Posted on 05/29/2003 5:37:30 PM PDT by arete
In many countries the stockmarket bubble has been replaced by a property-price bubble. Sooner or later it will burst, says Pam Woodall, our economics editor.
“BUYING property is by far the safest investment you can make. House prices will never fall like share prices.” This is the advice offered by countless estate agents around the globe. In the absence of attractive investment opportunities elsewhere, home buyers have needed little encouragement: from London to Madrid and from Washington to Sydney, rising house prices have been the hot topic of conversation at dinner parties. Over the past seven years, house prices in many countries have risen at their fastest rate ever in real terms. And now institutional investors are also eagerly shifting money from equities into commercial property. Many property analysts scoff at the suggestion that another bubble is in the making. House prices may have fallen after previous booms, but “this time is different”, they insist. That is precisely what equity analysts said when share prices soared in the late 1990s. They were proved wrong. Will the property experts suffer the same fate?
This survey will examine investors' current love affair with both residential and commercial property (or real estate, as Americans call it). It will explore the latest trends in property prices around the globe and consider different methods of estimating fair value in order to assess whether there is a bubble. This may well be the single most important question currently hanging over the world economy. Given the fragile state of many economies, the bursting of a housing bubble could easily drag them into recession.
Property is probably the biggest business in the world. By one estimate, construction, the buying, selling and renting of properties and the imputed benefits to owner-occupiers account for around 15% of rich countries'GDP. Property also makes up around two-thirds of the tangible capital stock in most economies. Most important of all, property is by far the world's biggest single asset class. Investors have much more money tied up in property than in shares or bonds (see chart 1).
A lot more people own homes than own shares. In all the big developed economies bar Germany, well over half of all households are home-owners (see chart 2). In most of Europe and Australia, housing accounts for 40-60% of total household wealth, and in America for about 30%. And even in America the typical household on an average income holds six times as much wealth in residential property as in shares.
Yet, curiously, there has been much less economic research into the property market than into the stockmarket, the bond market or the foreign-exchange market. One reason is that until recently much of this property investment was held fairly passively. For most people a home was simply a place to live. For most firms offices were a necessary but relatively unimportant part of their infrastructure. Commercial property made up less than 5% of most institutional investors' portfolios. But now many people, having lost faith in shares, see their home as an investment that will appreciate rapidly in value. Financial institutions are also pushing up the share of commercial property in their portfolios. To both sorts of investor, property seems to offer attractively high returns—as well as a safe haven in an increasingly risky world.
Betting the house
Over the past few years, house prices have been booming almost everywhere except Germany and Japan. Since the mid-1990s, house prices in Australia, Britain, Ireland, the Netherlands, Spain and Sweden have all risen by more than 50% in real terms. American house prices are up a more modest 30%, but that is still the biggest real gain over any such period in recorded history. Commercial-property prices in some big cities have also been looking rather frothy.
These property booms have been partly driven by economic fundamentals, but bubble-like symptoms abound. Real-estate investment has even made it into a TV series, “The Sopranos”. In one recent episode, the wife of Tony, the Mafia boss, suggested he invest in a real-estate investment trust (a fund which enables small investors to buy commercial property). Many viewers took her advice.
Rewards from investing in property in the past are certainly impressive. In Britain, for example, over the past ten years the total return from both commercial and residential property (including rental income) has been well over 10%, beating the return on equities or gilts. Over the past three years, British house prices have risen by 55%, whereas share prices are 40% down.
Over the past ten years, the total return from buying a house (including the implicit rental income) has exceeded the return from shares in half the countries in chart 3. But these figures understate the possible gains from investing in property. Unlike equities, most homes are bought with borrowed money, and the resulting leverage can greatly lift the return on the initial stake (or increase any loss). Suppose you had invested $20,000 in shares, which after five years are now worth $40,000, including reinvested dividends, implying an annual return of 15%. Then suppose you had used the $20,000 as a deposit on a $100,000 house that over five years had risen in value by a more modest 7% a year, to $140,000. Assume, for simplicity, that mortgage-interest payments and maintenance costs exactly offset the rental income. The average annual return on your deposit would have been almost 25%.
In addition, the taxman tends to treat housing far more favourably than financial assets. In most countries, owner-occupiers get tax relief on their mortgage interest payments or first-time buyers get a tax credit, and owner-occupiers are at least partially exempt from capital-gains tax. Admittedly the transaction costs of buying and selling property are high, but on reasonable assumptions the after-tax return from housing over the past decade has exceeded that from shares in most countries.
How long can the party last? Estate agents, builders, lenders, many economists and even Alan Greenspan, chairman of America's Federal Reserve, have all insisted that there is no house-price bubble. Rising house prices, the argument goes, are fully justified by low interest rates, rising real incomes, growing populations and a fixed supply of land. But this sounds a little like the “wall of money” argument used to defend inflated share prices in the late 1990s. Prices had to rise, it was said, because the number of shares in which pension funds could invest their billions was limited. Investors mistakenly came to believe that the traditional link between share prices and profits no longer mattered. Home-owners may be making a similar mistake today.
It is often argued that property is a much safer investment than shares because a share is just a (possibly worthless) piece of paper, whereas bricks and mortar are something tangible. Yet that tells us nothing about their relative value. Bubbles form when the price of any asset gets out of line with its underlying value.
Home prices are not listed daily in the Financial Times, but the same sort of valuation analysis can be applied to houses as to shares. The price you pay for a property should reflect the future rent at which you could let it. The fact that in many countries prices of homes and commercial buildings have been rising much faster than rents should be ringing alarm bells.
Housing is just as prone to irrational exuberance as is the stockmarket. Property is increasingly viewed as an easy way to make money. People buy a home in the expectation that its price will continue to rise strongly over time. Such expectations lie at the heart of all bubbles. Given the boom in the property market over the past few years, at the very least house-buyers betting on further rapid house-price gains are likely to be disappointed. Worse, there is a risk that house prices will take such a tumble that they take whole economies with them.
Vicious cycles
Swings in property prices can have a big impact on economic growth. Since the IT and stockmarket bubbles burst, rising property prices around the globe have helped to prop up the world economy. Rising house prices have boosted consumer spending by making people feel wealthier, offsetting the effect of falling share prices. Consumers have also been able to borrow more against the higher value of their homes, turning capital gains into cash which they can spend on a new car or a holiday. For firms, property is the main form of collateral for borrowing, so swings in commercial-property prices can also influence corporate investment.
But just as rising house prices help to boost spending, so falling house prices can cause economic pain. In an analysis of a number of earlier housing bubbles, the IMF's latest World Economic Outlook found that output losses after house-price busts in rich countries have on average been twice as large as those after stockmarket crashes. The average real decline after a house-price bust has been more modest than after a stockmarket crash (30% over four years against 45% over two-and-and-half years), but at the end of that period GDP had fallen by an average of 8% relative to its previous growth trend, compared with 4% after a share-price bust. The IMF also found that a sharp rise in house prices in real terms is much more likely to be followed by a bust than is a share-price boom.
There are three reasons why a house-price bubble might cause more harm on bursting than a stockmarket bubble. First, house prices have a bigger wealth effect on consumer spending, largely because more people own their homes than own shares. A study of 14 countries by three American economists, Karl Case, John Quigley and Robert Shiller, found that in most economies a change in property prices had at least twice as big an effect on consumer spending as a change in share prices of the same order.
Second, people are much more likely to borrow to buy a home than to buy shares. Some of them inevitably borrow too much and later have to curb their spending. Third, a decline in property prices also leaves some households with homes worth less than the amount they have borrowed, so housing busts have a greater effect on banks, which are typically heavily exposed to real estate. Falling house prices lead to an increase in banks' non-performing loans, and as their collateral shrinks, so does their capacity to lend.
This survey will conclude that the latest housing boom has inflated bubbles in several countries, notably America, Australia, Britain, Ireland, the Netherlands and Spain. Within the next year or so those bubbles are likely to burst, leading to falls in average real house prices of 15-20% in America and 30% or more elsewhere over the next few years, in line with average price declines during past housing-market busts. This time, however, with inflation so low, house prices will fall more sharply in money terms than they did in the past. In Britain as a whole, for example, average nominal house prices are likely to drop by 20-25%, and in London by much more. Significant numbers of owners may be left with homes worth less than their mortgages—especially as the proportion of owner-occupiers with mortgages exceeding 80% of the value of their homes is higher now than it was in the previous bust in the early 1990s.
There are already signs in some cities, such as London, New York and Amsterdam, that the housing market is cooling fast, but estate agents still insist that prices are unlikely to fall by much. Tell that to the couple who bought a four-bedroom house in San Francisco for $2.1m in 2000, then divorced and had to sell the house only two years later for $1.45m.
This survey will conclude that the latest housing boom has inflated bubbles in several countries, notably America, Australia, Britain, Ireland, the Netherlands and Spain. Within the next year or so those bubbles are likely to burst, leading to falls in average real house prices of 15-20% in America and 30% or more elsewhere over the next few years, in line with average price declines during past housing-market busts.
Mortgage rates are still falling but I doubt that trend can continue for much longer. One more year of the refi and new home boom?
Richard W.
Comments and opinions welcome.
Richard W.
I am renting a house at the moment for a reasonable rate. I couldn't fathom paying the market rate. My house would literally sell for close to $325k and it is only 1250 square feet.
I could afford to buy it, but I can't stomach it. It is great for people who invested at the right time, but I am wondering if there are other people like me, who say... gee, I can buy a tiny house in LA for a third of a million, or get myself land and a giant house elsewhere, and still have some change left.
This article is clearly satire. No one at the Economist can misunderstand economics so badly as to make the claims above, without intending them to be humor, anyway.But for those who don't get it, housing prices are determined by SUPPLY AND DEMAND, not by interest rates or high paying jobs.
There are plenty of high-priced homes in Moscow, Beijing, and Tehran where there are no good-paying jobs, and there are high-priced homes in places and times where interest rates are high, too.
Thus, the *reason* home values increase or decrease is NOT due to interest rates or jobs, but due to supply and demand.
Families will move in and live on top of one another before they'll let the right house get away, regardless of how high-priced it might be.
Rats, gotta run- wife & dog are bugging me...
It is going to get really ugly. Too many people doing cash outs and playing with artificially high home prices like they were a checking account. They are going to be stuck with more debt and a declining asset value.
Richard W.
Uh, dude..."Supply" and "Demand" are simply shorthand terms for describing the tradeoffs made at a variety of price levels for any good or service. If the "price" of something (the cost in terms of what you have to give up to get it, also called the opportunity cost)goes down, all other things being equal, the quantity of that thing demanded (in the short run) and possibly, the demand for that thing (in the long run) increases. The reverse when "price" (the cost of the next best alternative use of your resources) goes up.
When the federal govt follows a "low interest" policy, either through direct subsidized intervention in the market (think FreddyMac or FannyMae) or via monetary policy, or indirectly through tax policy (think mortgage deduction), it reduces the cost of capital associated with certain long term aquisitions below that which would exist in a voluntary "free" market. By doing this, it lowers the opportunity cost associated with the purchase of long term or capital assets - like housing. Since the stock of housing is, at any specific point in time relatively fixed, this reduction in opportunity cost will result in an increase in quantity demanded, which will translate into higher prices.
If intervention were not continuous, we might expect an expansion in the supply of housing to result in prices returning to a lower level. But, in the US, intervention has been continuous for many years, generally leading to higher prices and higher supplies than would otherwise exist. Moreover, in some markets (like San Fran, for example) a combination of limited land and excrutiating regulations dramatically limits the ability of the housing stock to expand at all, greatly exacerbating the problem.
I hope that my crummy spelling doesn't get in the way of this clearing up some things. Thank You.
That sounds great, but if interest rates were the sole cause of supply and demand, then we would have had HIGHER home prices back in the 1960's when interest rates were as low or lower than they are today.
Moreover, your theory doesn't explain why housing prices went UP along with interest rates in the 1970's.
In short, that's not how the world works. Nice try though.
You can have HIGH housing prices in areas with truly crummy jobs (e.g. Tehran, Moscow, and Beijing). You can have HIGH housing prices when interest rates are high (e.g. the 1970's), too.
Neither interest rates nor jobs explains the high prices for real estate in San Francisco and Hong Kong.
But "supply and demand" does explain it.
You want to see where real estate prices have dropped? Look for nations that have stagnant or declining populations (e.g. Germany, Japan).
Now, if you want to see where home prices go up, then simply look at areas that are expanding in population.
On the other hand, if your theory can't explain the 1960's and 1970's real estate markets, then why believe it?
What has old Brinker been saying lately?
Richard W.
Nonsense. First of all, we don't even have a national "housing bubble". Bubbles are caused by speculation. There aren't significant numbers of people speculating in houses. Instead, people are buying a home and then, gasp, living in it!
Second, our population is expanding. It's one thing for housing to decline in price when you have a declining population (witness the ghost towns of the Old West in the 1800's), but quite another to claim that housing prices will come down when there are more people being born than homes being built.
Third, we have a new corporate dynamic that hasn't even been considered by the hedge fund gloomsters: tax-free dividends.
What do dividends have to do with real-estate, you ask?
Well, one of the largest groups of dividend paying stocks are REITs. For the uninformed, REITs are Real-Estate Investment Trusts. These are companies that buy real estate, operate some form of business (such as leasing office space) with the real-estate, and then pass the profits (or more than 90% of the profits, at least) all back to the shareholders in the form of dividends.
But as of today, dividends are now exempt from 50% of income taxes, and as of next year, they will be completely tax free. This means that *shareholders* of REITs and other dividend-paying companies are about to see their investments rise, as their after-tax income from these stocks has just ballooned with the stroke of a pen (thank you, President Bush)!
So what does that have to do with real-estate? Well, for starters it means that REITs are going to have an easier time raising money for guess what, MORE real estate purchases.
Sure, we're only looking at a trickle here in 2003, but come 2004 this trickle will be a more respectable stream, and that means that there will be new money chasing real-estate across this great nation.
Tax free income. It's now spelled D I V I D E N D S!
So even if the overall number of people in a given area increases, house prices do not necessarily need to follow.
House prices collapsed in the L.A. area back in the mid-90's even though there was still a net increase in people moving into the state (despite the large number of people leaving.)
If it was a choice between one family in one house or homelessness, then your argument would be entirely valid. But there are a myriad of other choices which could act to dampen the demand on home buying.
Did I miss a detail in the new tax plan? I thought dividends were going to be taxed at a 15% rate (which is still a substantial improvement), and that the tax-free concept was killed in conference committee.
Here in the RTP area of NC, I see a lot of commercial and residential construction going on. I also see a lot of "Space for lease" signs on vacant commercial properties. A lot of empty parking lots.
I'm reminded of Heinlein's novel Door Into Summer where the protagonist gets a job destroying brand new cars built to soak up increased monetary supply.
Inflated money has to go somewhere. For a while it inflated the dot-com bubble. And now?
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