Posted on 09/03/2002 11:26:06 AM PDT by lds23
Disillusioned investors have turned from shares to housing. A bubble, anybody?
FOR all the newspaper space devoted to stockmarkets, households around the world have far more of their wealth tied up in property than in shares. American households' shareholdings briefly surpassed the value of their houses in the late 1990s. Now they have about $11 trillion-worth of shares (held directly or in mutual funds), compared with almost $14 trillion in housing. In other countries, housing is even more important. In rich countries as a whole, individuals own $23 trillion in equities, but perhaps $40 trillion in property.
Property is thus the world's biggest asset class, yet timely data on house prices in different countries is hard to find. That is why, earlier this year, The Economist launched its global house-price indicator: a set of house-price indices for 13 countries, going back to 1980, both on an average nationwide basis and for big cities. It is time for a mid-year update.
Almost everywhere, house prices continue to outpace inflation. The exceptions are Japan, where house prices are now in their 11th year of decline, and Germany, where prices have been more or less flat since 1992. Britain has risen to the top of the house-price inflation league, with prices up by over 20% in the year to July, double the pace of a year ago. Australia, Canada and Spain have also all seen price gains of at least 10% (see table).
Average house-price inflation in America has slowed to around 7%, from 9% in mid-2001—a rise, still, of more than 5% in real terms. American house prices have risen by more in real terms since 1997 than in any previous five-year period since 1945. The National Association of Realtors says that house-price inflation has accelerated strongly in many cities in the second quarter. New York, Washington DC and Los Angeles all saw rises in median house prices of 18-22% over a year earlier.
At the other extreme, house-price inflation has slowed sharply in Ireland, Sweden and the Netherlands. These three countries had among the fastest price increases in real terms over the previous five years, and were starting to look distinctly frothy. Irish house prices rose by an annual average of 20% between 1996 and 2001; in the year to June prices rose by just 5%.
Chart 1 compares the change in house prices with the fall in share prices since March 2000, when the stockmarket bubble burst. The canny British investor who sold all his shares in early 2000 and bought a house would have enjoyed a 40% gain in his wealth, compared with a loss of 35% had he stayed in shares.
Housing snakes and ladders
If 1980 is taken as a starting-point, however, equities have risen by more than house prices everywhere, despite the bear market (see chart 2). Martin Barnes at the Bank Credit Analyst, a Canadian research firm, has tracked total returns from housing and shares in America over a longer period, including rental yield and dividends. The total return from investing in property consists not only of a capital gain, but also a rental income or benefit from living there (you would otherwise have to rent somewhere else). Mr Barnes finds that investment in American homes massively outperformed shares between 1960 and 1980, but then did badly from 1982 to 2000 (see chart 3). Now housing is outperforming once again.
Unlike most equity investment, most homes are paid for by borrowing; interest payments may offset the rent. But the use of leverage can also greatly boost the return on your initial stake. Suppose you invest $20,000 in shares, which after five years are worth $40,000, including reinvested dividends. That implies an average annual return of 15%. Alternatively, you could use the $20,000 as a deposit on a $100,000 house, which then rises by an average of 7% a year over five years, to $140,000. Assume for simplicity that mortgage-interest payments and maintenance costs exactly offset the rental income (or the benefit of living in the house). Then comparing the total capital gain of $40,000 with the initial stake of $20,000 gives an annual return of almost 25%.
The more favourable tax treatment of housing adds to its attractions. In many countries, home owners get tax relief on mortgage-interest payments; more important, owner-occupiers are exempt from capital-gains tax. Against this, the costs of buying and selling a house are far bigger than the cost of trading shares. Taking all this into account, the net return from property, over long periods of time, has in many countries exceeded that from shares.
Traditionally, shares and houses have risen and fallen together. Yet house prices have risen as equities tumbled over the past two years. There are two explanations. With interest rates at 40-year lows, mortgages are unusually cheap. And people increasingly see property not just as a roof over their head, but as the only way left to earn a decent return on investment.
With the value of mutual funds (unit trusts) shrinking, and future pensions looking less secure, many Americans and Britons now see their homes as, in effect, a part of their future pension. They are borrowing more either to buy a bigger house or to buy a second property to let. When they retire they can unlock their wealth in several ways: by selling and moving into a more modest house, by taking out an annuity against the value of the property, or by selling an investment property.
A recent study by the Milken Institute in Los Angeles suggests that, in America, housing has replaced gold as a safe haven in times of uncertainty. This, they say, is why investors have poured money into property as the stockmarket has slumped. The authors find that, from 1945 to 1980, the share of property in households' total assets was positively correlated with GDP growth. Since 1980 they find a negative correlation: housing becomes more attractive at times of slower growth. Until the 1980s, households invested more in housing as equities rose; as shares fell, they put less into housing. By contrast, the recent fall in share prices has seen more money move into housing.
One reason for the change since 1980 is financial deregulation, which has allowed mortgage rates to vary more over an economic cycle, making housing more affordable in downturns. Another is that financial innovation has made property an asset that is easier to tap. A home owner may now convert capital gains into cash by borrowing against the rising value of his house. Home-equity withdrawal (the increase in borrowing in excess of new investment in housing) is running at record levels in both America and Britain.
There are reasons to think that the increased interest in property as an investment is here to stay. Yet there is also a big risk that investors, burnt by the stockmarket, are now overinvesting in housing. The market for housing is almost as prone to irrational exuberance as the stockmarket. And a housing bubble is more dangerous than a stockmarket bubble, because it is associated with more debt. A steep fall in house prices would harm the global economy far more than a slump in share prices.
The best gauge of whether house prices are overvalued is the ratio of house prices to average disposable income—the equivalent, as it were, of the price/earnings (p/e) ratio for shares. In America and Britain, this ratio is now close to its peak of the late 1980s, and the ratio is flashing red in some cities, such as London and Washington, DC. In Ireland and the Netherlands, the ratio is at a record high.
House prices cannot continue rising at today's pace. Yet unless interest rates rise sharply, which seems improbable in the near future, most economists reckon that prices are more likely to flatten off than collapse. Prices appear to be levelling off in London as well as in parts of America.
American house-price inflation is likely to slow, yet Mr Barnes expects that housing will continue to outperform shares. The previous two peaks in the ratio of house prices to income happened, he says, when the p/e ratio for shares was low, making shares cheap relative to housing. Today, shares look overvalued, which boosts the relative attraction of housing.
All this means that house prices might continue to rise for a while yet. But the higher they climb, the more households' debt will swell. The real housing bubble in America and Britain is not the rise in house prices, but the growth in mortgage debt, which is at record levels in relation to incomes. The optimistic view is that, with interest rates at 40-year lows, households can afford to borrow more. Still, home buyers may be underestimating the true cost. Interest rates are low because inflation is low. But that means that borrowers can no longer rely on inflation to erode their debts, as it did in the past.
At the very least, households hoping that ever-rising house prices will provide generous nest eggs are likely to be disappointed. At worst, the risk is that prices in many countries may take a tumble. Falling house prices, massive debts and low inflation: now that really would be an unpleasant cocktail to contemplate.
At least I hope so, considering I'm buying a house next month!
If you buy a $900,000 three bedroom split in a boomtown, you are in danger of taking a $700,000 hit when the bust comes.
If housing prices do start to fall, it will be a long and painful slide like in Japan, not a crash.
Disclaimer: Opinions posted on Free Republic are those of the individual posters and do not necessarily represent the opinion of Free Republic or its management. All materials posted herein are protected by copyright law and the exemption for fair use of copyrighted works.