Loitering in front of the shiny new high-rise, we could be in Midtown Manhattan or London. But we’re not. This is Dalian, China, one of the fastest growing cities in the world’s hottest economy. Two decades ago, this street was lined with what an American in a charitable mood would call slums. Now it’s skyscrapers, fancy shops and well-dressed, busy people, as far as the eye can see.

But step through the building’s entrance, and the First World illusion disappears. It seems that after finishing the exterior two years ago, the developer ran out of money and moved on without installing interior walls or fixtures. The workers, many of whom were never paid, moved in, constructing shacks out of scavenged cinder blocks and snaking wires from central conduits to light their surreal squatters’ paradise. One stairwell serves as the “village” dump, and is now filled two stories high with the detritus of semi-modern Chinese life.

If this were an isolated case, it might simply be a colorful example of the crazy things that happen in a dynamic economy. But it’s not an isolated case. Think of it instead as a metaphor for China’s entire commercial real estate sector: slick and modern on the outside and, to a growing extent, empty and/or non-functional on the inside. What we’re witnessing here is a bubble of immense, historic proportions. And like all bubbles, this one is destined to burst.

Now, “bubble” is admittedly a vague, overused term, which requires a little defining. So  think of it as a market where a huge inflow of capital causes prices and/or activity to blow through previous records and just keep climbing. The beneficiaries—in this case the developers involved in China’s real estate sector—interpret the boom as a reward for their genius, conclude that things will always be thus, and proceed to bet ever-larger sums on the proposition that the good times will keep rolling.

Eventually, the resulting debt becomes unmanageable, and the flow of credit slows and then reverses. Prices collapse, wiping out the people who bought/borrowed at the top. This play has been performed literally dozens of times in recent history, from the mining boomtowns of the North American West, to the savings and loan crisis of the late 1980s, to the Japanese real estate market of the 1990s.

The best example of this boom-bust cycle might be the first. As gold and silver deposits were discovered in California, Colorado, and the Yukon, would-be miners (and their money) flooded into camps with names like Aspen, Blackhawk, and Leadville. Saloons and hardware stores followed the miners; camps became towns, and fortunes were made by the quickest, luckiest, smoothest operators. For a time, Leadville was actually known as “the richest square mile on earth,” and instant millionaires like Horace Tabor, Colorado’s legendary “Silver King,” were everywhere. But Tabor and his peers were new to the market—by definition, since the market itself was new. With little understanding of business cycles, they poured their fortunes into high living, trophy buildings, and ever-riskier mining ventures. And when the mines began playing out and the miners left, their fortunes blew away in the wind. Many of the towns revived, and a few eventually thrived, but the first generation of developers weren’t around to enjoy the second act.

Substitute Shanghai and Dalian for Blackhawk and Leadville, and you understand today’s China.

The business cycle? Never heard of it

Global capital has been lusting after the Middle Kingdom since Marco Polo returned with tales of life at Kublai Khan’s court in 1300. Now, thanks to the vision of Deng (“it’s glorious to be rich”) Xiaoping and his successors, the outside world has its opening. With 1.3 billion consumers and wage rates 5% – 20% of those in the U.S., China has become the one must-have market of the 21^st century. It is today’s global factory floor and tomorrow’s cell phone, car, and oil market. Either you’re big in China or you’re small globally. And like the Internet in 1998, the whole world is racing to claim the best street corners, risk be damned. Though China’s economy is less than a tenth the size of America’s it now attracts the larger share of global capital.

Because China has emerged as a global capital magnet in a relative eye blink, its local movers and shakers have little personal experience with the business cycle. Most weren’t even in the construction business when the boom began. Shanghai’s biggest real estate developer, for instance, was selling plastic flowers on street corners a decade ago, and most of his peers were communist party bosses. Overnight, they’ve learned how to build very exciting, world class buildings, but they’ve yet to figure out how to tell when there are enough buildings. Like late-90s dot-com entrepreneurs, they see the profit margins generated by the initial wave of projects, and assume the next batch will perform the same way. The notion that doubling the supply of something can depress its profitability and value is, at the moment, unknown.

Bureaucrats with credit cards

Now here’s where China departs from the traditional boomtown script. Because this was a communist country until just a few years ago, it doesn’t have a broad, deep class of capitalists running the show. Instead, the government controls land supply, project selection, and bank lending. To understand what this means, first consider how it’s done in the U.S. and the rest of the developed world. In, say, Denver, a private developer comes up with an idea and proceeds to fight/politic his way through a gauntlet of regulations and bureaucracy. If successful, he then runs into conservative bankers and investors who require a track record, pre-leasing, and significant investor equity. The people putting up the cash, in other words, demand a building that turns a profit by generating rents sufficient to cover its debt and operating costs.

In China, more often than not local development officials drive rather than hinder the process, based on a very different agenda. First, they’re faced with millions of people moving from the countryside to cities, and need, at all costs, to provide jobs for these potentially destabilizing immigrants. Second, because they’re bureaucrats and politicians, their holy grail isn’t profit, it is size and prestige. Their dream is to turn their town or region into an economic powerhouse, and to parlay this empire into a seat on the Politibureau. Pride, in other words, trumps economics.

Meanwhile, the Chinese system grants its development officials powers that their U.S. counterparts can only dream of. For example, PEDA, the Pudong Economic Development Administration, owns a portfolio of construction companies, at least one of which is big enough to be listed on the Shenzhen stock exchange. PEDA officials can negotiate outside investors’ federal as well as local taxes. They control the local utility, and set power and water rates. They own most local land and can clear it out and offer it to investors for free. They control the local banks and can guarantee favorable financing terms. They can build mass transit in a year that would take a decade in the U.S. Show up with some foreign capital and a dream, and PEDA will make it a reality.

Like the 1980s partnership of Japan’s zaibatsu and its Ministry of International Trade and Finance, this arrangement allows the Chinese to do extraordinary things in no time flat. With no red tape to cut through and effectively unlimited capital, Chinese real estate developers can literally move mountains, planning and building entire cities from scratch, rather than having them accumulate haphazardly over decades as in the U.S. This concentration of power is obviously a source of enormous strength.

But it’s also a source of extraordinary excess. When a regional development minister, tired of playing second fiddle to Shanghai and Beijing, decides he needs a nice skyline to gain entrance to the politibureau, he builds two 80-story office buildings side by side. Next to them he puts 60-story towers, then a couple of 40s. Then (this is a real example, by the way) he installs a rail system connecting this complex to the area’s industrial zones. In the blink of an eye he’s presiding over a brand new mid-town Manhattan. But—and here’s the key to the whole story—at no point in the process is thought given to who’s going to occupy these buildings. “Build it and they will come,” is the guiding philosophy. Now multiply this process across China’s 100+ boomtowns and you have a sense of the scope of the bubble.

Empty Buildings

As the chart below illustrates, during Denver’s building boom of the 1980s, the vacancy rate topped out at 28%, and rents then plummeted by over half. Banks pulled back, and construction ground to a halt. That’s how a cycle normally works.

The common sense proposition that overbuilding leads to falling profits would, you’d think, make Chinese office vacancy rates a closely-watched, much-discussed number. Unfortunately, this isn’t a statistic that the government tracks at the moment, so private analysts are left to fend for themselves. The resulting estimates are all over the map, with some studies putting, for instance, Beijing’s vacancy rate at a benign 15%, while Colliers International, the well-respected global real estate firm, predicts 25% by year-end.

Without reliable statistics, it’s hard to say where Beijing is on the bubble scale today. But since the pipeline of new buildings is huge and growing, it’s highly likely that the pendulum will swing far into overbuilt territory over the next few years.

And Beijing is far from China’s hottest real estate market. In the same way that new, small Internet stocks wrested market leadership from Intel and Cisco in the blow-out phase of the tech bubble, emerging Chinese towns like Dalian are now attracting boatloads of foreign capital. In a very real sense, today’s China isn’t one economy; it’s 100 economies, each in competition with the others for size and importance, in an environment with none of the disciplines normally imposed by market forces.

The inevitable, quite predictable result will be a spike in office vacancy rates, a nasty downturn in rents, and a drying up of construction in the latter half of this decade. But here again, the fact that it’s China adds some unique twists. First, there’s the question of how its people will react to having their dreams of progress deferred for another decade. In the U.S., real estate busts produce at most a few million temporarily unemployed workers. But even in the current boom, there are 100 million “underemployed” Chinese, who are doing less and/or lower-paying work than they could. And 40 million new workers move from farms to cities each year, hoping for a better life. If today’s real estate boom pacifies the multitudes with jobs and hope, then tomorrow’s bust will create a very volatile mix.

And unlike most real estate busts, this one will reverberate around the world. Since office buildings are long-lived and can’t be moved, excess inventory leaves landlords with no choice but to slash rents. Recall that Denver’s office rents fell by half in the early 1990s. This was agonizing (and financially fatal) for many landlords and most local banks, but because Denver is, in the scheme of things, pretty small, it had little global impact. China, however, is not small. And when its landlords (that is, its local governments) find their credit cards cut off and their people getting restive, they’ll respond with the only tools at their disposal: dramatically lower rents and prices. The resulting office space fire sale will be unlike anything the world has seen. And the outsourcing wave that’s now driven by China’s lower costs may become a tsunami.

Denial, Worry, Panic

Most real estate bubbles burst in the following way: Early warning signs like higher vacancy rates and diminishing capital flows are met with denial: “It won’t happen here, my project is special.” Then, when the bad numbers can no longer be ignored, comes: “This is a short correction, my building will fill up and rents will rise soon.” The optimists, though worried, are still optimists.

But as landlords begin to reduce rents in a desperate attempt to service their mortgages, the collective mood shifts from worry to panic. Deteriorating cash flows lead mortgage bankers to tighten their lending criteria. Landlords and developers fail, and liquidate their assets for whatever the market will bear. Prices plunge, causing banks to pull back even further, ad, it seems at the time, infinitum.

Right now, China is somewhere between denial and worry. Vacancy rates are rising, but rents aren’t falling. Lots of empty buildings are for sale, but their owners have yet to lower their asking prices. No one seems to understand the time value of money or the role of price in clearing a market. But soon enough they will.

For an idea of what the “panic” stage of China’s bust will look like, think back to the U.S. Savings & Loan implosion of the late 1980s. As builders and banks were liquidated by the Resolution Trust Company, massive amounts of real estate hit the market. Good buildings were available for 11%-30% of their bubble prices, and fortunes were made by buyers (like Marcel) who were able to pick the quality properties from the rubble. So the coming China bust will look familiar. And for investors with cash, the last part of this decade will be kid-in-a-candy-story time: Beautiful buildings in cities that will grow like crazy in the next recovery, available for a song.

© 2004 Marcel Arsenault & John Rubino
Editorial Archive

Marcel Arsenault is founder and chairman of the Arsenault Family Foundation and the Ending War Foundation, and CEO of Colorado & Santa Fe Real Estate, which manages a rapidly growing global real estate portfolio. Before founding Colorado & Santa Fe, he pursued a Ph.D. in molecular biology from the University of Colorado and created Mountain High Yogurt, a public company eventually acquired by Beatrice Foods. He lives in Superior, Colorado. Contact by Email

John Rubino is the author of The Coming Collapse of the Dollar (co-written with James Turk, due out from Doubleday in December), How to Profit From the Coming Real Estate Bust (Rodale, 2003), and Main Street, Not Wall Street (William Morrow, 1998). A former Wall Street financial analyst and columnist with theStreet.com, he currently writes for Fidelity Magazine, CFA Magazine, Kiplinger's Personal Finance, and Merrill Lynch Advisor. He lives in Moscow, Idaho. Contact by Email.