SHANGHAI — In July, Wan Jiani received the letter she’d been dreading: there was an issue with the construction of her new home.

Like millions of others in China, Wan and her husband have poured their life savings into a presale apartment, paying for the property years before it’s completed. Now, the developer was saying it needed to push back the delivery date by at least four months.

The delay means that Wan’s family will not be able to move into the building until mid-2024 at the earliest. Meanwhile, they will have to continue paying the mortgage — and renting a temporary home in Shanghai. The developer has offered zero compensation, as it claims the construction issues were caused by China’s “zero-COVID” restrictions, which are beyond its control.

Wan is just praying the project gets completed at all.

“Given all the bad news spreading around, it’s hard not to imagine the worst-case scenario: What if the building is left unfinished?” she tells Sixth Tone.

It’s easy to understand Wan’s concern. China’s real estate sector has been plunged into its worst debt crisis in decades. Developers across the country are defaulting on payments and bringing construction on new projects to an abrupt halt. 

Unfinished apartment blocks — known as lanweilou, or “rotten-tail buildings,” in Chinese — ring China’s urban centers. Around 5% of the apartments under construction in 50 major cities — around 71.5 million square meters of property — are now lanweilou, Shanghai Yiju Real Estate Research Institute found in a survey conducted during the first half of 2022.

Buyers who invested in these developments have been left in dire situations. Some, no longer able to afford their rent, have taken the desperate step to squat inside their half-constructed homes. Others have organized joint mortgage strikes, arguing they should not be forced to pay for apartments that do not — and may never — exist.

Meanwhile, confidence in the real estate market has fallen sharply. Commercial property sales were down 28.8% year-over-year during the first seven months of 2022, according to National Bureau of Statistics data. Local government land sales were down more than 30%.

Chinese authorities are taking emergency steps to ease the crisis. The central government plans to issue 200 billion yuan ($29 billion) of special loans to allow cash-strapped developers to finish construction on stalled projects. Several local governments are also launching their own bailout funds.

Yet some argue more fundamental reforms are needed. For decades, China’s property boom has been built on a lax presales mechanism, which allows developers to require buyers like Wan to pay for new-build apartments in full long before they are completed. 

This policy has handed developers enormous power to raise capital, enabling them to finance gigantic amounts of construction. But it has also led to them amassing dangerous levels of debt — and riding roughshod over buyers when projects go sour.

For many analysts, the presales mechanism is the root of the current crisis. China’s real estate market cannot be set on a sustainable path, they argue, until the system is overhauled. Yet doing so could also have far-reaching — and painful — consequences for the Chinese economy.

Jump-starting the market

To understand how integral the presales system is to China’s housing market, it helps to explore why the policy was first introduced. Its origins lie in a previous crisis: China’s acute housing shortage of the 1990s.

The country’s market reforms unleashed an unprecedented wave of urbanization during this period, as people left their farms to seek higher-paying jobs. Over 150 million people moved into the cities between 1990 and 2000 — and all of them needed somewhere to live. The existing urban population, meanwhile, began demanding larger, more modern homes as their living standards rose.

China’s traditional, state-controlled property sector couldn’t cope. In 1990, the average urban resident in China had just 7.1 square meters of living space, according to government data. Most families relied on employers to provide housing, but they often had to wait years because the system was overwhelmed.

“The practice was not sustainable,” says Huang Zhonghua, a professor at East China Normal University who researches China’s real estate market. “It led to lots of capital pressure on the government and the slow development of the property sector.”

Dong Liping, a retiree in Shanghai, recalls waiting more than five years for her employer — a public hospital in the city — to provide her family with an apartment, after beginning her career in the late 1970s.

“It was in 1984 that my family of three moved into the one-bedroom, 27-square-meter apartment,” says Dong. “Although all the apartments were small, we were all very happy to finally have a home.”

The Chinese government turned to the private sector to solve the shortage. In 1991, China had 4,200 property developers. Four years later, that number had jumped to more than 33,000, as officials opened up the real estate market. Yet these private firms were brand new and cash-poor. Each developer held just 46.6 million yuan of assets on average in 1996.

“That asset scale means the developer is incapable of building even one medium-sized residential building in Beijing,” Yan Xiaodong, the then-deputy director of the Beijing Unirule Institute of Economics, wrote in an article published in 1999. “We cannot compare them with foreign real estate developers, which have billions in assets.”

And so, in 1994, the Chinese government issued a new policy designed to jump-start the market: the urban commercial housing presale management method. The system — which was closely modeled on a similar policy Hong Kong had been using for four decades — allowed developers to begin selling properties inside new residential projects once at least 25% of construction had been completed.

The regulation took effect in 1995 — and its effect was almost immediate. Chinese developers began routinely demanding buyers pay 100% of the apartment price upfront once they had signed a presale contract. This enabled them to raise huge amounts of capital, and begin scaling up their operations dramatically.

“The change injected lots of vitality into the property sector,” says Huang. “It eased the capital pressure on developers, substantially increased the market supply, and improved people’s living conditions.”

The growth of China’s real estate market over the following years was stunning. In 2003, Chinese developers built nearly 117,000 square meters of new properties. By 2010, this figure had soared to 4 billion square meters, making the country’s property market the largest in the world.

Shaky foundations

Yet opposition to the presales system was already intensifying. As early as 2005, China’s central bank — the People’s Bank of China — called for the policy to be scrapped, arguing it was creating unacceptable levels of financial risk.

According to the PBOC, developers were committing fraud on a jaw-dropping scale to fuel their expansion. Under the presale mechanism, many property firms financed the construction of new projects using the capital from mortgages issued for presold apartments. Yet the mortgages were often fake: If the developer couldn’t presell enough properties in time, they simply applied for the mortgages themselves — and assumed they’d find some real buyers later.

“Developers use the information of their own staff or their close contacts to get mortgages from the bank,” the PBOC wrote in a report. “Some developers paid back the bank after they sold the apartments, but some didn’t — they ran away with the money after they failed to sell all the units.”

The fraud was causing major problems for Chinese banks. Around 80% of the bad debt held by the Industrial and Commercial Bank of China — one of the country’s “big four” state-run banks — was linked to fake mortgages, the PBOC said.

But the presale mechanism was not canceled. Instead, it became even more central to China’s real estate sector over the next 15 years. In 2005, 57% of new commercial properties on the market were presales, according to the National Bureau of Statistics. By 2021, this figure had climbed to 87%.

The problems with the presales model did not go away. As developers financed more and more new projects, they began amassing eye-watering debts. Market leader Evergrande alone reportedly owes over $300 billion. Concerns about overbuilding simmered, with reports of “ghost cities” filled with unoccupied properties in some areas.

Meanwhile, real estate firms were able to rip off buyers with impunity. As customers were required to pay the full price in advance, developers enjoyed enormous leverage. Many abused that power, using shoddy materials, installing cheap appliances, or delaying construction without offering compensation, according to Chinese economist Ren Zeping’s research team.

“The presale mechanism is unfair to the public even though it helped solve the shortage of apartments in the 1990s,” the team wrote in their 2021 report. “Under the presale regime, developers have used fancy marketing tactics and made promises that they didn’t necessarily keep. Seeing is believing matters a lot — it provides a fundamental guarantee for property buyers. It can also pressure the developers to improve the quality of construction.”

Yet, until the crisis erupted, presale apartments were often highly sought-after in China. Due to government price controls, new homes are far cheaper than second-hand properties in many regions. And as China emerged as one of the world’s most unaffordable real estate markets, price trumped all other concerns for buyers.

Wan is a case in point. When the 40-year-old decided to invest her family’s life savings in a property in Shanghai, she faced a choice: She could spend the 5 million yuan on a second-hand apartment on the outskirts of Shanghai, around 40 kilometers from her office; or a presale home that was far closer to the city center.

The presale would not be ready for two years, but Wan eventually decided it was still the right choice. The location was just so much better, and new builds tend to be higher quality, she says.

“New developments are priced more reasonably,” says Wan. “But the bad thing is that they will be ready in two years and there’s the risk of delay, which unfortunately happened to us.”

Wan had seen reports about lanweilou in the past, but these zombie projects were rare in Shanghai. They tended to happen in smaller, less prosperous cities. It wasn’t until this summer — when reports emerged of thousands of buyers boycotting mortgage payments over unfinished properties — that Wan began to worry her home might be left in limbo, too.

“This is a new phenomenon,” says Huang, the professor. “It warned us of the loopholes with the monitoring of presale capital.”

Too big to fail?

Now that developers’ debt problems have reached crisis point, many in China are once again calling for the presale mechanism to be canceled. Yet industry insiders argue the cure may prove worse than the disease.

An investment director at a state-backed real estate company, surnamed Cheng, tells Sixth Tone that many developers would be unable to survive without the presale mechanism. Their need for capital is too extreme due to their high debt loads.

“The development of the property sector is very fast-paced,” says Cheng, who declined to reveal his full name due to the sensitivity of the topic. “If you pull the brake now, many will crash.”

A few years ago, a group of government officials visited Cheng’s company and asked Cheng what would happen if they overhauled the presale policy. “I replied that the market and developers wouldn’t be able to handle the consequences,” he recalls.

The immediate effect would be to cause developer after developer to fold, leading to a wave of new lanweilou, Cheng says. Over the longer term, there would be a dramatic slowdown in the property market, as the surviving companies would no longer be able to finance as many new housing projects.

Despite all its problems, the presale mechanism is an effective tool for getting large numbers of buildings off the ground quickly. Chinese developers are often able to recoup their entire investment within eight months of purchasing a parcel of land, Cheng says.

“But if we’re only allowed to sell completed homes, it takes 1.5 years to get an 18-story building completed,” he says. “That’s three times the current period for developers to get the money from buyers. The pressure on capital flow will be huge.”

The upshot of this would be a spike in housing prices, Cheng predicts. Despite overbuilding in some areas, the underlying demand for new housing remains enormous in China. In 2021, there was over 18 trillion yuan of commercial property sold in the country — dwarfing the total in the United States.

“If the policy changes, there won’t be a valid supply in 2023,” says Cheng. “The public will panic as there are no apartments to buy, and property prices will rise.”

Huang agrees that property prices would increase if China removes the presale mechanism. “The cost of development will go up, but developers will still need to make money: They can only turn to the consumers for that,” he says.

Any slowdown in the real estate sector would also have knock-on effects for many other industries, Huang adds. By some estimates, housing activity drives nearly 30% of China’s gross domestic product, a far higher rate than most developed nations.

“Businesses along the supply chain, such as those in the construction materials industry and manufacturers, will also need to deal with the blow,” says Huang. “The bigger a developer is, the longer it takes for them to pay those suppliers … If the developers disappear or go bankrupt, who will pay these suppliers?”

Local governments, meanwhile, would have to confront gaping fiscal deficits, which could have sobering consequences for communities across the country. In 2021, land sales totaled 8.7 trillion yuan in China, accounting for nearly 43% of the country’s fiscal revenues.

This year’s property crisis has already sent shockwaves across the Chinese economy and forced local governments to take drastic measures to balance their budgets. If the slowdown becomes permanent, China would likely undergo a major economic and fiscal readjustment.

Lu Wenxi, an analyst at property agency Centaline Property, says it would be impossible to scrap the presales mechanism completely. But there is an urgent need for better regulation — especially when it comes to monitoring developers’ use of capital.

“Capital supervision should be made more open and transparent,” says Lu. “Homebuyers and even the whole society should be allowed to supervise the accounts.”

Under China’s current presale rules, the money buyers pay upfront is supposed to go into an account that is then monitored by both the banks and local housing regulators. Developers are only allowed to access a certain proportion of the money based on the progress of the project — such as 50% of the capital once 50% of construction is completed, though local rules vary.

Yet, in reality, the funds often go missing. According to Cheng, many developers are so desperate for capital that they’ll go to any lengths to access the money early.

“When they see a chance to break through (the restrictions), they’ll go for it,” he says. “Developers will always have the motivation to bribe their way through to access the capital in advance.”

The Chinese government should also consider reforming the presales system to shift the risk away from individual buyers, Lu says. Buyers, for example, have long resented having to make mortgage payments on properties long before they’re ready to live in.

“Changes could be made to this practice,” Lu says. “Homebuyers should be allowed to start paying back the mortgages after the apartments are ready for them.”

China could also partly restrict developers’ access to capital on presale apartments, Lu says. If they could only access the buyers’ down payments — which are set at a minimum of 35% of the property price for new homes in Shanghai — then buyers would be at less of a disadvantage. The economic fallout from this kind of reform would be significant, but manageable, Lu suggests.

“This change would definitely phase out many developers. But why do we need so many developers? It’s a good chance to kick out businesses with low capabilities,” says Lu. As of 2019, China had nearly 100,000 real estate development companies.

Huang, meanwhile, says that China could take inspiration from European countries, which allow buyers to pay for presale homes gradually based on the progress of the project. “Consumers can also participate in monitoring the project,” he says. “If things go wrong with the project, they can refuse to pay the rest.”

Introducing a step-by-step payment system would be challenging in China, however, due to the sheer size of the property market. In 2021, Chinese developers invested a total of 14.76 trillion yuan ($2.16 trillion). In the U.S., meanwhile, commercial real estate investment hit a record high of $746 billion.

“The scale of new property development in the whole of the U.S. is only equivalent to that of a few large Chinese cities,” says Huang. “It’s a huge market to regulate.”

Cheng considers a step-by-step model unrealistic. “When a part of the project gets done, the housing authorities would need to dispatch people to inspect it,” he says. “That’s a huge amount of work. How many more staff would the government have to hire to take charge of this?”

Then, there’s the question of whether the new system would work in practice. In Cheng’s view, it won’t — unless the government manages to eliminate corruption within the system.

“The more steps and procedures are involved, the more opportunities there’ll be for developers to access the money in advance using any means they can think of,” says Cheng.

For now, it remains unclear what policy approach China plans to take. Wan, the buyer in Shanghai, is more concerned about what will happen to the country’s hundreds of stalled projects — and her half-finished home in particular.

She has spent the past few weeks closely monitoring the work at the construction site, and the developer’s other projects in Shanghai. So far, she hasn’t seen anything to suggest the company is about to fold, she says.

“It feels like there’s a better guarantee here,” says Wan. “The city government won’t allow lanweilou to interrupt its urban development plans, right?”

Editor: Dominic Morgan.

(Header image: Buildings under construction in Shenzhen, Guangdong province, Aug. 12, 2022. VCG)