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Rein: Accounting Frauds Push Chinese to Buy Property

I was interviewing Mr. Zhou, one of China's largest real estate developers, when he started to share his investing strategies with me. "I never buy Chinese stocks. Who can trust the accounting? It is far safer to buy real estate. There are too many Chinese without adequate housing so demand will always outstrip supply.”

Apartment buildings in Liaoning Province, China.
Jerry Driendl | The Image Bank | Getty Images
Apartment buildings in Liaoning Province, China.

As we sat in his enormous living room, Mr. Zhou continued to tell me why he preferred to buy homes rather than put money into the stock market, “There are no annual property taxes, so I just buy homes and leave them empty to resell at some point. At the end of the day, if things go wrong, you still have tangible assets if you buy property."

Many Chinese investors hold similar views: they deem real estate as the safest investment in a country ravaged by accounting fraud. After all, even famed investors like billionaire John Paulson lost $340 million according to Fortune Magazine investing in companies hit by accounting scandals like Sino-Forest .

Mr. Zhou’s investment strategies indicate the Chinese real estate sector is being driven as much by a belief in the sector as a fear of other sectors.

Mr. Zhou explained why he shies from stocks, "Chinese stocks are political plays as much as business ones. State-owned oil giants Petrochina or Sinopec might do poorly because the government forces them to cap prices. Or Baidu , Netease or Sina might get hit by Internet regulation campaigns. You need to analyze political winds as well as business ones. It is simpler to buy homes."

Many wealthy buyers simply buy multiple homes and leave them empty because they do not know where else to park their money. Leaving homes empty does not mean there is a bubble, as hedge fund short seller Jim Chanos argues, if buyers can afford to hold the homes, as they generally can, however, it does indicate resource misallocation. Millions of Chinese live in sub-human homes yet millions of units remain empty.

To remedy the situation the government should force real estate developers to sell completely renovated apartments. The vast majority of homes currently are sold as empty concrete hulls. Homebuyers need to buy pipes, paint, faucets, tiles, flooring and install it themselves.

Renovating your own home is a tiresome process, so many homebuyers buy units and leave them untouched, hoping to sell later.

The cost and hassle of renovating outweighs rental income so buyers leave units empty. Forcing developers to sell fully renovated units would also allow homebuyers to rent their homes right away, creating a larger supply of homes available, and lessening the need to buy a home or else having to rent a ramshackle apartment.

Aside from forcing developers to sell finished apartments, the government needs to introduce annual property taxes for larger homes. Not only will this create better revenue streams for local governments who are addicted to land sales, and thus let them think sustainability when green-lighting projects, it will also help spur more development into affordable housing.

Taxes would force new buyers of luxury apartments to be more discerning in their purchases while giving lower income and smaller homebuyers the ability to buy homes without paying annual taxes. Real estate developers would also start focusing more on small and mid-sized homes, which is where the future market is.

There is no dangerous bubble in China’s real estate sector because little leverage exists but that does not mean the sector is healthy. Prices are too high for the average Chinese so more affordable housing needs to be built. High prices do not cause dangers of a systemic financial crisis when people buying homes can afford them and are not buying on debt. Chinese homebuyers for the most part can afford them.

But the sector is in dire need of reform to ensure adequate housing supplies and social stability. Tax strategies should be implemented to encourage the construction of affordable housing and to minimize soaring prices.

The government also needs to implement strong oversight to stop fraud so that investors can have investment options other than just real estate.

Shaun Rein is the founder and managing director of the China Market Research Group (www.cmrconsulting.com.cn) a strategic market intelligence firm, and is based in Shanghai.

He is the author of the upcoming book “The End of Cheap China: Economic and Cultural Trends that will Disrupt the World” published by John Wiley & Sons in the U.S. He does not own shares in any company mentioned. Follow him on Twitter at @shaunrein.