2022 proved to be a challenging year for Chinese developers, with a significant number of them defaulting and the housing market shrinking considerably. In the aftermath of such a difficult period, it is natural to wonder about the future of the Chinese real estate market, once hailed as the most crucial sector in the universe. Does it still hold opportunities for investors? While the era of rapid growth may be behind us, the overall market is expected to remain stable, albeit with a gradual decrease in size in the medium to long term. Challenges arising from slowing urbanization will be mitigated by a steady rate of household formation, driven by shrinking household size. However, there is a potential upside risk stemming from solid upgrader demand, which may introduce volatility into the market. According to our base case scenario, we anticipate a Compound Annual Growth Rate (CAGR) of -0.7% in primary home sales (by area) by the end of this decade.
Demand from Upgraders and Household Formation
We view demand from property upgraders as a positive factor. This view is supported by an expected increase in the size of the 35-45 age group and the above-average GDP growth rate projected for China until 2031. Nevertheless, the release of upgrader demand is likely to be uneven, depending on the country's short-term economic performance. Developers with geographic and product diversification will benefit from this trend, as they will be able to swiftly adapt to the latest market trends. On the other hand, net household formation, which represents the net change in the number of households, is expected to have a neutral impact on demand, despite the shrinking population. Our analysis indicates that household formation is primarily driven by the 20-25 age group, which will remain stable in the near and medium term until 2040. However, as China approaches the average urbanization rate of developed markets, currently at 75%, housing demand could face further downside pressure.
Insights from Proprietary Research
Our own proprietary research on the ground further supports our thesis. We found that the sharp decline in housing sales in the past year largely reflected a decrease in investor demand. Previously, investors accounted for over 20% of total property demand in China, but this dropped to nearly zero in the second half of 2022. To prevent negative investor sentiment from impacting real owner-occupier demand, the Chinese government implemented price floors during the worst period in 2022. This policy successfully averted a prolonged property slump, similar to what Japan experienced in the past. Looking ahead, we expect some investor demand to re-emerge, but at a more modest level of 8-10%. This will result in a healthier vacancy market. We anticipate that Chinese investors will continue to view real estate as a key asset class in their portfolios, but with time, they will reduce the proportion of wealth invested in this sector, currently exceeding 50%. Furthermore, the recent increase in property listings in the secondary market is unlikely to exert fresh price pressure. This surge in listings can be attributed to the unavailability of secondary apartment viewings during the Covid pandemic, leading to the release of pent-up demand for secondary houses. Primary market apartments continue to meet over 70% of total housing demand in 1Q23.
Investment Implications
Firstly, we do not anticipate a repeat of the developer default event witnessed in 2022. With some investor support emerging in the market, we believe it is possible to identify surviving developers among the remaining names. Secondly, volatility will remain a characteristic of the sector, emphasizing the importance of bottom-up bond selection. Given that developers heavily rely on upgrader demand to support their credit profile, investment performance is expected to vary. Our fundamental analysis will prioritize factors such as liquidity, diversity of product offerings, and geographic concentration to ensure that the developers in which we invest can withstand temporary periods of sales weakness. In summary, the China real estate sector should continue to be considered a high-risk, high-reward segment in the bond market.
Image source: UN population estimates, JPMAM estimates, JPM Equity Research, China National Bureau of Statistics; As of April 30, 2023.
