There are two types of real estate investors in China. The first are pure speculators who treat residential real estate as a source of value, far removed from its original residential use. These investors purchase multiple properties without bothering even to remodel their units for actual use. They are responsible for the empty condo buildings that have become so common in China’s cities.

The second are the normal citizens who purchase real estate as their primary residence. The high prices of the real estate bubble created by the speculators have created much pain for these normal home-buyers. Recent policies of the central government designed to contain the real estate bubble have been designed to benefit this segment of “normal” home buyers. However, it is probable that the recent collapse in real estate values has damaged these normal home buyers as much as, or even more than, the speculators.

A recent story in the local Qingdao newspaper illustrates the situation. The article is about Mr. Li (age 31) and Ms. Zhao (age 28), both of whom are successful young professionals. Both are college graduates. Both work in good jobs in the visual design sector. Mr. Li earns RMB 6,000 per month and Ms. Zhao earns RMB 2,000 per month. These are good salaries for young professionals in Qingdao.

For three years, this couple has been planning to marry. The obstacle has been their inability to purchase a home. Their families do not have the resources and they do not have the savings. Mr. Li proposed they forget about owning a home and just live in a rented apartment after marriage. As is typical in this region, Ms. Zhao refused: no home ownership, no marriage. With great reluctance, Mr. Li agreed to work on purchasing a condo.

In April of this year, they found a suitable unit in Li Cang, a village to the north of Qingdao City. Services there are bad and transportation is inconvenient. However, they determined that a 90 square meter unit on the 15th floor of a sprawling condo project was just about the only thing they could afford in the Qingdao area.

They completed the purchase in April on the following terms:

The price of the unit was RMB 9,300 per square meter. Compared to the 20,000 to 40,000 RMB per square meter price in Qingdao City, this seemed reasonable to them.

The total price was RMB 830,000. Of this, RMB 350,000 was required as a down payment.

The couple was able to come up with the down payment by using their savings, by Mr. Li moonlighting, and with a contribution from their parents. The down payment was accumulated from the struggles of the couple and both their families over the past 10 years. For payment of the remaining RMB 480,000 of the purchase price, the couple obtained a 20 year bank loan. Payments on this loan will be RMB 4,700 per month for the life of the loan, over half of their combined total income, before taxes.

Consider the following:

Their down payment was actually a deposit on an uncompleted unit. The project is far from completion. At best, the project will be complete at the end of 2012. Thus the down payment money is tied up and yet the couple still have to pay rent until the project is complete. If the project is not completed there is a substantial risk their down payment will never be returned. This risk is never discussed in China, but the risk is substantial in a declining market as we know from our experience in other real estate markets around the world.

This young couple has now joined the ranks of the Chinese “house slaves” 房奴”, or what we call “mortgage slaves” in the U.S. The total household income of this couple is RMB 8,000 per month, before taxes and their mortgage payment constitutes more than half their monthly income. They are in their early thirties. How will they save for their child’s education? How will they save for retirement? How will they save for medical emergencies? How will they save for the care of their four parents? How will they live a normal life with about RMB 3,000 per month in disposable income? No one knows other than to say they will suffer.

The total price of this 90 square meter unit is RMB 830,000. This is ten times the annual income of this young professional couple. Most economists believe housing costs should not exceed 3 to 5 times annual income. The unit is therefore about twice as expensive as recommended. All this for a condo in a not particularly nice exurb of a second tier Chinese city.

In October, the couple became uneasy when they heard rumors that units in their project were being offered at a 90% discount. At the end of November, the couple was shocked to see advertisements in the local newspaper offering units in their same project at RMB 6,300 per square meter, a 30% discount off the price they had already contractually agreed to pay. A group of buyers formed to demand their purchase price be reduced to the new price or they would cancel their purchase contracts. Some members of the group picketed the sales office. The developer refused their requests. Mr. Li states that he has reviewed the purchase contract carefully and concluded that none of the buyers have the right to a refund or cancellation. He is therefore resigned to his fate and sees no reason to participate in the protests.

Ms. Zhao calculates that over the life of the loan, the couple will pay RMB 400,000 in mortgage interest in excess of the amount they would be paying if their unit were re-valued at the new, lower price. This makes her sad. It makes her husband resentful that she insisted on purchasing the condo unit when he had proposed they rent. Their excitement at becoming new homeowners is now drowned by the sorrow of the economic disaster they face. The prospect of 20 years of “home slavery” is not a good way to start a marriage. The couple has not even considered the two additional disasters that may be waiting for them:

The price drops have only just started. The couple hopes prices will recover over time. The more likely scenario is for prices to continue to fall next year after buyers truly recognize that the bubble has burst.

Once it is clear the bubble has burst, the developer of their uncompleted unit will not be able to sell units at any price. This means the project will fail and the units will not be completed. What will happen to the substantial deposit this couple has already paid? No one knows. Chinese law provides that it must be returned. However, there are no good controls in place to guarantee that will actually occur.

Our couple and their fellow buyers are already upset with the fall in price. What will happen if the project fails and their deposits are not returned? What will happen to their bank when their mortgage loans turn out to be worthless? What will happen to the development lender when the project fails and the development loan is not repaid?

The story above is being repeated in every city in the coastal provinces in China. The impact is personal and direct. Every person in China knows at least one person impacted. The effect on the economy is incalculable. Just when the government is promoting a new program to increase domestic consumption, the collapse of the residential real estate market is pushing Chinese consumers in the opposite direction. The uncertainty will cause them to reduce their spending and move into an even more intense savings mode. The result will be to freeze up the economy for a considerable period.

I must emphasize again that what I have described has already happened; it is not a projection. A government cannot prevent what has already happened. It is too late for that. All we can do is wait and see what will be done about the situation. Current indications are that nothing at will be done. Given the way governments work, this just may be the best possible result.

What will you do to adjust to this new reality?

UPDATE: China Bystander has a really good post on China’s real estate market and its likely impacts, entitled, China’s Property Bubble: Bursting or Deflating?