Affordable Housing Institute : US

As an equal-time counterpoint to a previous blog post about Harvard’s State of the Nation’s Housing study showing strong home-price fundamentals, we present the Economist, which refreshingly cuts through the newspaper blather shrieking “housing bubble” with a reasoned and statistics-heavy global survey of home prices and a soberly dour editorial that indeed opens with a curious bit oxymoronic reasoning:

 

PERHAPS the best evidence that America’s house prices have reached dangerous levels is the fact that house-buying mania has been plastered on the front of virtually every American newspaper and magazine over the past month.

 

Unreasoning panic is reason to panic?

 

 

Disdaining the bubble and froth metaphors many superficial stories have used –

 

That’s bubble and squeak to you

 

– the Economist first offers an uncaptioned visual metaphor –

 

 

– and then launches into a fact-based investigation of the unprecedented and uncertain market we find ourselves enjoying:

 

 

 

 

1.         House price are at remarkable levels relative to past norms

 

The Economist starts with the unquestionable: home prices have enjoyed an unprecedented rise:

 

NEVER before have real house prices risen so fast, for so long, in so many countries. Property markets have been frothing from America, Britain and Australia to France, Spain and China. Rising property prices helped to prop up the world economy after the stockmarket bubble burst in 2000. What if the housing boom now turns to bust?

 

Property prices are powerfully influenced by interest rates, and we have been enjoying a decade of low and stable rates, but the rise in ownership values has outstrips its cousin, that of rental property:

 

The most compelling evidence that home prices are over-valued in many countries is the diverging relationship between house prices and rents.  [Chart 1]

 

Chart 1: House prices have risen much faster than rents

 

The ratio of prices to rents is a sort of price/earnings ratio for the housing market. Just as the price of a share should equal the discounted present value of future dividends, so the price of a house should reflect the future benefits of ownership, either as rental income for an investor or the rent saved by an owner-occupier.

 

America’s ratio of prices to rents is 35% above its average level during 1975-2000 (see chart 1). By the same gauge, property is “overvalued” by 50% or more in Britain, Australia and Spain.

 

The divergence of futures has led to two curious and a-historical consequences:

 

In many countries, renting is cheaper than buying, which means that buyers are making a fairly sizable bet on future appreciation in home prices, and meanwhile:

 

Rental yields have fallen to well below current mortgage rates, making it impossible for many landlords to make money.  

 

All this bespeaks a tenure shift, with homeownership gaining market share at the expense of rental.  That’s fine in the US, where roughly 31% of all tenures are rental, but in markets with only a narrow private rented sector (like Ireland, Britain, and much of continental Europe except Germany), too many first-timers chasing too few new homes has led to a frenzied mindset.

 

2.         Housing asset value runup has been powering the global economy

 

This too is undeniable:

 

According to estimates by The Economist, the total value of residential property in developed economies rose by more than $30 trillion over the past five years, to over $70 trillion, an increase equivalent to 100% of those countries’ combined GDPs.

 

Not only does this dwarf any previous house-price boom, it is larger than the global stockmarket bubble in the late 1990s (an increase over five years of 80% of GDP) or America’s stockmarket bubble in the late 1920s (55% of GDP).

 

As I blogged a few days back, at least in America’s case, this has been an anticipated byproduct of the Fed’s stimulating monetary policy:

 

Over the past four years, [US] consumer spending and residential construction have together accounted for 90% of the total growth in GDP.

 

So what is driving housing up?

 

3.         What is driving the price rise?

 

As the Economist puts it:

 

The global boom in house prices has been driven by two common factors: historically low interest rates have encouraged home buyers to borrow more money; and households have lost faith in equities after stock markets plunged, making property look attractive. Will prices now fall, or simply flatten off? And in either case, what will be the consequences for economies around the globe? The likely answers to all these questions are not comforting.

 

Boiled down to its essence, the price rise has been driven by two things:

 

1. People think homes are a good investment.
2. Capital markets are rapidly innovating to get more people into home investment.

 

Each is fine by itself, but together they are more combustible.  If you push too much debt into the hands of people with too little equity, their eyes may be bigger than their stomachs, and they may stretch for too much hard debt:

 

New, riskier forms of mortgage finance also allow buyers to borrow more. According to the National Association of Realtors, 42% of all first-time buyers and 25% of all buyers made no down-payment on their home purchase last year. Indeed, homebuyers can get 105% loans to cover buying costs. And, increasingly, little or no documentation of a borrower’s assets, employment and income is required for a loan.

 

Not only is the leverage high, the interest rate is more volatile:

 

Such loans are usually adjustable-rate mortgages (ARMs), which leave the borrower additionally exposed to higher interest rates. This year, ARMs have risen to 50% of all mortgages in those states with the biggest price rises.

 

Access to cheap capital with low cost of entry encourages those who already occupy one home to buy another as an investment:

 

A study by the National Association of Realtors (NAR) found that 23% of all American houses bought in 2004 were for investment, not owner-occupation.  Another 13% were bought as second homes. 

 

Shifting from user-think to trader-think really increases the risk of impulsive action, which encourages price volatility, both up and down.

 

4.         Is this price rise merely cyclical, or could there be a genuine paradigm shift?

 

In any asset rise, there are some who say that what goes up must come down:

 

Robert Shiller, a Yale economist, who has just updated his book “Irrational Exuberance” (first published on the eve of the stockmarket collapse in 2000), disagrees. He estimates that house prices in America rose by an annual average of only 0.4% in real terms between 1890 and 2004.

 

Customers think interest rates are low — but are they?

 

A common objection to this analysis is that low interest rates make buying a home cheaper and so justify higher prices in relation to rents.  But this argument is incorrectly based on nominal, not real, interest rates and so ignores the impact of inflation in eroding the real burden of mortgage debt.  If real interest rates are permanently lower, this could indeed justify higher prices in relation to rents or income.  For example, real rates in Ireland and Spain were reduced significantly by these countries’ membership of Europe’s single currency—though not by enough to explain all of the surge in house prices. But in America and Britain, ‘real’ after-tax interest rates are not especially low by historical standards.

 

Customers, however, perceive interest costs and inflation quite differently.  Inflation is ethereal, connected predominantly to the cost of goods (and their annual salary raises), whereas interest cost is direct, tangible, monthly.  Low nominal rates with low inflation encourage high-leverage investment.

 

As more Americans have been resorting to ARMs, so the housing market is becoming more vulnerable to rising rates.

 

But might interest rates stay low?  Improbably, the capital markets think so, because the yield curve is flat.

 

It’s certainly within the realm of economic plausibility that we have seen a historic shift in terms of taming runaway inflation and moving a larger proportion of the population into homeownership as part of a conscious wealth-building strategy.  Indeed, such a conclusion would seem implied by Hernando de Soto’s oft-cited thesis (best described in his book The Mystery of Capital) regarding the value of liberating ‘dead capital’. 

 

5.         Which correction: inflation up, or prices down?

 

If house prices are over-inflated — and that is a big if – how will the prices correct?  Once again, there are only two choices:

 

1. Inflation rises.
2. Prices drop.

 

Which would you recommend?  They’re both nasty:

 

Indeed, a drop in nominal prices is today more likely than after previous booms for three reasons:

 

1.       Homes are more overvalued

2.       Inflation is much lower

3.       Many more people have been buying houses as an investment

 

If house prices stop rising or start to fall, owner-occupiers will largely stay put, but over-exposed investors are more likely to sell, especially if rents do not cover their interest payments.

 

House prices will not collapse overnight like stock markets—a slow puncture is more likely.

 

“Could you help me, Mr. Greenspan?”

 

6.         Even a slow decline could be ugly too

 

Over the next five years, several countries are likely to experience price falls of 20% or more.

 

The fall will not happen all at once:

 

Many people protest that house prices are less vulnerable to a meltdown. Houses, they argue, are not paper wealth like shares; you can live in them. Houses cannot be sold as quickly as shares, making a price crash less likely. It is true that house prices do not plummet like a brick. They tend to drift downwards, more like a brick with a parachute attached. But when they land, it still hurts.

 

“What color is my parachute?”

 

But even if the house price decline is slow, any extended fade would really drag down the developed economies:

 

All but one of those housing busts [over the last thirty years] led to a recession, with GDP after three years falling to an average of 8% below its previous growth trend.  

 

7.         Prices are already cooling in some markets that may be harbingers for America

 

A doom scenario is always best offered while things are improving, which the Economist concedes:

 

Our latest quarterly update shows that home prices continue to rise by 10% or more in half of the countries (see table).

 

 

America has seen one of the biggest increases in house-price inflation over the past year, with the average price of homes jumping by 12.5% in the year to the first quarter.

 

In Europe, prices have long been at dizzy heights in Ireland and Spain, but over the past year have also spurted at rates of 9% or more in France, Italy, Belgium, Denmark and Sweden. Both France (15%) and Spain (15.5%) have faster house-price inflation than the United States.

 

Meanwhile, not everybody is prospering — indeed, Germany and Japan are in the doldrums:

 

Japan provides a nasty warning of what can happen when boom turns to bust.  Japanese property prices have dropped for 14 years in a row, by 40% from their peak in 1991. Yet the rise in prices in Japan during the decade before 1991 was less than the increase over the past ten years in most of the countries that have experienced housing booms (see chart 3).

 

 

Chart 3: Will the Anglosphere follow Japan?

 

It is surely no coincidence that Japan and Germany, the two countries where house prices have fallen for most of the past decade, have had the weakest growth in consumer spending of all developed economies over that period. Americans who believe that house prices can only go up and pose no risk to their economy would be well advised to look overseas.

 

Meanwhile, two of the three just cited are already showing weakness:

 

Prices are already sliding in Australia and Britain. America’s housing market may be a year or so behind.

 

Here the Economist may be indulging in rorschach cyclicality, as the curves do not seem visibly phase-delayed:

 

Chart 2: Does America’s line look like Britain’s and Australia’s?

 

Setting that aside, there’s no question the markets are cooling in Britain and Australia:

 

British first-timers now account for only 29% of buyers, down from 50% in 1999. And, according to the National Association of Estate Agents, buy-to-let purchases are running 50% lower than a year ago. As prices become more and more heady in America, the same will happen there.

 

Nevertheless, there are significant differences between America

 

America has faster population growth than Britain, but its supply of housing has also been rising rapidly.  Economists at Goldman Sachs point out that residential investment is at a 40-year high in America, yet the number of households is growing at its slowest pace for 40 years. This will create excess supply.

 

Indeed, America is unlikely to be next in line, as the Eurozone is more vulnerable:

 

Both France (15%) and Spain (15.5%) have faster house-price inflation than the United States.

 

8.         There are reasons to be worried

 

Even if America’s housing market roars along (and remember, home buying runs on an annual seasonal cycle, so it’s naturally going to cool this fall and winter), the dynamics could change even without a sharp shock:

 

The lesson from recent experience in Australia, Britain and the Netherlands is that, contrary to conventional wisdom, a big rise in interest rates is not necessary to make house prices falter. This is bad news for America. Even if prices there initially just flatten rather than fall, this will hurt consumer spending as the impulse to borrow against capital gains disappears.

 

Home-price downturns can be quite painful and enduring:

 

Another sobering warning is that after British house prices fell in the early 1990s, it took at least a decade before they returned to their previous peak, after adjusting for inflation.

 

9.         Government has limited strategies

 

All of this means it’s reasonable for policy makers to be concerned:

 

No wonder that the Federal Reserve is starting, belatedly, to fret about house prices.

 

By holding interest rates low for so long after equities crashed, the Fed helped to inflate house prices. This prevented a deep recession, but it may have merely delayed the needed economic adjustments.

 

“What do I do for an encore?”

 

Even if we agree something should be done, what might that be?  Government is a factory with only two tools, one of which is blunted:

 

In 2000, America had a budget surplus. Today it has a large deficit, ruling out big tax cuts.

 

If pumping money into the system doesn’t help, there are no laws that can prevent falling markets from clearing. 

 

The whole world economy is at risk. The IMF has warned that, just as the upswing in house prices has been a global phenomenon, so any downturn is likely to be synchronised, and thus the effects of it will be shared widely. The housing boom was fun while it lasted, but the biggest increase in wealth in history was largely an illusion.

 

All of this would be more persuasive, of course, if the Economist had not been sounding the same alarms three years ago:

 

That’s what the charts showed three years ago; compare with the one above!

 

Will the housing economy land safely, or will it crash?

 

 

Governments ignore home price collapse at their peril. 

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