Pre-Sold Homes Supply a Third of China's Property Development Funding — and the Practice Isn't Even That Old

The cancellation, it seems, was a misunderstanding.

Jiangmen, a city few people pay attention to, became the focus of real estate news after a policy about-face.

On July 16, the Jiangmen municipal housing authority released a draft policy on the sale of completed commercial housing, open for public comment. It was read as a ban on selling unfinished homes — the end of the pre-sold housing that Chinese buyers have long taken for granted.

Real estate developers may not sell commercial housing projects that have not obtained a pre-sale permit, unless and until they have received a Notice of Acceptance of Filing for Completed-Home Sales.

Cities announce new housing sales rules almost daily, but banning pre-sales would be a big deal. Most new residential projects today go on sale before construction finishes.

Months, sometimes years, before a building passes inspection, buyers have paid their down payment and started making mortgage payments. That money is a major source of funding for developers.

As of the first half of this year, of the 7.9 trillion yuan Chinese developers had put into development, nearly a third came from buyers' deposits and advance payments. For an entire industry, losing a third of its money would change everything.

Set aside the worries about the property business: buying a pre-sold home is not normal consumer behavior.

Back when Xiaomi sold phones, it took no deposits, and shipping two months after launch was enough to get the phones called "futures." But with property, people willingly hand over a down payment of several hundred thousand yuan — sometimes more than a million — on the strength of a developer's rendering and a promise, then pay a year or two of mortgage before they ever get the home.

Whether pre-selling makes sense has been argued many times. Nanning, in Guangxi, briefly scrapped pre-sales in 2010 and piloted completed-home sales. Last year Sanya, in Hainan, issued rules banning the resale of pre-sold homes.

But Jiangmen is not the beginning of the end for pre-sold housing.

A day after the draft came out, the Jiangmen housing and urban-rural development bureau issued a statement calling the reports — that pre-sales were being scrapped in favor of completed-home sales — a misreading. The document published on the 17th, it said, was a revision of the completed-home sales rules issued in 2013: "it is a management measure for newly built commercial housing sold on a completed-home basis, and does not cancel or suspend the pre-sale management system currently in effect in our city."

Misreading or not, pre-selling now looks set to continue as a sales model, and to stay part of everyday common sense.

But that common sense, so unlike the way anything else is sold, has not been around long.

Pre-sold housing started in Hong Kong. Henry Fok Ying-tung invented it in 1953.

Leng Xia, former director of the Macau Policy Research Institute, writes in The Complete Biography of Henry Fok (《霍英东全传》) that Fok had already set up a property company. With his lawyers and staff he worked out how to sell a building about to break ground on Sifang Street in Yau Ma Tei, Hong Kong: collect part of the deposit from buyers upfront and take the balance in installments — in effect, build with the buyers' money.

"Like paying rent — by the time the new building was finished, all of the buyer's payments would be in, and the buyer would own the property, an owner in his own right," Fok recalled later. He consulted lawyers, then put the plan into practice, calling the method "selling building flowers."

Explanations of the term "building flowers" vary. The common one: a home at the pre-sale stage is a fruit tree still in blossom, and completion and handover is the fruit ripening — so selling homes this way became "selling building flowers."

His first pre-sale plan asked buyers for 50% of the price upfront, another 10% with each floor completed, through a sixth installment that cleared the balance. Once pre-selling caught on, Fok cut the down payment to 10%-30%.

Building flowers appeared because neither Hong Kong's developers nor its homebuyers had money.

World War II was followed by civil war on the mainland. More than a million people flowed into Hong Kong, bringing US$500 million in goods, securities, gold and foreign currency. But Hong Kong industry was backward — its signature products were towels and thermos flasks — and the finance industry the city later became famous for did not yet exist. Property development and mortgage lending were out of the question.

That left Hong Kong's early developers carrying enormous risk. They sank huge sums into land and construction and could sell only after completion. And because buyers had to pay in a single lump sum, ordinary people faced crushing pressure, so buying a home stayed the preserve of a few rich ones.

Fok later recalled that once he announced the "selling building flowers" method, all of Hong Kong seemed to go mad. "Ordinary people were all swept into the property whirlwind. Every day crowds poured in from all over Hong Kong and Kowloon to the sales offices of the buildings we were developing. The lines stretched on and on — sales on a scale never seen before. Some people queued up, bought a unit, resold it to someone else on the spot, and made money in a single day."

Fok made more. In little more than a year after introducing pre-sales, he put up over 100 buildings on Sifang Street alone — more than 600 floors in all, roughly 500,000 square meters. In the currency of the day, he cleared at least HK$6 million. Hong Kong's per-capita annual income at the time was about HK$1,452-1,578.

This was the start of Hong Kong's property industry. Enamelware factories, cement plants and other businesses moved out to cheaper land in the near and outer suburbs, then built on their old sites downtown.

Pre-selling solved developers' financing problem in the early stages of buying land and putting up buildings, and it made property one of the pillars of Hong Kong's economy — for years, more than 20% of GDP.

After the property slump caused by a banking credit crisis from the 1960s into the early 1970s, Chinese businessmen including Li Ka-shing used mortgage loans to buy land, then used pre-sales to get their money back fast and take the profits. In 1981, Li's Cheung Kong took in about HK$1.385 billion, 31 times what it raised when it listed in 1972.

Hong Kong today has one of the soundest, most developed financial markets in Asia, if not the world. Developers have every kind of financing available, but the system of selling building flowers — taking money straight from buyers — is still there.

Building flowers entered mainland China along with Hong Kong capital.

China's property market got started in 1987. That December the Shenzhen government auctioned its first parcel of land, and Hainan's property boom followed. But development loans did not appear in China until 1992, which left developers under the same funding pressure their Hong Kong counterparts had faced in the 1950s.

On July 18, 1994, the National People's Congress reviewed and passed the Urban Real Estate Administration Law of the People's Republic of China, which legally allowed developers to pre-sell homes they had not yet built. That same year the Ministry of Construction issued the Measures for the Administration of Pre-sale of Urban Commercial Housing, spelling out the rules.

National Bureau of Statistics figures show developers nationwide received 38.1 billion yuan in development funding in 1997. Self-raised funds were only 25% of that; mortgage loans and pre-sale proceeds came to nearly 40%.

After several rounds of legal revision, the main conditions for pre-selling commercial housing in China today are:

• The full land-use rights transfer fee (the cost of the land) has been paid;
• The developer holds a construction project planning permit;
• Construction funds account for more than 25% of the project's total investment;
• The developer has registered for pre-sale with the housing management department and obtained a pre-sale permit for commercial housing.

As developers grew and ran several projects at once, the pre-sale money went to building the next phase of the same project, or to buying land for the next one.

For most people over the past decade and more, buying a new home has meant buying one that does not exist yet.

A 2005 report by the Residential Real Estate Chamber of Commerce under the All-China Federation of Industry and Commerce showed that pre-sold floor area accounted for 62% of commercial housing that year, and pre-sale proceeds for 64.5% of the total (1.16 trillion yuan).

Unlike today, when pre-sale prices run high, prices in the early years were usually a little lower than for completed homes — one reason buyers accepted the model.

Buyers took on the risks along with the discount. China's financial risk controls were weak then, and developers sometimes mortgaged the same land and unfinished buildings more than once, leaving buyers unable to get their property deeds in the end. Developers also failed to deliver what they had promised at the pre-sale stage — the layout of a residential compound, the amenities nearby — which set off consumer disputes.

In Shantou, Guangdong, disputes over pre-sale contracts made up 64.5% of the real estate cases the city accepted between January 2002 and November 2003. A 2005 article in Industrial and Commercial Administration reported that consumer associations across Sichuan took 7,632 complaints about commercial housing between 2003 and the third quarter of 2005, more than 90% of them about pre-sales.

Pre-selling has since spread from Hong Kong around the world — to the UK, Australia, the US.

But a market that uses pre-sale money as property development's main source of investment is still a Chinese peculiarity.

Chinese-language argument about building flowers and pre-sold homes never stops. In the US, in the early years, almost nobody mentioned pre-selling.

So little, in fact, that the Census Bureau — which had precise records of manufacturing workers' hourly wages back in the 1920s — did not start counting pre-sold home sales until 1963. Its reports show that of the 560,000 homes sold nationwide that year, 54% were pre-sold. As recently as last year the share was still 65.5%. In the decades in between it fell below 50% only once, during the 2008 financial crisis.

But unlike in China, buying a pre-sold home in the US does not mean handing the developer all the money upfront.

Yiding Investment is 5i5j's US property development arm. Zhang Heng, its general manager for the northern region, told QDaily that in the US the biggest capital outlay comes at the land-development stage, when pre-sales are not allowed.

Once a project reaches the building stage, developers usually hand construction to subcontractors, who put up the construction money. The rules then vary by state: in New York, developers may set prices, submit them to the state attorney general for approval, and start selling once approved.

Down payments on pre-sold US homes are typically 5%-20%, and buyers apply for a mortgage — up to 60% of the price — after signing the contract. Some states release the loan to the developer once it is approved; others hold it until handover.

And to keep developers from spending buyers' money on anything but construction, deposits and down payments sit in an escrow account run by the developer's law firm. The developer does not get the money until the home is formally handed over.

Construction money for US developers comes mainly from Wall Street, not from ordinary homebuyers.

First, banks lend to developers directly. By the count of Ren Zeping, former chief economist at Everbright Securities, US legislation in 1916 allowed banks to lend against real estate other than farmland. By 1925, new home construction permits in the US were up 208% from 1919; in 1926, newly started construction was valued at US$12.1 billion, 12% of that year's GDP in the currency's purchasing power at the time.

Bankers also invented financial derivatives — REITs, commercial property mortgages, subprime mortgages. While lending to developers and individuals, they drew in the pension funds and private equity funds scattered across the states to finance those instruments.

Like China, the US has had property manias. Between 1923 and 1925, some Miami homes rose fivefold in price, from $800,000 to $4 million. The bubble burst in 1926, and local transaction values shrank to a tenth of the previous year's.

A bigger bubble burst in 2007-2008. More than $10 trillion of US assets evaporated, millions of people were left without homes, the properties they had borrowed to buy became worthless, and the commercial banks holding the mortgages failed. Wall Street had taken the returns, and it carried the risk after inflating the bubble.

Once the storm passed, finance went on underwriting US property development. Xinhua Trust's figures show that in 2012 alone — the year that came close to setting off another global financial crisis — 55% of US national wealth sat in buildings. Outstanding property financing in the US that year exceeded $4 trillion, about 70% of it loans from financial institutions.

Chinese developers, meanwhile, have grown more dependent on pre-sale money. Ren Zhiqiang, former chairman of Huayuan Group, said this month that pre-sold homes account for about 90% of home sales in China each year. Developers raise more development funding through pre-sales than they raise on their own.

They lack other sources. China's securities regulator has always denied barring property companies from listing on the A-share market, yet no new property company has gone public since 2010. Listed developers that wanted to raise more through the stock market have been stopped as well.

Bank loans are the other big source of development funding, but Chinese financial institutions have no financing tools built for property. US REITs, for example, package land or buildings into stock-like investment products that trade on an exchange; the money raised develops the property, and investors are paid interest within a contracted period. Other regulators, the tax authorities among them, amend their own rules to match, lowering policy risk for developers.

But building with consumers' advance payments means developers pass the risk of falling prices on to consumers and banks.

This has been argued out before. In 2005, the central bank held that many market risks and transaction problems came from the pre-sale system for new commercial housing, and proposed scrapping it in favor of completed-home sales.

The Ministry of Construction said it would write no such policy. The disagreement came down to this: property is capital-intensive and runs on debt, tying up large amounts of bank credit and leaving banks to absorb the risk along the way. In 2004, the bad-loan ratio on Agricultural Bank of China's mortgage book reached 16%; at ICBC and China Construction Bank, which managed risk better, it was still around 7%.

Pre-selling speeds up the turnover of property capital, which speeds up the arrival of new developments and pulls in more developers. Governments take in revenue from selling land, and tax every stage of both land deals and pre-sales.

Mainland developers now carry average liabilities above 50% of assets; their Hong Kong counterparts mostly run debt ratios around 20%. The mainland companies keep using pre-sale money to speed up investment. A 2012 rumor that pre-sales would be scrapped was enough to shake the stock market.

Developers' debt loads have not touched the buying and selling of pre-sold homes. And with price caps making new homes cheaper than resale ones, people will wait years, because they reckon the keys alone put them ahead.

In hot cities like Hangzhou, Nanjing and Xiamen, a down payment plus a mortgage is already not enough to buy a new home. Buyers enter a lottery, or put up a deposit of several million yuan, just to earn the right to pay in full for a home that will be delivered in two years.

Pre-sold housing does not look like it is going away.

Image credits: the banner image was taken by the author; the long cover image is from Unsplash.

Appendix: A timeline of pre-sold housing in China

1987.10

The 13th National Congress of the Communist Party of China proposed that the socialist market system include factor markets such as real estate, announcing the birth of China's property market.

1990.5

The State Council issued the Interim Regulations on the Assignment and Transfer of the Right to the Use of State-owned Land in Urban Areas of the People's Republic of China, changing land use from free and indefinite to paid and fixed-term.

1992

The Communist Party called for faster reform of the housing and social security systems. Property prices were liberalized nationwide, many government approval powers were delegated downward, and financial institutions began issuing property development loans.

1994.7

The State Council issued the Decision on Deepening Urban Housing System Reform. The National People's Congress reviewed and passed the Urban Real Estate Administration Law of the People's Republic of China, establishing the pre-sale permit system and setting out basic rules on pre-sale conditions and oversight.

1998

Several State Council ministries pushed the monetization of housing reform, and the central bank adjusted property credit policy, applying preferential interest rates to personal home loans.

2001.8

The Ministry of Construction revised the Measures for the Administration of Pre-sale of Urban Commercial Housing, further clarifying the details of the pre-sale system.

2004.7

The Ministry of Construction revised the pre-sale measures again, stipulating that companies without a pre-sale permit for commercial housing may not pre-sell it. It also set clear, strict requirements for the documents and materials developers must submit to apply for a permit, and for the procedures they must follow.