House of cards -- Housing Market Outlook and Commentary

The Economist.com ^ | 5/29/03 | Pam Woodall

[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In many countries the stockmarket bubble has been replaced by a property-price bubble.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.

[arete]

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.

Yeah, I have some relatives up in Cary. Whole office buildings up there unoccupied and yet they keep building. What does that tell you? I'm seeing the same thing down where I live except it is with all these little strip shopping centers. Businesses open and close faster than I change my socks. I wouldn't touch a REIT right now. Just a way for the investment bankers and construction people to offload a bunch of soon to be bad investments on to the sheep.

Richard W.

[mickie]

I agree that 'supply and demand' is at the heart of the matter.

Where I work (30 miles southwest of Philly) there are tons of buyers for every house on the market. That creates multi offers, with homes many times selling above the asking price.

Very difficult to explain to first time buyers.

[jscd3]

Friend

I don't think that I ever said or even implied that interest rates were the "sole" cause of housing price changes. What I did say was that the terms "supply" and "demand" are simply shorthand ways of describing the tradeoff made by buyers and suppliers of a goods or service with respect to their next best opportunity. That's not a "theory", that's the definition.

The rate of interest will clearly impact the cost of aquisition of a long term asset, which will, therefore, raise or lower it's cost relative to the cost of your next best alternative use of resources. Again, not theory, just stating the obvious.

Nowhere here do I say that interest rates are the only thing that affects opportunity costs, only that they are a thing. Historically, though, they have been a pretty important thing; that's why the government is always intervening in the interest rates market. Ya see?

Since I was specifically addressing a comment you made (ineterst rates and salaries don't matter, only supply and demand) by pointing out that things like interest rates and salaries are in fact components of those functions that we call supply and demand, I'm not really sure what "theory" you are attacking here...since interest rates affect costs (and therefore can affect what your next best use of resources are) and since salaries impact the amount of resources available to the buyer (and once again, your options, as well as the total amount that you can aquire) it should be pretty obvious that these are pretty big factors in the "supply and demand" for housing.

Housing prices increased during the 60's and 70's due to a combination of :

1. Increase in the size of the population that was the age to buy houses
2. increase in the wealth of these individuals due to productivty gains of an expanding economy (higher salaries)
3. An active policy of the Federal Govt to encourage home ownership through subsidizing mortgage interest rates and intervention in the mortgage market
4. and, especially in the 70's, inflation, the devaluation of the value of the dollar. Since inflation reduces the purchasing power of the dollar, all dollar denominated goods and services will rise in nominal (but not necessarily real ) value. Moreover, once people start to think that inflation will continue or maybe get worse (pretty common thinking in the 70's) there will be a rush to aquire long term dollar denominated assets that can be funded via a fixed interest rate instrument (particularly when the inertest rate is being subsidized and is tax deductible). Debtors are big winners when there is unexpected inflation. Like George Gilder noted in Wealth and Poverty, during the 70's, a house was an inflation hedge and tax shelter that you could live in.

Frankly, most of the rest of your comments are sort of spurious. If costs of housing is "high" in a city (that is, a lot of really highly valued alternatives are being sacrificed to aquire a home) than clearly the resources to drive those prices high must be available. Right? If the resources weren't, then there wouldn't be anyone buying the property to begin with. Right?

Alternatively, if people don't have many (or any) real alternatives to buying a home (I can't imagine this, but bear with me), than the opportunity cost is low and the real cost (in terms of alternatives sacrificed) will be low, irrespective of what the nominal "price" is. You do see that, don't you?

As far as Hong Kong, you are talking about a very wealthy place (much higher per-capita income than England, for example,at least until recently) which suffers from an extremely limited supply of land. Because of this, the price will be bid up by those individuals with the highest value uses (and, consequently, the highest opportunity cost). If someone wanted the prices to go even higher, all they would have to do is subsidize the interest rate paid by propert owners, since, in the short run, "costs" would decline, but not the value of alternatives, meaning that prices could (and would) be bid even higher.

Japan is an example of housing prices reflecting an extreme combination of limited land and government intervention in the mortgage market - I think mortgages there might have been as low as 2-3%. Prices there absolutely ballooned through the 70's and 80's...then crashed. No matter what your interest rate policy is, you can't pump up the price of an asset forever. You do realize that Japan is a text book case of the long term impact of government interest and credit policies on the real estate market, don't you?

With respect to San Fran, I specifically noted in my comments the affects of government regulation and restricted land limiting the ability of the housing stock to expand. And yes, people do pay for those high property costs with the incomes they earn, with late arrivers paying an effective premium while early arrivers receive an affective wealth transfer from the new comers. As a side note, I've been to SF, it's a pretty place; but you'ld have to be a lunatic to pay those prices to live there...either that or you don't perceive yourself as having many high value alternative uses for your wealth, in which case the real price to you in terms of opportunity cost is not high. See what I mean?

None of this is "theory", it's just straight forward economics 101...you know, like supply and demand.:>)

Things possibly working against the housing market in the US are:

1. The perception that interest rates may be going higher. Higher rates would increase the "cost" of the home and, consequently, drive down prices (maybe)
2. Declining real incomes. I could be wrong, but I believe that mean, median, and modal individual incomes have, after inflation, been declining since 1990. Aquisition overall in the 90's was not so much fueled by individual salary growth (in real terms) as it was by the unprecedented percentage of households with both spouses working full time. With a slowing economy, the two income strategy for attacking declining individual income runs into problems.
3. Demographics. Just as the baby boom boosted demand for housing, a decline in the population age groups looking to buy homes would pressure prices downward, assuming that there is no higher value alternative use for the property.

Oh well, bed time for me. Thanks for the opportunity to engage in a little basic economics core-dumping.

[Southack]

"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."

The last thing that I read was that the dividend tax was cut in half in 2003 (down to 15% from 30%) and then down to zero in 2004, but who knows what made the final print in the Federal Register.

[Southack]

"If house prices get so high that either a person has to choose between mortgaging themselves to the brink of economic collapse or commuting for hours, then they can make other choices. For example, they can move to another city or they can live in an apartment, or they can share space with someone else."

You're making the same argument as I am, in that it still comes down to population. When enough people move OUT, then sure, housing prices can fall, but if only a minority of people leave compared to those arriving, it's pretty tough for home prices to decline.

The "bath" that real-estate took in California in the 1990's and in Texas in the 1980's saw less than 20% home price drops, all of which have been more than made up for by those who continued to hold onto their possessions until times got better, for instance...

[festus]

;You want to see where real estate prices have dropped?
;Look for nations that have stagnant or declining
;populations (e.g. Germany, Japan).

Prices do drop outside of population variations, but these drops tend to be cycles on the overall trend line. So your point is valid.

The little things like SARS, other infectious diseases, etc. are probably the single largest threat to the US realestate market next to nuclear assaults. The reason of course is that it would result in a declining population.

Consider what happened to Europe's population when it was ravaged by some diseases in the past.

I'm not claiming the sky is falling. I'm still putting money into realestate. I'm just watching my debt to asset ratio and ensuring I can absorb a large drop in price and rents and still remain solvent.

[Tauzero]

" On the other hand, if your theory can't explain the 1960's and 1970's real estate markets, then why believe it?"

Sure it does.

You're just confusing real and nominal rates.

[glorgau]

As a side note, I've been to SF, it's a pretty place; but you'ld have to be a lunatic to pay those prices to live there...either that or you don't perceive yourself as having many high value alternative uses for your wealth, in which case the real price to you in terms of opportunity cost is not high. See what I mean?

True. In the Sacramento area there is significant anecdotal evidence of many people "cashing out" from the Bay Area and getting 3 or 4 houses for the the price of one house. In the housing development where I bought a house 2 years ago, approx. 30 of the 93 homes were bought by "speculators" - those who planned to sell or rent. All the houses are in the 300K range now. The bubble is holding - as an example, I refinanced, reappraised, lost the PMI and saved $600 a month in payments! But all that momentum will go away when rates go up. From a political perspective, I'd guess that rates won't be raised before June or August 2004. A whole lot of those "extra houses" will be left earning their owners negative cash flow if they don't have the interest rates locked in.

[AdamSelene235]

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.

Not quite. REITs already evade dividend taxes by providing "return of capital", a income category distinct from dividends. REITs should be hurt by the tax plan as other dividend yielding stocks will now be more competitive. The WSJ has been saying this for months. You already know what I think of the real estate market.

[AdamSelene235]

Nonsense. First of all, we don't even have a national "housing bubble". Bubbles are caused by speculation

Where I live I know welfare moms and supermarket clerks who hold multiple homes for purposes of speculation. One welfare mom holds probably around 750K in real estate. I make about 3X the average salary and am priced out of the market.

[HamiltonJay]

Portraying the housing market like the stock market at its very basis is a flawed comparisons. Sections of the housing market boom or bust all the time, geographical regions boom and bust independently of the overall market. The boom and bust in texas in the 80s, and boston, and currently in Silicon Valley/San Fran!

Housing is largely a regional market, that are all different. Various towns go through booms or busts independent of national trends... a big employer moves in, boom, an established large employer leaves bust....

If you live in a modest area, like say the rust belt, pittsburgh, cleveland, cincinatti, or most other areas, there has been no real boom, and there will be no real bust. The only bubble in these markets will center around the newer built homes that are now and have been vastly overpriced for years. If interest rates rise sharply, or employment dips this segment will get hit hardest, because buyers will chose the more modest homes over these bohemoths. In the markets I am talking about typical nice homes are in the 70-120 range, and their appreciation is not large over time, a few percent a year on average, and in down times they tend to just flatten, not fall. Newer built homes in these markets will fall drastically, but their overall markets will remain stable.

Places like NYC, LA, SF Bay area and the like will see busts, but many of them saw unrealistic booms where prices were going up 20-30% per year... thats clearly bubble and will pop. In most of the nation, at best modest corrections at the high end will happen, or flatlining.. but not massive deflation in home values.

That's my .02 cents.

[Southack]

"Not quite. REITs already evade dividend taxes by providing "return of capital", a income category distinct from dividends. REITs should be hurt by the tax plan as other dividend yielding stocks will now be more competitive."

You've missed the point of the tax cut: it reduces the tax that the SHAREHOLDERS now pay on dividends.

Back on your 2002 income tax, you had to pay as much as 30% income tax on all of the personal dividends that your stocks paid to you (even if your income came from REITs).

Now in 2003 the cap is reduced to 15%, and in 2004 there will be NO TAX left on your dividend income.

The REIT tax exemption was and is on CORPORATE profits, *not* on what you file on your own personal income tax form. That tax exemption is still in place.

This means that REIT corporations continue to pay NO TAXES on 90+% of their income, and now it further means that shareholders of those REITs pay no more than 15% income tax on those dividends this year (followed by paying absolutely no income tax on those dividends next year).

I.E. we've gone from DOUBLE TAXATION to NO TAXATION, at least in the case of REITs and their shareholders.

And that means that you've grossly miscalculated what will happen to REIT (and other dividend paying stocks) valuations in the future, along with miscalculating the effect that this tax cut will have on future real estate prices.

[Southack]

"Where I live I know welfare moms and supermarket clerks who hold multiple homes for purposes of speculation. One welfare mom holds probably around 750K in real estate. I make about 3X the average salary and am priced out of the market."

Sounds like you just need to be on welfare to be rich!

But seriously, the Average American family brings home $46,000 per year (2 family earners), which is roughly $4,000 per month (most of which is tax-free under Bush's new tax plan, too). The Median family home costs $163,000, which means a mortgage payment of between $840 up to $1,080.

That's not "bubble" territory. Americans AREN'T priced out of their own housing market. $4k per month can easily afford an $840 per month mortgage payment, so we aren't seeing people being priced out of the entire housing market.

If you make 3X what the average family earns, then you can easily afford to live in a $500k home. That hardly prices you out of the housing market, as some homes still manage to sell for less than half a million in even the priciest of hot, booming home markets.

[AdamSelene235]

But does the average income and the average home value happen in the same place? In San Fran, Denver, Boston, and many other places, these numbers are waaay out of whack.

Most high end jobs are in places where the housing markets are distorted. The obvious solution is to move the jobs but this is a slow process.

[AdamSelene235]

REIT Horror Show, Forbes Magazine

[Southack]

"And under the Bush plan, there almost certainly won't be any tax cut for REIT dividends.

Says Stuart Seeley, head REIT analyst at UBS Warburg and a master of understatement: Bush's proposal "may be a negative for the REITs." David Shulman, who runs real estate research at Lehman Brothers, puts it more plainly: Even a watered-down version of Bush's plan "looks likely to the detriment of REITs. It is a big deal." Shulman believes many REITs could ultimately choose to lower their dividends and convert to ordinary taxable corporations.

The thinking is simple. REITs aren't getting an effective 50% hike in dividend yields. But other stocks would. So any investor who'd been holding REITs primarily for the dividend income would bail out."

The thinking is simple minded, not simple.

Had the Bush tax cut actually left REITs in a bad position, those corporations would simply refile their tax returns as C Corporations (which would insure that they got the tax break for their shareholders).

Apparently even Forbes has uneducated liberals hidden amongst their staff.

[Southack]

REIT

NYSE: NFI

[who_would_fardels_bear]

Maybe the average home price drop was 20%, but there were some houses that dropped by as much as 50% or more.

This is happening right now in Colorado. Of course in Colorado they are increasing the supply at a rapid rate while the economy is in the tank.

But in any case, the article specifically mentioned supply and demand rather than just basing assumptions on interest rates, so we are all in agreement. The article specifically mentioned rents as a key indicator of whether or not a bubble is about to burst. Last year when I moved to California it was tough to get an apartment without agreeing to a 1 year lease. This year, there are more and more offers of "one month's free rent" and other enticements. There's even one place that is providing in-home full-up entertainment centers for use by prospective renters.

Finally, I am starting to notice an increase in advertising for negative amortization home loans. This happened before the beginning of the last price collapse: lots of people so desparate to get into the house market that they will sign up for anything in hopes of cashing in on the gravy train. Like all the lemmings that bought CMGI at $100/share because it was certain to go up to $200 ... Not!

[ambrose]

I'm with you. Here's a typical Los Angeles real estate "bargain"...

[ambrose]

I'm with you. Here's a typical Los Angeles real estate "bargain"...

http://visitors.themls.com/search/profile_page.cfm?mls=03-018631&property_type=0&pass_la=Logan%2C%20Rodney