International
Global House Price Boom: The greatest BUBBLE in history
By Finfacts Team
Jun 19, 2005 - 8:13 PM

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The US National Association of Realtors says that in the Washington area, more than a third of homebuyers are using interest-only loans, up from about 2 percent just five years ago
The Economist
magazine says that never before have real house prices risen so fast, for so long, in so many countries. Property markets have been frothing from America, the UK 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 it asks?

According to its estimates, the magazine says that 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. The surge not only dwarfs 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). The Economist says that the rise looks like the biggest bubble in history.

The house price boom has been driven by historically low interest rates and the move from stocks in the aftermath of the tech dominated bubble bust. Optimists say that prices will ease rather than plunge but past evidence shows that a bust is more likely with serious implications for the world economy.

The Economist says that 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.

Prices are cooling or falling. In Australia, official figures show that the 12-month rate of increase in house prices slowed sharply to only 0.4% in the first quarter of this year, down from almost 20% in late 2003. The magazine says that wishful thinkers call this a soft landing, but another index, calculated by the Commonwealth Bank of Australia, which is based on prices when contracts are agreed rather than at settlement, shows that average house prices have actually fallen by 7% since 2003; prices in once-hot Sydney have plunged by 16%.

In the UK, the Nationwide index, used by The Economist, rose by 5.5% in the year to May, down from 20% growth in July 2004. However, the Royal Institution of Chartered Surveyors (RICS) reports that prices have fallen for ten consecutive months, with a net balance of 49% of surveyors reporting falling prices in May, the weakest number since 1992 during the UK's previous house-price bust. The volume of sales has slumped by one-third compared with a year ago as both sellers and buyers have lost confidence in house valuations. House-price inflation has also slowed significantly in Ireland, the Netherlands and New Zealand over the past year.

The Economist says that since 1997, home prices in most countries have risen by much more in real terms (ie, after adjusting for inflation) than during any previous boom. (The glaring exceptions are Germany and Japan, where prices have been falling.) American prices have risen by less than those in Britain, yet this is still by far the biggest boom in American history, with real gains more than three times bigger than in previous housing booms in the 1970s or the 1980s.

The magazine says that compelling evidence that home prices are over-valued in many countries is the diverging relationship between house prices and 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.

Calculations by The Economist show that house prices have hit record levels in relation to rents in America, Britain, Australia, New Zealand, France, Spain, the Netherlands, Ireland and Belgium. This suggests that homes are even more over-valued than at previous peaks, from which prices typically fell in real terms. House prices are also at record levels in relation to incomes in these nine countries.

America's ratio of prices to rents is 35% above its average level during 1975-2000. By the same gauge, property is "overvalued" by 50% or more in the UK, Australia and Spain. Rental yields have fallen to well below current mortgage rates, making it impossible for many landlords to make money.

To bring the ratio of prices to rents back to some sort of fair value, The Economist says that either rents must rise sharply or prices must fall. After many previous house-price booms most of the adjustment came through inflation pushing up rents and incomes, while home prices stayed broadly flat. But today, with inflation much lower, a similar process would take years. For example, if rents rise by an annual 2.5%, house prices would need to remain flat for 12 years to bring America's ratio of house prices to rents back to its long-term norm. Elsewhere it would take even longer. It seems more likely, then, that prices will fall.

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. However, the magazine says that 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 the UK, real after-tax interest rates are not especially low by historical standards.

Ireland and the US

In Ireland, according to Davy Stockbrokers:

  • Construction's share of employment in the Irish economy has soared over the last decade. Building now accounts for 22% of GNP and 12% of employment in the economy.

  • Housebuilding is now more important to the Irish economy than other building (e.g. office blocks, industrial estates, roads, schools and hospitals).

  • Building accounts for a greater share of employment and expenditure in Ireland than in other developed economies.

  • Over 40% of houses built in the past two years are lying vacant as second homes, holiday homes or unlet investment properties.

In the US, a National Association of Realtors (NAR) study found that 23% of all American houses bought in 2004 were for investment, not owner-occupation. Another 13% were bought as second homes. The Economist says that investors are prepared to buy houses they will rent out at a loss, just because they think prices will keep rising "the very definition of a financial bubble. "Flippers" buy and sell new properties even before they are built in the hope of a large gain. In Miami, as many as half of the original buyers resell new apartments in this way. Many properties change hands two or three times before somebody finally moves in.

The NAR says that 42% of all first-time buyers and 25% of all buyers made no down-payment on their home purchase last year. In the Washington area, more than a third of homebuyers are using interest-only loans, up from about 2 percent just five years ago.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. In California, over 60% of all new mortgages this year are interest-only or negative-amortisation, up from 8% in 2002. The national figure is one-third. The new loans are essentially a gamble that prices will continue to rise rapidly, allowing the borrower to sell the home at a profit or refinance before any principal has to be repaid.

If America's largest banks become the nation's largest real estate brokers, homebuyers will be much more likely to take out high risk interest-only loans, the National Association of Realtors testified on Wednesday at hearings called by US Rep. Mike Oxley (R-Ohio), an advocate of allowing banks into real estate. "All the firewalls in the world won't cool off the zeal of the money-center lenders trying to sell their most profitable loans to people who should not be taking such risks. If lenders were to become real estate brokers, nothing will stand in their way," NAR President Al Mansell, CEO of Coldwell Banker Residential Brokerage in Salt Lake City, told the House Financial Services Committee.

Last week Federal Reserve Chairman Alan Greenspan expressed concern that the growing use of riskier new mortgages is helping push up home prices to "unsustainable levels" in some local markets. He stated that, "The dramatic increases in the prevalence of interest-only loans, as well as the introduction of other relatively exotic forms of adjustable-rate mortgages, are developments of particular concern."

NAR recently launched a new consumer education campaign to help consumers, particularly those with credit problems, avoid the pitfalls of "toxic" loans and abusive lending practices.

The Economist says that the rapid house-price inflation of recent years is clearly unsustainable, yet most economists in most countries (even in Britain and Australia, where prices are already falling) still cling to the hope that house prices will flatten rather than collapse. It is true that, unlike share prices, house prices tend to be somewhat "sticky" downwards. People have to live somewhere and owners are loth to accept a capital loss. As long as they can afford their mortgage payments, they will stay put until conditions improve. The snag is that eventually some owners have to sell "because of relocation, or job loss" and they will be forced to accept lower prices.

The magazine says that contrary to conventional wisdom, it does not require a trigger for prices to collapse, such as a big rise in interest rates or unemployment, for house prices to decline. British home prices started to fall in the summer of 2004 after the Bank of England raised rates by a modest one and a quarter percentage points. Since 2002, the Reserve Bank of Australia has raised rates by exactly the same amount and unemployment is at a 30-year low, yet home prices have fallen. The Federal Reserve's gradual increase in rates by two percentage-points over the past year has done little to scare away buyers, because most still have fixed-rate mortgages and long-term bond yields have remained unusually low.

House Price and Global Economic Growth

The risk for the world economy is that over the past four years, US consumer spending and residential construction have together accounted for 90% of the total growth in GDP. And over two-fifths of all private-sector jobs created since 2001 have been in housing-related sectors, such as construction, real estate and mortgage broking.

In a paper for the International Monetary Fund, Housing price bubbles - a tale based on housing price booms and busts, Thomas F Helbling says that the recent equity price bust has been a forceful reminder of how dramatic asset price reversals and their implications can be. The paper examined the main empirical regularities of housing price booms and busts in 14 industrial countries during 1970-2001. The evidence suggests that while housing price busts are infrequent events, they nevertheless occur frequently enough to be of great concern to policymakers and investors alike. Like other asset prices, housing prices do sometimes decline, especially when they are adjusted for general consumer price increases, notwithstanding frequent claims to the contrary. However, booms and busts are not as closely connected, as it is widely believed. Depending on the metric used to identify booms, only between two fifths and two thirds of all housing price booms in the sample ended in a bust. The paper also established that large housing price increases over several years need not be good indicators of forthcoming busts. Relatively rapid increases over a short period of two years or less appear to be better but still imperfect indicators. Housing price busts coincided with sharp slowdowns in economic activity and, in all but one case, with outright recessions. They are thus costly from a welfare point of view.

During housing price busts, inflation-adjusted housing prices fell by about 27 percent. Strikingly, with about four years, busts lasted much longer than average bear markets. As in the case of booms, the research implies roughly one and a half busts per country over three decades or one bust in 20 years. However, the experience across countries varied considerably. Three countries, the United States, Belgium, and New Zealand, did not record any housing price crashes during 1970-2001.  Others, including the United Kingdom, Sweden, and Switzerland experienced three busts. If the cumulative housing price increase for the eight quarters up to a peak is used as a metric, roughly two thirds of all booms ended in a bust.

Helbling  says that the evidence from the busts in the sample clearly suggests that housing price busts in industrial countries were associated with substantial negative output gaps, as real GDP growth decreases noticeably. On average, the output level three years after the beginning of a housing price bust was about 8% below the level that would have prevailed with the average growth rate during the three years up to the bust (about 6% if the average growth rate for all housing price bull markets were used).

The lower panel of Figure 3 shows the effects on economic activity of housing price bear markets more generally. Comparing output behaviour by quartiles of the price declines corroborates the notion that housing price busts are different when it comes to their association with economic activity. The output level three years after the beginning of a bear market in the lower middle quartile (that is, price declines in the quartile immediately above that for busts) is roughly where it would have been with the average growth rate during the three years prior to a bust, suggesting that regular housing price bear markets should not be of great concern to policymakers or investors.

During house price busts, inflation-adjusted housing prices fell by about 27 percent.

The link between house purchase and consumer spending has been highlighted in a research paper published in the Bank of England's quarterly bulletin on June 20, 2005.

Britons are two to three times more likely to buy durable goods when they move home, suggesting big changes in housing turnover could alter the outlook for spending.

The study, coincides with mounting evidence of a UK retail spending slowdown led by falls in household durable goods sales and a pronounced decline in property market transactions.

"People are much more likely, around two to three times, to buy certain durables, especially white goods, when they move home," the article, by Andrew Benito and Rob Wood at the BoE's structural economic analysis division, said.

"The effect is likely to be largely due to households bringing forward durables purchases to coincide with the house move. But the impact on aggregate consumption of a change in housing transactions is likely to be moderate."

Housing turnover is down about a third while mortgage approvals, often viewed as a good indicator of the strength of the housing market six months out, are also down about the same from their recent peak.

But Benito and Wood argue that the sudden rise in durables spending when housing transactions pick up is usually just a reallocation of spending from lifetime resources that would otherwise have taken pace more smoothly over time.

Q1  2005 Q1 2004 1997
-2005
one year earlier
South Africa 23.6 28.1 244
Hong Kong 19.0 17.4 -43
Spain 15.5 17.2 145
France 15.0 14.7 87
New Zealand 12.5 23.3 66
US 12.5 8.4 73
Denmark 11.3 6.0 58
Sweden 10.0 7.7 84
China 9.8 7.7 na
Italy 9.7 10.8 69
Belgium 9.4 8.8 71
Ireland 6.5 13.2 192
UK 5.5 16.9 154
Canada 5.2 5.7 47
Singapore 2.0 -1.5 na
Netherlands 1.9 5.5 76
Switzerland 1.0 3.4 12
Australia 0.4 17.9 114
Germany -1.3 -0.8 -0.2
Japan -5.4 -6.4 -28
Source; The Economist

"Since moving home does not increase those resources, and in particular does not do so for the economy as a whole, then housing transactions can only provide a short-term stimulus to spending," the paper said.

"This suggests that any pronounced change in the number of housing transactions could alter the short-term profile for spending, but not its profile in the medium term."

The research found that 47 per cent of people moving house bought new white goods, compared with 19 per cent of people who stayed where they were.

The article's research was based on data from the Office for National Statistics as well as disaggregated survey data from the British Household Panel Survey, an annual survey broadly representative of the population.

The Economist says that 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. The magazine says that 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.

Download reports (in pdf format):

Housing price bubbles - a tale based on housing price booms and busts and other papers

Irish economy Construction risk manageable - Davy Stockbrokers


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