By Shawn Tully
January 23, 2012

FORTUNE — The Chinese government’s announcement last week that growth for 2011 slowed only slightly to a still impressive 9.2% was greeted enthusiastically by the world’s stock markets. Investors also remain buoyant on China’s future. They appear to be buying the official line that the gigantic property price bubble is gradually and smoothly deflating, posing little risk to an engine that’s so crucial to the future of global trade.

But the math tells a different story. The housing frenzy has driven prices so high, so fast, that a crash on the scale of the real estate collapse in Japan in the 1990s is a virtual certainty. And China’s already exaggerated official growth rate could take a pounding, all the way to the zone of the unthinkable, into the low single-digits.

For this analysis, I’ll borrow heavily from my former professor and mentor at the University of Chicago’s Booth School of Business, Robert Aliber. Affectionately known to his students by his initials “RZA,” Aliber is now retired to New Hampshire, but he writes a superb newsletter for his friends and clients. He spotted the reckless credit expansion, huge trade deficits and asset bubbles that now haunt both the U.S. and European economies long before most experts.

As Aliber puts it, “In China, the housing boom is a far bigger source of growth than is widely recognized, and it’s totally unsustainable.”

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Aliber got his first clue that the craze spelled disaster from a former student living in Beijing. The young Chicago alumnus told Aliber that he’d just moved into an apartment building with several hundred units, and was the only one living there. Investors had bought all the other apartments that hadn’t sold.

Later that year, Aliber visited the office of an upscale developer in Beijing, who was getting $600,000 for 1100 square foot units with bare walls. The folks doing the purchasing were earning between $20,000 and $30,000. Given those modest incomes, it was obvious that the buyers weren’t purchasing an affordable new residence, but speculating in real estate, either to live there for awhile then flip the unit, or simply leave it vacant while seeking a buyer willing to hand them quick windfall.

Rent vs. price

What amazed Aliber was the chasm between the prices of the apartments and the rents they fetched. A typical $600,000 unit brought a landlord less than $1000 a month in rent after expenses (assuming no mortgage). It wasn’t the rental yields that attracted investors, it was the huge price appreciation, averaging from 20% to 30% from 2008 until last year.

Rents — the cost of living in the unit — exercise a sort of gravitational pull on prices. That’s because people won’t pay far more to own a home than to rent a similar one, unless they think prices will keep soaring — a view that’s a sure sign of casino mentality, and never lasts. In China, prices in the frothiest markets are fifty or sixty time rents. That’s the case with the example we discussed above, where the price is $600,000, and the rent is $12000, a ratio of 50-to-1. The 50 to 60 multiple is far above the level in most U.S. markets at the height of the bubble in 2006; in those heady days, a multiple of 40 was considered giant.

So how far do China’s prices need to fall so that the cost of owning is reasonably close to the level of rents? Aliber reckons that the rental yield on apartments will eventually go from less than 2% to 5%, or even a bit higher.

The rental yield is simply the annual rent divided by the market price, just as the yield on a bond is the fixed interest payment divided by the price of the bond that day. In the U.S., the rental yield averages around 6%, meaning the multiple of prices to rents is around 17. The adjustment to a 5% rental yield in China would push prices down by 60%.

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Aliber is by no means the sole China expert to predict that a steep drop is coming. “I estimate that a decline of 60% or even more is the upper end of the range, but is indeed possible,” says Derek Scissors, an economist at the Heritage Foundation.

The adjustment has already begun. While the government’s official figures show modest declines starting late last year, those numbers are famously unreliable. A better view comes from owners trying to sell their units. Losses of 30% aren’t uncommon. In fact, many owners who paid, say, $600,000 in 2010 are furious that their landlords are now offering unsold units in the same building for $450,000.

What’s the probable hit to China’s vaunted growth rate? It’s important to recap the forces that caused the frenzy. China imposes tight restrictions on returns on bank accounts, government bond yields and other domestic investments. Inflation for 2011 exceeded 5%, but 10-year bond yields are just 3.5%. It’s extremely difficult to find investments that yield more than inflation. When the easy money policies took charge after the worldwide crash of 2008, the excess cash flowed into the only place with big returns — real estate.

For around four years, China has been building around 1 billion square meters of housing a year, ten times the figure in the U.S. The amount needed to accommodate real owners — people moving from farms to the cities, for example — is 700 million square meters.

So let’s assume that demand goes back to that level. China is also swamped with seven to eight million vacant units. If around two million of those are sold a year, China will need to build just 500 million square meters annually — half of the total over the past several years. That decline will pound not just expenditures on apartments, but production of steel, copper and appliances.

By Aliber’s reckoning, the sharp decline in housing production could lower China’s growth rate by a full five points. In his view, around three points of its 9.2% growth rate in 2011 came from the bubble. Shave two more points for the empty apartments that need to be sold, and future growth looks far less robust than the official projections.

Unlike the post-crash U.S., China will keep growing after the bubble bursts, though at a far slower rate. What bears watching is the effect of another gigantic stimulus program to compensate for the decline in housing. If renewed inflation follows, so will a slowdown needed to tame it.

Or as Aliber observes, “China’s spurt of a 10% growth rate is likely to be history.”

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