The global housing boom
In come the waves
Jun 16th 2005
From The Economist print edition
The worldwide rise in house prices is the biggest bubble in history. Prepare for the economic pain when it pops
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 (see article).
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%.
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). 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.
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.
Betting the house
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). 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.
Rung at the bottom
British
and Australian prices have stalled mainly because first-time buyers
have been priced out of the market and demand from buy-to-let 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.
One of the best
international studies of how house-price busts can hurt economies has
been done by the International Monetary Fund. Analysing house prices in
14 countries during 1970-2001, it identified 20 examples of “busts”,
when real prices fell by almost 30% on average (the fall in nominal
prices was smaller). All but one of those housing busts led to a
recession, with GDP after three years falling to an
average of 8% below its previous growth trend. America was the only
country to avoid a boom and bust during that period. This time it looks
likely to join the club.
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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