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Resi Wrap - The Great Population Wall Of China
February 2023

Friends of ResiShares:

China’s population is officially shrinking. After many decades of a sub-replacement level birthrate and (no immigration of which to speak), China finally saw more deaths this past year than births.

This is a rather important phenomenon. The thing is, China is really big. How big? This big.

China alone makes up nearly 1/5 of the world’s population. If China is shrinking, that has major implications for global population growth overall. More importantly for us as investors and operators in the built world, it has powerful implications for the long-term trajectory of the global economy. Because as large as China’s population is, its planned economy’s focus on building housing and infrastructure has caused it to punch far above its already immense weight as a producer and consumer of physical commodities, like cement, steel, and copper:

Think about the scale of those numbers for a second. Think of all the steel that goes into your car, the apartment building project you see downtown, the new wing on the airport that never seems to get done. Extrapolate that across the entire United States. That is somewhere around seven times less than what China has been using.

By the way, they have mostly been using it to build apartments for their rapidly urbanizing population, and roads and rails to move that population around.

So, to be clear, the Chinese have been using over 2x more steel (and copper, and cement) than the entire US, just to build homes for a population that is now officially shrinking.

What happens when that demand begins to cascade lower? To extrapolate further, what happens when the demand shrinkage accelerates for vinyl flooring tiles, window glass, composite doors, countertops, and sinks?

In a capitalist vaccuum, it would mean a rapid price adjustment lower and a financial incentive for China to export their sticky production capacity abroad. In the real world, given recent global protectionism, it likely means some share of the difficult adjustment will occur within China itself, in which inefficient producers are shuttered. Even so, this shrinkage could presage a general cost tailwind for builders globally for some time.

Ask not for whom the bell tolls…

China’s population decline not only affects our markets through the mechanism of decreased demand for the building blocks of housing, but, more importantly, as a preview of what’s to come. In the modern, industrialized and urbanized era, when a country’s birth rate falls below replacement rate, it tends not to come back. How infrequently does it recover?

Well, it has literally never happened. Not once. There is not a single example in recent history of a developed, industrialized country seeing its birthrate decline below the 2.1 birth replacement rate and then recover. In fact, it typically continues to fall with urbanization. The thing is, with the green revolution in agriculture over the past 100 years, we just don’t need very many people to make food anymore. As would-be farmers sell their land to more efficient food producers and move to the cities and suburbs, children are no longer a financial asset, but a luxury item.

This population decline phenomenon is coming to a country near you. It is not a question of if. It is a question of when (and the timing thereof is almost entirely dependent on a each country’s willingness to accept immigrants and success in attracting them).

Obviously, we’re thinking about what this means for those who make money in real estate. To investigate, I called a Friend of ResiShares who has some experience with precisely this sort of thing. He invests in housing in Japan.

Japan’s population started shrinking 15+ years ago (before it was cool)! Judging by their population pyramid, that slight shrinkage is about to accelerate exponentially in the coming decades.

So how do you invest in housing, an incredibly long-duration asset, when you know that the overall demand for housing is going to be lower in 30 years than it is today?

Here is what we learned:

1) There’s always a bull market somewhere.

Despite Japan’s shrinking population, Tokyo and its outlying suburbs and exurbs continues to grow at a pace most cities in the world would envy.

Against the backdrop of a shrinking population, the lifestyle and livelihood tradeoffs between different regions drive entirely new behaviors. We have long described the clustering of households in physics terms, speaking of “gravity” and “critical mass” to describe the ability of a growing region to maintain its success. This works in the opposite direction as well. Every time a rural Japanese prefect becomes a ghost town, its young people get absorbed somewhere else, like cosmic dust accruing into a neighboring solar system. In Japan, that solar system is likely to be a major metropolitan area.

2) Value add opportunities abound

Real estate includes both land and improvements. Land becomes less scarce overall as population shrinks, by definition (though as mentioned above, CERTAIN bits of land can still become more valuable through increased clustering and urbanization/suburbanization).

Improvements are more complicated. The thing about a shrinking population is that the entire mindset of investors and operators shifts. A growing market is no longer available to bail out a risky investment. As a result, less speculative work gets done. This has the potential, in a rich, highly industrialized country and region, to lead to a dearth of high-quality housing stock, as older housing physically depreciates through neglect and newer housing is less likely to get built. A savvy operator can therefore spot opportunities to make money by providing a nicer (and more expensive) place to live, even if it’s not providing it to more people.

3) Betting on exit cap rates

I’m old enough to remember those Halcyon days of 2021, when Very Serious Economists questioned whether interest rates could ever go up again. This was not just an economic argument, but a structural one. I read numerous notes during the 2010’s trying (unsuccessfully) to explain to my doltish equity brain how the Fed somehow lacked the appropriate financial ammunition for their Open Market Operations. I never once grokked this alleged obstacle. Luckily for my sense of self-worth, it turned out not to be true.

When a country has a terminally declining population, however, it certainly DOES stand to reason that rates should asymptoticaly approach zero over the long run. The ratio of capital to humans, already growing exponentially worldwide since the Industrial Revolution, will kick into an even higher growth gear as the absolute number of humans declines. To the extent that rates are the price of capital, one can expect a resumption of the prior rate regime.

In a world of zero (or negative) nominal interest rates, it does not take much in the way of yield to create a very profitable investment, even in the complete absense of rent growth or price appreciation.

Rest of Resi

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