Abstract: This article discusses the difficulties facing the current real estate industry in China and suggests the need to boost consumer confidence. Furthermore, the article points out that improving the relevant policy regime needs to be accompanied by an increased risk tolerance, which requires all parties’ participation. Finally, the article puts forward a series of policy recommendations to stabilize and boost the real estate sector, including ensuring the availability of construction funds for developers, distinguishing between mortgages for term housing and mortgages for existing housing, innovating the pre-mortgage model for term housing, innovating the model of debt-transferable mortgages, and innovating the mechanism of floating interest rates for mortgages.
Over the past two decades, the real estate industry has played a pivotal role in China's rapid economic development. Although it has progressed from a state of scarcity to a fundamental equilibrium, and the era of high growth and high value-added development seen in the past two decades is ending, the real estate sector will continue to be a critical factor in economic development for a significant period.
However, the future pillar role of the real estate industry is only valid for the economy as a whole and will differ across regions and developmental stages. The ongoing process of urbanization and modern agriculture means that some third- and fourth-tier cities may face saturation or even an oversupply of real estate, whereas large cities experiencing a constant influx of population will maintain a strong demand for real estate. Simultaneously, some older buildings constructed between the 1970s and 1990s no longer align with modern lifestyles and environmental standards, necessitating demolition and reconstruction, which offers substantial growth potential for the real estate industry. Consequently, there is every reason to remain confident in the real estate market's future development.
Yet, amidst the current challenges in the real estate industry's recovery, it is crucial to restore confidence in the market, which requires temporarily accepting some risks while simultaneously enhancing relevant systems. Maintaining liquidity, particularly for real estate developers, is the linchpin to achieving this. Stabilized liquidity can reignite market demand, leading to the recovery of market confidence.
Stabilizing the liquidity of the current real estate market requires a multifaceted approach. Firstly, it is crucial to clarify that stabilizing liquidity does not entail rescuing individual real estate companies engaged in irrational operations or expansions or offering financial aid without imposing any accompanying responsibilities. It must be implemented with due consideration to prevent moral hazards. Secondly, although unconventional measures may be necessary, they should still conform to legal frameworks and respect market principles. Thirdly, while multiple funding channels are essential to stabilize liquidity, measures must be in place to mitigate the spread of risk.
Regardless of the solutions to the liquidity dilemma real estate companies face, assistance to real estate enterprises should be based on a clear and actionable legal agreement, with real estate companies bearing the primary responsibility in both legal and economic contexts.
The process of multi-channel financing should commence with the prompt payment of outstanding dues by local governments at all levels, which is not an additional burden but rather a legal and economic obligation. Establishing an honest business environment hinges on the integrity of local governments.
During the process of assisting real estate enterprises in stabilizing liquidity, a thorough evaluation of the pros, cons, and risks associated with various funding sources is imperative. Strategically speaking, it is essential to completely insulate home buyers from the risks posed by unfinished properties.
Whether they acquire properties with loans or not, home buyers make full payments for their homes. In the event of unfinished buildings, the repercussions extend beyond developers, builders, suppliers, and banks that provide development loans. Moreover, the rights and interests of both home buyers and banks that grant mortgage loans will also be adversely affected. Consequently, these risks could broaden, transforming what was originally a purely economic concern into a social issue.
At the same time, when buyers have paid in full, it means that the construction project will no longer receive any cash inflow. Any capable enterprises taking over the project would be making a capital investment with no possibility of recovering their funds. This situation creates a significant obstacle to the marketing of stalled projects. Therefore, in order to foster a healthier development in the real estate market, protecting home buyers from the risks of unfinished buildings becomes a pivotal factor.
To this end, improving the current pre-sale housing system and innovating the mortgage lending model are indispensable.
I. POLICY RECOMMENDATIONS
1. In addition to the existing requirements for developers to pre-sell houses, they must also ensure construction funds are in place.
The so-called "construction funds in place" refers to the proper arrangement of subsequent construction funds of pre-sale houses, encompassing self-financing and bank loans, without leaving any gaps. It's imperative that bank loans are not merely pre-approved but based on real credit, contingent upon project progress and contract terms.
Currently, banks often review large bank loans separately for credit and credit approval, and their processes are identical. They may also introduce new conditions. Unpredictable timelines and abrupt changes in requirements for credit approval render borrowers unable to plan assets and liabilities in advance, risking disruption in operation and a breakdown in the capital chain.
To address this, banks should design specific loan products and review processes tailored to different loan purposes. In fact, established practices in the construction industry involve executing loan contracts according to spending plans and reviewing them against contract terms during the draw period. This process eliminates the need for additional approvals, let alone new credit approval requirements.
A case in point is a bank's collaboration with a Japanese-funded enterprise producing canned bamboo shoots in the late 1980s and early 1990s. Each year, they negotiated a loan plan specifying not only the loan amount, term, and interest rate but also precise draw and repayment dates for each sum. It turns out that each year the company aligned with the parent company in the production plan as well as the time and the batch of products exported to Japan. After that, it negotiated purchase prices and amounts with local farmers. Subsequently, it finalized the loan program with the bank. The company would kick off production once the things mentioned above were confirmed.
Real estate projects can be operated in a similar way in which even if the debt ratio is high, there is typically minimal risk of unfinished building since there is strict supervision that prevents misappropriation of funds by developers.
2. Distinguish between mortgages for existing homes and pre-sale homes, and establish different loan policies and modes.
A housing mortgage loan serves as a means for home buyers to mortgage purchased properties. Its primary function is to finance home acquisitions. Applying for a mortgage loan for an existing home involves clear collateral. In contrast, the current mortgage loan for pre-sale homes lacks collateralizable assets at the loan's initiation, effectively offering uncompensated financing to developers. Although developers provide guarantees for loan approval before the ownership certificate is issued, these guarantees become null if the property stalls.
In this scenario, home buyers remain loan debtors, assuming primary responsibility for repayment. Despite having paid in full, they cannot obtain their purchased goods. Moreover, the bank, having issued the mortgage loan, is unable to access the collateral it rightfully deserves. The current mortgage loan model can neither prevent nor address the risk of unfinished buildings and requires innovation.
3. Introduce an innovative pre-mortgage model for term housing to mitigate the risk of uncompleted buildings and safeguard home buyers' rights and interests.
Several options exist for the pre-sale housing system. One option mirrors our current system: full payment pre-sale. Under this arrangement, developers receive sales payments in advance. However, without robust safeguards, purchasers bear a substantial risk of stalled projects. In essence, they lose the ability to default and must assume the risk of the seller's default.
Another option involves making an upfront deposit and paying the full amount upon delivery. This system offers transaction certainty to both buyers and sellers while allowing both parties the possibility of default. Importantly, there are mechanisms in place for compensation, maintaining equitable risk-sharing without overwhelming risks.
The author advocates abolishing the current pre-sale housing system in favor of the second one: pre-sale housing with an innovative pre-mortgage loan model. Recovered money from pre-sale housing should not serve as a source of liquidity for developers.
Under the pre-mortgage loan model, when home buyers and developers sign the purchase contract and the bank enters a mortgage loan contract, the down payment is deposited into a bank account. This account is designated for disbursing loans, along with the home buyer's down payment, to the real estate developer when they hand over the property. Simultaneously, the necessary property mortgage formalities are completed. This approach shields both home buyers and banks from losses stemming from stalled pre-sale housing.
4. Consider an innovative debt-transferable mortgage loan model
If the first model remains, it is necessary to introduce a debt-transferable mortgage loan model in order to protect the rights and interests of home buyers when projects stall.
Under this model, home buyers apply to a bank for a mortgage loan, including a down payment and the full purchase price. The loan contract involves the buyer, the bank, and the developer. Additional contract terms state that when construction projects stall to the point of the developer being unable to hand over the property, the buyer's debt is unconditionally transferred to the developer. Essentially, the developer becomes a direct debtor through the guarantee guarantor, and the remaining debt principal and interest mature instantly, eliminating the decades-long installment repayment obligation for the buyer. This instantly absolves the home buyer of debtor liability.
This arrangement is entirely reasonable and legitimate, given that the developer is wholly responsible for the unfinished building. In contrast, the current mortgage loan setup requires the developer to guarantee security. While the bank can recover the full amount from the developer, the home buyer remains the primary debtor, lacking protection in case of building suspension. This inequitable situation requires reform.
The debt-transferable mortgage loan model, when construction projects stall, exempts buyers from debt principal and interest repayment obligations, with the exception of the down payment and debt principal and interest they've already paid. As a bank, when financing buyers’ home purchases, their creditor-debtor relationship does not entail responsibility beyond that, and the legal right to recover loan principal and interest upon maturity remains intact.
Consequently, addressing the losses incurred by home buyers during the home purchase process should involve both buyers and sellers. Defining risk responsibility for buyers and sellers in cases of stalled construction projects requires a distinct institutional arrangement. Absent a feasible institutional arrangement, the author still advocates abolishing the current pre-sale housing system.
5. Innovating floating interest rate mechanism for mortgage loans
There are no fixed or bad rules on whether mortgage loans should use fixed or floating interest rates.
If a fixed interest rate is adopted, a rise in market rates is favorable to the borrower; a fall in market rates will be favorable to the lender. Different durations of loans also present different risks for both borrowers and lenders.
If a floating interest rate is adopted, both borrowers and lenders bear the risks of market rate fluctuations. But because there are different floating rate mechanisms, the fluctuations of market interest rates will have subtlely different impacts on the borrowers and lenders.
Given the long term of mortgage loans, neither borrowers nor lenders are capable of predicting the interest rate fluctuations in the long term, and most countries and regions use floating exchange rates. A significant portion of US housing mortgage loans adopt fixed interest rates. The reason is that the US lending institutions tend to securitize mortgage loans to let the market instead of themselves absorb the risks of interest rate fluctuations, whereas the borrowers are fully exposed to the risks of interest rate fluctuations in the market.
Floating interest rates generally involve selecting a benchmark rate and determining how many basis points to add to or subtract from this benchmark rate. Within the loan term, the increase or decrease of basis points is fixed while the benchmark rate is floating. The number of basis points to be added or subtracted is determined by each bank in accordance with its own cost of liabilities and competitive needs and may vary from period to period. Therefore, the determination of the plus/minus basis points is the result of market competition. Hence, floating interest rates are more reasonable both for borrowers and lenders.
China's current floating interest rate mechanism for mortgage loans is slightly different from the general mechanism. China's floating interest rate for mortgages is determined on the basis of LPR plus basis points. But in previous years, the banks’ decisions on adjusting the basis points were not entirely the result of market competition but were also affected by the macro-control regulatory requirements. At present, in order to stabilize the economy and accelerate economic recovery, the central bank has appropriately reduced policy interest rates. More importantly, the regulators have guided banks to reduce the interest rates on loans to the real economy and small and micro enterprises, as well as guided the reduction of the absolute interest rates on new housing mortgage loans. In other words, the rates on existing and new mortgages both imply a certain regulatory guidance.
This situation in the Chinese mainland is different from that in the Hong Kong market: as the US dollar strengthened due to the Fed’s rate hike, the Hong Kong dollar followed suit. The lending preferential rates announced by the Hong Kong Association of Banks also picked up. However, there was no change in the basis points added by the banks on top of the preferential rates, so the borrowers' borrowing costs went up.
Currently, as the interest rates on existing mortgage loans are higher than those on new loans, some voices from the market are calling for a rate cut on the existing mortgage loans. However, this is not a simple question of whether it is fair or not, and it cannot be resolved simply by a rate cut on the existing mortgage loans.
Mortgage loans can be described as a type of ultra-long-term loan that will witness multiple fluctuations in market interest rates throughout the term of the loan, which is a source of great uncertainty for both the borrower and the lender. Therefore, a reasonable interest rate is extremely important. Generally speaking, after the loan contract is signed, no further adjustments will be made to the interest rate. If banks are now asked to uniformly reduce the interest rates during the loan term, they will encounter the question of by what standard the reduction should be made.
If the adjustment of the standard is non-market-based and fixed in the form of a new contract, there will be greater distortion, not only contrary to the direction of the reform of interest rate marketization but also laying dangers for the future. Therefore, it is necessary to innovate the floating interest rate mechanism not only to solve the current problem and stabilize the real estate market but also to address the distortion of market interest rates in the long run and to ensure the healthy development of the real estate market.
The new mechanism could have different options: first, when banks negotiate new loan agreements with the borrowers, it could be made clear that the reduction of the original loan interest rate is a time-limited adjustment, which could be set at 1-3 years and after that, the original interest rate standard would be resumed. Second, the standard of the floating interest rate mechanism could be negotiated by period, such as three years as a period, to re-determine the basis points added to the LPR. Both the existing mortgages and new mortgages could be contracted under this program.
In reality, due to the large customer base, it is difficult for banks to negotiate on a personalized basis. They can only determine a unified standard for signing contracts with all customers, which inevitably puts them in a stronger position. The remortgage business could be considered so that customers can easily transfer their remaining mortgage loans to banks offering more favorable terms, giving customers more negotiating power through competition among banks.
In short, the banks’ business model needs to be innovated to solve the problems in the real estate market phase-by-phase, stabilize the liquidity of the real estate market, unlock effective demand, and promote the healthy development of the real estate sector.
The article is translated by CF40 and has not been subject to the review of the author himself. The views expressed herewith are the author’s own and do not represent those of CF40 or other organizations.
