China’s luxury real estate is among the priciest in the world, and all signs indicate the market will continue rising—and leading the way is a city that might surprise some real estate watchers.

In August, Chinese homes were ranked as the world’s most expensive in global property consultant Knight Frank’s Q2 Prime Global Cities Index. For the third consecutive quarter, three Chinese cities placed in the top five of the 41 cities tracked around the world.

But the city with the fastest-growing property prices wasn’t Beijing or Shanghai, but Guangzhou, China’s third-largest city and a port town on the Pearl River located 75 miles north of Hong Kong.

According to the report, year-over-year prices of prime residential property—defined as the top 5% of the market—surged in Guangzhou by 35.6%, Beijing by 15%, and in Shanghai by 19.7%, though the government’s cooling measures have led to a decline in annual growth rates compared to the previous quarter. Shanghai and Guangzhou dipped by under 1%, but Beijing’s rates fell by 4.8%. Still, average prices per square foot surpassed $5,907 in Beijing, $4,461 in Shanghai and a relatively more affordable $2,383 in Guangzhou.

Guangzhou’s real-estate market also made international headlines in June, when one of China’s biggest developers, China Vanke Co., closed a $55.1 billion yuan (USD $8.1 billion) deal on a land auction that included prime parcels in the city center, allowing the development of 22.6 million square feet of commercial and residential development. At approximately $360 per square foot, it’s considered the highest price ever paid for buildable land in China.

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"I’m not surprised that it was a record deal. Guangzhou is a first-tier city, and the availability of land in central areas is limited," said David Ji, director of Knight Frank’s Research & Consultancy in Greater China.

One possible reason Guangzhou’s housing prices are lower in comparison to Beijing and Shanghai is that the city has been overshadowed by neighboring cities like Shenzhen, a mere half an hour away by train but more popular due to its proximity to Hong Kong, the Shenzhen Stock Exchange, and its reputation among high-tech companies.

A ‘non-volatile’ market

These days, attention has naturally turned to Guangzhou because there are still good bargains to be found there.

Robert Ritacca, senior manager and head of research for Savills Southern China, said the Vanke deal demonstrated the developer’s "bullish outlook" on Guangzhou’s residential market and the potential of surrounding core cities of the Guangdong Greater Bay Area.

"Guangzhou is a non-volatile, relatively stable market…and supports a stable average quarter-on-quarter growth rate of 2.2% over the last three years," he said. "It offers lower residential prices compared to its tier-one peers and even some tier-two cities like Hangzhou and Xiamen."

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What housing bubble?

Seven Chinese cities ranked in the Top 10 for price appreciation, according to Knight Frank’s most recent Global Residential Cities Index, which tracks the average prices of residential properties in 150 cities around the world. Moreover, growth in second-tier cities like Wuxi and Nanjing outpaced that of Beijing and Shanghai between 8.3% and 12% during the first quarter of 2017. As prices climb to ever higher heights, the world has openly wondered if China is in the middle of a housing bubble.

The answer is no, asserted Dee Hu, research director and assistant to the chairman at Beijing Sotheby’s International Realty. "In no way has China reached a peak. China is a young country, wealth is growing, and there are policies promoting new economic development," she said, adding that there is always high demand for real estate in central areas of metropolitan cities, and competition is even fiercer in China because it is a large country with a proportionately large population of wealthy individuals.

"There’s been talk of a bubble for years, but it’s never materialized because people have wealth they want to invest, and the only channels for investment are either houses or the stock market," Mr. Ji said, noting that China’s GDP has grown at an annual rate of 6.5%, and household income a notch higher, at 6.9%. "The price hikes are still driven by demand, not speculation, because Chinese see owning a house as a more stable and concrete investment. It’s why you see them investing in property abroad—and domestically, they want to own in first-tier cities," he said.

Compounding that, Mr. Ji added, is the fact that China’s residential real-estate market is just a few decades old, and early price volatility is unavoidable. (Before the 1980s, housing was distributed by the government, and workers were assigned units based on the years of service.)

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"We don’t believe there’s an imminent crash in the tier-one cities," agreed Mr. Ritacca. "Crashes occur when there is exuberant optimism and uncontrolled speculation in a market. We believe the government is doing a fine job at controlling both factors."

In the last few quarters, the government has cracked down on real-estate speculation, enforcing cooling measures like raising down-payment requirements on additional home purchases, establishing property-purchasing limits and loan restrictions, and levying heavy taxes and mortgage burdens. Some mayors are under strict KPIs to limit real-estate transactions that might spur speculation.

In addition, continuously expanding infrastructure will ease the pressure and allow people to live in less expensive satellite cities.

According to Mr. Ritacca, Guangzhou’s subway network continues to expand, allowing for easier commutes to other economic centers, such as the neighboring city of Foshan, which is known for being the largest production center of electrical appliances in the world.

"Given these market conditions, we believe Guangzhou residential real estate still has room to appreciate, but we also see the price levels increasing modestly and stably, as government curbs have some modest effects," he said.

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What luxury buyers want

On the higher end of the market, nonstop growth in the country is due to the priorities of Chinese buyers, who see luxury real estate as a legacy investment driven more by property value and function rather than amenities or design.

In May, Sotheby’s International Realty Affiliates, a network of independent brokerages for the luxury real estate market, released a report surveying consumer sentiment among Chinese people with $250,000 to $1 million in investable assets. The vast majority was "confident" in the housing market. Over half (53%) were ready to buy a home in the next year, and 92% in the next three years.

Sotheby’s Luxury Lifestyle Report, a study of high net-worth real estate consumers, revealed that 93% considered houses a legacy investment to leave to future generations. The most desired feature was location, with 82% willing to pay more for a prime one. Guangzhou, while eclipsed in some ways by other cities, is an easy commute to Shenzhen, and more industries are looking at it as a gateway to Central China.

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More growth expected

The purchase-transaction volume in just Guangzhou, Shanghai and Beijing is staggering. This activity accounted for nearly one-third (31.4%) of the total revenue of China’s real-estate industry, according to research firm IBISWorld’s March 2017 Industry Report on residential real estate in China. Moreover, luxury housing across China—including high-end apartments and villas of more than 1,550 square feet—represented the second-largest product segment, equalling 11.7% of the total value of real-estate industry transactions. (The largest segment is "regular housing," which refers to standard units smaller than 1507 square feet.)

The report also indicated the real estate industry’s profits have been increasing gradually over the past decade, from 2.3% of revenue in 2000 to 11.0% in 2015, and has grown at an annualized rate of 9.1% to reach $949.1 billion. In fact, IBISWorld analysts are forecasting industry revenue to increase 6.9% per year to reach a whopping $1.3 trillion by 2020.

As far as Guangzhou is concerned, Mr. Ritacca noted both supply and demand in the market would continue pushing prices up despite the government’s recent cooling measures

"The population and culture of Guangzhou will continue to drive sustainable demand for residential real estate purchases," he said, noting that the developments in the downtown Guangzhou area will continue to attract high-net-worth individuals in both the first-hand and second-hand residential markets. Simultaneously, new developments in suburban areas will positively influence prices as more people move to the outer areas of the city.