cash available through this process. Or they have enjoyed success in business ventures which may have allowed them to access expensive real estate. If you don’t have the money, you simply don’t buy that US$ 8 million apartment — simple! You stick with the $5 million place — tough.

As a policy matter we should be less concerned about prices at the high end aimed at the very wealthy but do not need to be very concerned about housing affordability for the middle and lower income households.

Q: “So, given all these facts, I am extremely worried about the local property market, and am expecting a massive slump. If history is any guide, no bull market lasts forever and epic booms are followed by epic busts!”

Asian property markets — particularly Hong Kong and Singapore — have been the most volatile in the world over the past 30 years. See figures 1-3. There have been at least 6 downturns in the Hong Kong residential market in that time, and 2 of those were more than 60% from peak to trough.

Each of these big downturns have followed a period when our affordability index was around 1 or more standard deviations from the long term averages. We are nowhere near that level right now, but as noted above, affordability is worsening as prices rise faster than incomes, and will likely worsen further with higher interest rates and depending on the level of price appreciation from here.

Figure 1: Hong Kong Affordability Index

Hong Kong Affordability Index circa April 2011. Affordability= Change in Cost of Housing / Change in Household Income. Mean Affordability 86.6, -1 Standard Deviation 39.9, +1 Standard Deviation 133.3. Notes: A: As of March 2011 the Affordability Index stands at 102 points, above the average of 86.6 points. B: Assuming that over 2011 there is a 20% increase in property price, an increase in interest rate by 200 basis points and an average wage rise of 3%, by the end of 2011 the Affordability Index would rise to 128 points, significantly closer to the +1 Standard Deviation level of 133.3 points.

Figure 2: Centa-City Leading Index: Hong Kong Residential Price Index

Centa-City Leading Index: Hong Kong Residential Price Index from 1994 - April 2011. Note: Centa-City Leading Index is based on the total market value of the constituent estates in a week/total market values of the constituent estates in the previous week, multiplied by the CCL for the previous week.

Figure 3: Hong Kong Residential Property Price Index

Hong Kong Long Term Residential Property Price Chart, charting the Nominal Price Index from 1973 - April 2011.

Pegged Currency Encourages Asset Price Volatility.

The pegged currency destines Hong Kong to potentially greater asset price volatility given that Hong Kong’s monetary policy is dictated by the US Federal Reserve. From time to time monetary policy in the US is very much at odds with what is needed in this part of the world. Such a time is now. Hong Kong would probably have much higher interest rates right now if monetary policy was set at home. As long as the pegged currency remains this potential for great asset price volatility will remain.

Policy Aimed at Applying the Brakes to Slow Pace of Asset Price Rises.

Given the current underlying tight supply conditions, rising employment and wages, in-flux of high paid personnel and easy liquidity, there are powerful forces pushing all residential prices to the upside.

Given this, there is every reason for policy makers and bankers to think about applying the brakes to slow the advance of prices which typically can pose problems for the banking system — the cause of the global financial crisis. Government in Hong Kong is trying to increase land supply to ease shortages, but this will take some years to come into the market. In the meantime, shortages are likely to persist.

Expectations of a rising Rmb are also likely to influence investment appetite for Hong Kong based assets.

Governments around the region have embarked on various policy measures to artificially slow the advance of asset prices, and will likely keep applying the brakes until such time as the policy measures produce a slowdown in asset price appreciation. Rising interest rates may do the job for them. While governments are wary of the potential to create a property linked problem for the banking system, they equally do not wish to precipitate a crash in real estate markets. It is a delicate balancing act that they are embarked on.

I believe that governments will succeed in slowing down property transactions volumes (some evidence is showing this to be so) and believe that the rise in residential property prices in most Asian markets will slow or even fall a few percentage points in some instances. Exogenous shocks can be the main catalyst for a crash at this point.

Current policy measures are unlikely to cause a major crash in property markets, but as we have seen before, exogenous shocks from outside the region can and do wreak havoc on regional asset markets. A crash in regional property markets at this stage would likely be created by externally generated forces than domestic ones. I will leave it up to you to identify what these might be! In Hong Kong’s case a meltdown in the China economy or a series of major political/social upheavals will always have the potential to transform economic fundamentals in Hong Kong.

China’s Real Estate Concerns Dwarf Those of Hong Kong

China’s real estate markets exhibit much stronger bubble characteristics than Hong Kong’s.

While I am modestly concerned about the possibility of a real estate bubble emerging in Hong Kong, followed by the inevitable bust, I am much more concerned about the potential for systemic problems in China driven by real estate, and real estate lending. A bursting of a property bubble in China will inevitably have adverse impacts on Hong Kong’s economy and its asset markets.

China Has Initiated Dozens of Real Estate Cooling Measures.

Various Chinese government agencies at the highest level have also seen problems looming and have initiated rafts of policy measures aimed at cooling a rampant property market over the past 15 months or so. However it is also fair to say that the government’s policy response to the global financial crisis was the big driver of China’s property bubble. Like many other countries around the world, China’s response to the crisis was to flood the markets with liquidity, probably now seen in retrospect to have been excessive to needs. In 2009 China’s banks made close to US$1.4 trillion of new loans, with an estimated 25% of this going into the real estate sector at various levels — both developers and consumers. Despite policy mutterings to slow the lending in 2010, the pace continued at a brisk rate of around US$1.1 trillion, still well above longer term averages.

The developer community in China numbers approximately 60,000 companies — a staggering number, in a very fragmented industry. The top 100 developers account for only about 12% of the residential supply.

China’s banking industry is very vulnerable to a slowdown in the property market and could experience systemic problems in the event of a significant decline in property transaction volumes and property prices. Thus while the need to slow down lending to the real estate industry is clear, equally clear are the potentially serious problems to China’s banking industry of a major tumble in the country’s real estate markets. Not to mention social unrest if China’s new homeowners suddenly find their assets worth 30% less and are unable to make mortgage payments.

The authorities are walking a tightrope. Too little tightening and the bubble grows further with the risk of an even bigger bust later, or too much tightening and a serious decline hap-pens imminently, with also big systemic problems for the banking sector. An ideal outcome would involve a gentle slowdown in transaction activity, and construction, with a leveling of property prices, or even a small decline. This outcome will be extremely difficult to engineer.

Real Estate Fallout is Inevitable — How much pain will it induce?

The conditions for a minor tsunami for the banking sector are already in place. Huge numbers of property developers are highly indebted with debt/equity ratios of well over 100%. Even a small slowdown in volumes and prices can very easily push thousands of these companies over the edge. Most are purely developers with a build and sell business model. Most have little to no investment properties producing steady rental income that could help service debt in a time of a sharp fall in residential property sales.

Second, at the consumer level, there are serious impending problems. Anyone who has visited Shanghai recently may well have noticed huge blocks of completed apartments sitting with only a handful of lights on at 9 o’clock in the evening. The developments have been sold but sit empty. The apartments have been bought by investors/speculators. A couple of months ago I was visiting a very large development in Chongqing. This is a very well built and designed development, with excellent landscaping, great common areas, well planned and laid out. The units had been totally sold out, and delivered to the owners in May/June 2009. Almost 18 months later, during my visit I estimated that only about 35%-40% of the units were actually occupied.

Many analysts and observers suggest that these hundreds of thousands of units bought by investors all over the country are largely bought with cash and no debt. I find it hard to buy that assertion. A certain proportion may have been bought with little or no debt, but there must be a very large proportion where substantial borrowings are involved. Any hiccup in the China economy which might adversely affect the ability of borrowers to service the debt on properties that sit empty, with no rental income, will come back to bite the banks in a big way.

The authorities seem to see these problems also and have moved to raise reserve ratios of banks to around 20% (I think the highest I am aware of in any major economy) to cushion the impact of the huge wave of loan defaults that is highly likely. Banks are also being instructed flatly to stop lending to real estate in many instances.

Municipal Finances at Odds With Central Government Policies.

An added problem in this whole cocktail of impending disaster is the role of municipalities. Most municipal governments rely very substantially on land sales and other property based revenues to fund their operations, development of infrastructure and local services, some to the tune of 50%-60% of their budgets. It is not in their interests to support central government efforts to engineer a slowdown in land sales and the real estate markets generally. A major fall in their budgets will likely have knock on effects for the local economies.

All in all, it is hard to see China escaping from a property lending induced meltdown, or at least a partial meltdown which will produce a sharp increase in non-performing loans for the banking sector. Even if it is not a lethal dose it will be a very painful one. There will be substantial knock-on economic impacts in the form of reduced municipal spending and increased unemployment.

This has the potential to knock at least several percentage points of China’s economic growth, and potentially tip the country into a recession.

Hong Kong Will be Adversely Affected by the Bursting of China’s Property Bubble — But the Condition Will Not be Lethal.

And of course any serious economic decline in China will produce spillover effects for Hong Kong’s economy and its asset markets. So when all is said and done, although Hong Kong’s property markets may not be in a bubble stage as defined by our technical criteria, it is nonetheless quite vulnerable to a correction when China’s bubble bursts. The saving grace in Hong Kong is that the developer community is lowly geared (average net debt-equity ratio for the sector is less than 30%) and Hong Kong consumers are also lowly geared generally speaking. Even in the last mega property downturn following the onset of the Asian financial crisis in the late 1990’s, when average residential property prices fell 60%, and almost 15% of homeowners fell into negative equity, non-performing mortgages amounted to only about 1.3% of the total.

A set of circumstances that could conspire to drive Hong Kong property prices down say 25% or 30% from current levels (that is the fall that followed the demise of Lehman in the period late 2008 — mid 2009) would be highly unlikely to engender any systemic problems in the Hong Kong banking system and/or its mortgage system.

Singapore Residential Property Price Index from 1975 - April 2011.

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