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?
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). In other words, it looks like the biggest
bubble in history.
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 stockmarkets 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.
The increasing
importance of house prices in the world economy prompted The Economist
to start publishing a set of global house-price indices in 2002. These
now cover 20 countries, using data from lending institutions, estate agents
and national statistics. 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 California, Florida, Nevada. Hawaii, Maryland
and Washington, DC, they soared by more than 20%.
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.
By contrast,
some housing booms have now fizzled out. In Australia, according to official
figures, 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.
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%.
Housepricecrash.co.uk collates information and statistics on house prices
in Britain. Nationwide and the Royal Institution of Chartered Surveyors give
differing appraisals of Britain’s housing market. A study from America's
National Association of Realtors, summarised here, found that one-quarter
of houses bought in 2004 were for investment, not owner-occupation. See
also the Federal Reserve.
Britain's housing
market has also cooled rapidly. The Nationwide index, which we use, rose by
5.5% in the year to May, down from 20% growth in July 2004. But once again,
other surveys offer a gloomier picture. 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 Britain'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.
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 most 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
(see chart 1 above). By the same gauge, property is “overvalued”
by 50% or more in Britain, 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, 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....
America's housing
market heated up later than those in other countries, such as Britain and
Australia, but it is now looking more and more similar. Even the Federal Reserve
is at last starting to fret about what is happening. Prices are being driven
by speculative demand. 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. 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.
New, riskier
forms of mortgage finance also allow buyers to borrow more. According to the
NAR, 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.
Interest-only
mortgages are all the rage, along with so-called “negative amortisation
loans” (the buyer pays less than the interest due and the unpaid principal
and interest is added on to the loan). After an initial period, payments surge
as principal repayment kicks in. 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. 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.
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.
Indeed, a drop
in nominal prices is today more likely than after previous booms for three
reasons: homes are more overvalued; inflation is much lower; and 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 stockmarkets—a
slow puncture is more likely. But over the next five years, several countries
are likely to experience price falls of 20% or more.
While America's
housing market is still red hot, others—in Britain, Australia and the
Netherlands—have already cooled (see chart 2 above). What lessons might
they offer the United States?
The first is
that, contrary to conventional wisdom, it does not require a trigger, 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. But as more
Americans have been resorting to ARMs, so the housing market is becoming more
vulnerable to rising rates.
British and
Australian prices have stalled mainly because first-time buyers have been
priced out of the market and demand from buy-to-let (i.e. to rent) investors
has slumped. 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.
British experience
also undermines a popular argument in America that house prices must keeping
rising because there is a limited supply of land and a growing number of households.
As recently as a year ago, it was similarly argued that the supply of houses
in Britain could not keep up with demand. But as the expectation of rising
prices has faded, demand has slumped. According to RICS, the stock of houses
for sale has increased by one-third over the past year. 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.
Another mantra
of housing bulls in America is that national average house prices have never
fallen for a full year since modern statistics began. Yet outside America,
many countries have at some time experienced a drop in average house prices,
such as Britain and Sweden in the early 1990s and Japan over the past decade.
So why should America be immune? Alan Greenspan, chairman of America's Federal
Reserve, accepts that there are some local bubbles, but dismisses the idea
of a national housing bubble that could harm the whole economy if it bursts.
America has in the past seen sharp regional price declines, for example in
Boston, Manhattan and San Francisco in the early 1990s. This time, with prices
looking overvalued in more states than ever in the past, average American
prices may well fall for the first time since the Great Depression.
But even if
prices in America do dip, insist the optimists, they will quickly resume their
rising trend, because real house prices always rise strongly in the long term.
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. And if the
current boom is stripped out of the figures, along with the period after the
second world war when the government offered subsidies for returning soldiers,
artificially inflating prices, real house prices have been flat or falling
most of the time. 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.
Another worrying
lesson from abroad for America is that even a mere levelling-off of house
prices can trigger a sharp slowdown in consumer spending. Take the Netherlands.
In the late 1990s, the booming Dutch economy was heralded as a model of success.
At the time, both house prices and household credit were rising at double-digit
rates. The rate of Dutch house-price inflation then slowed from 20% in 2000
to nearly zero by 2003. This appeared to be the perfect soft landing: prices
did not drop. Yet consumer spending declined in 2003, pushing the economy
into recession, from which it has still not recovered. When house prices had
been rising, borrowing against capital gains on homes to finance other spending
had surged. Although house prices did not fall, this housing-equity withdrawal
plunged after 2001, removing a powerful stimulus to spending.
Housing-equity
withdrawal has also fallen sharply over the past year in Britain and Australia,
denting household spending. In Australia, the 12-month rate of growth in retail
sales has slowed from 8% to only 1.8% over the past year; GDP growth has halved
to 1.9%. In Britain, too, a cooling of the housing market has been accompanied
by an abrupt slowdown in consumer spending. If, as seems likely, home prices
continue to fall in both countries, spending will be further squeezed.
Even a modest
weakening of house prices in America would hurt consumer spending, because
homeowners have been cashing out their capital gains at a record pace. Goldman
Sachs estimates that total housing-equity withdrawal rose to 7.4% of personal
disposable income in 2004. If prices stop rising, this “income”
from capital gains will vanish.
And after the
gold rush?
The housing
market has played such a big role in propping up America's economy that a
sharp slowdown in house prices is likely to have severe consequences. Over
the past four years, 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.
...
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). And 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.
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