The spread of the global housing bubble

John Calverley - Wed 29 Jun, 2005

...The global housing bubble is spreading to more and more countries and regions. Undoubtedly a key driver is low mortgage rates, as buyers fail to recognise that lower nominal interest rates do not actually mean housing is cheaper, only that inflation is set to be lower in future. So future house price gains will be slower than in the past...

The spread of the global housing bubble

The global housing bubble is spreading to more and more countries and regions. Undoubtedly a key driver is low mortgage rates, as buyers fail to recognise that lower nominal interest rates do not actually mean housing is cheaper, only that inflation is set to be lower in future. So future house price gains will be slower than in the past.

It is possible of course that real interest rates - nominal rates minus inflation - will remain at current low levels indefinitely. But this seems unlikely if the economic upswing continues. And, if the upswing does not continue house prices are in trouble anyway.

But there is also a view in many quarters that there have been structural changes in demand and supply patterns which justify a permanently higher level of house prices.

The spread of the global housing bubble: This time it's different

So this is not a bubble at all, people think. In other words, this time it's different.

In the United States, the housing bubble probably IS different this time. But not because there is more justification for rising prices. Rather because the bubble is spreading far more widely across the country than in the late 1980s.

A recent study by the FDIC found that 55 metropolitan areas are now experiencing a "boom market" - defined as a rise of real house prices of more than 30% in 3 years - compared with 24 metropolitan areas at the height of the last boom in 1988. On a national basis US home prices advanced only 13% ahead of inflation between 1983 and 1990 whereas they have soared 38% above inflation in the last 7 years.

It remains true that some parts of the US are still virtually unaffected, principally in the South and Mid-West. But the US is behaving far more like an integrated housing market than before, with the bubble spreading out by region and gradually moving from the most desirable locations to less desirable ones. This of course makes the bubble potentially much more dangerous to the economy as a whole. But with mortgage rates low, the economy still growing solidly and unemployment declining, it is much too early to call the end of the US housing bubble.

My guess is that it is good for another year or two at least and that it will probably need the 10-year Treasury yield to rise to well above 5%, or the economy to slow sharply to bring the bubble to an end.

The spread of the global housing bubble: In the UK

In the UK by contrast the bubble stopped growing almost a year ago. Prices have been stable or down slightly depending on which index you believe. Prime London and country properties have fallen up to 20%, while rental flats in some areas have taken a hit too. The cause of this slowdown is the rise in interest rates in 2003-4 coupled with public warnings from the Bank of England and others, combined with a slowdown in economic growth.

So now, with the bubble run out of puff, we come to the true test of whether the UK housing market can stay at these elevated levels - more or less - as some people argue, or whether it is riding for a fall.

In other words, is it really different this time?

Three times before, UK house price upswings have been followed by a major correction, twice in the 1970s and most recently in the late 1980s. Those who believe that risks are low this time, or expect only a small correction, base their optimism on one or more of the following arguments:

** underlying demand for housing is increasing, particularly in the south of England;
** there is no likely trigger for a house price correction;
** lower interest rates justify permanently higher house prices, relative to earnings or rents.

This last claim depends on real interest rates staying low but, in any case, even permanently lower real interest rates cannot justify the current heights of the UK market.

The spread of the global housing bubble: Demographics and underlying demand

What about the other two arguments in the British case? Many of the claims about demographics and underlying demand are grounded in reality. There has been an increasing tendency for people to want to live in London and the south-east of England. London has become an increasingly cosmopolitan city, led by the financial sector and global business services as well as knowledge and media-based activities.

There are also demographic changes such as an increase in the number of divorces, a growing desire for young people to live in their own flats rather than at home or in house shares. Meanwhile new supply remains tight.

However, there are serious problems with all of these arguments as a justification for today's hugely higher house prices. For a start, most people were not nearly so keen on buying when prices were at half current levels, as recently as 1996-8. Now, with prices high, they believe they must buy now or pay even more later. It is very difficult to deny that a crucial factor in this is expectations of future price appreciation.

Most people do realise of course that double-digit gains are impossible every year and that the last few years have been exceptional. But many, nevertheless, still believe that - even if prices fall a little near term - they will be higher in 10 years time.

And yet, this is far from guaranteed. It was the same belief that made people confident about stocks in 1999-2000.

The spread of the global housing bubble: Tax

Moreover, even if you buy the arguments that demand for UK housing could be structurally higher than before, don't forget that there are arguments the other way too. One is that the tax treatment of property in the UK is no longer as favourable as in the past. In the 1970s, the mortgage interest on any size mortgage could be set against tax. In the 1980s this benefit began to be restricted, though it was still an important tax break during the house price boom of the 1980s.

Mortgage interest relief was finally phased out completely in 2000-2001. The Bank of England has calculated that the change in tax treatment between 1990 and 2000 effectively raised the borrowing cost by about 3% pa and that this should have reduced the equilibrium real house price by 9%

Meanwhile, stamp duty on the purchase of houses has been increased sharply, which again should have lowered the value of housing, probably by around 3%. Finally, Council Tax on property values should also have reduced house prices, by raising the cost of trading up to a more valuable house. In the late 1980s, Britain had no tax on housing values because Poll Tax - a flat tax on residents - had just replaced the old Rates system. With Council Tax running at something like 0.25% to 0.5% of housing values, this should be enough to pull prices back by some 2-5% compared with the 1980s.

Overall then, these tax changes ought to be reducing house price levels by about 15% relative to incomes or rents. Housing does still have tax advantages since owner-occupied homes are free of capital gains tax, while foreign investors do not pay capital gains tax on investment property. But these arrangements have not changed recently. In principle, they cannot justify the rise in prices.

One thing that has changed over the last 15 years, however, is the introduction of a favourable regulatory and tax regime for investors, following an overhaul of tenancy arrangements in the late 1980s - too late to impact much on the bubble then. And the switch to taper relief on capital gains (for residents) has further improved the environment in recent years. However, the surge in ownership of investment property is as much a cause for worry as a good explanation for why high prices are justified.

The spread of the global housing bubble: Rents

Rents have been showing much less buoyancy than prices. There are signs that inexperienced investors have been carried away by strong returns in 2000-4. Some investors are becoming excited about the prospect of being able to include residential property in pension schemes from next April, via their SIPPS (self-invested personal pension schemes). This change in the rules will allow people to make much larger pension contributions and therefore could boost savings overall, some of which could go into rental property. But it does not change the relative attractions of housing versus stocks per se or any other investments.

Far more likely is that people will take advantage of the new rules to transfer savings that are currently outside a pension scheme, including equity in existing property, into a pension scheme, thereby saving on income tax. However, the government seems to be having second thoughts about this anyway and may well water down the scheme.

The second major offset to argument about excess demand is the number of extensions that people have made to their houses. This point is often overlooked, but extensions effectively increase the housing stock, even if there are few new houses being built. If every 3-bedroom house is extended to provide a fourth bedroom and another downstairs living room, in effect there is 25% more housing available!

The spread of the global housing bubble: High expectations

Ultimately though, to see how much the current bubble rests on high price expectations rather than fundamentals, consider the following questions:

If people believed that housing was NOT a good investment, how much housing would they buy then? Would they increase their debt to secure a larger house, or a better area or a second home, knowing that the mortgage interest payments were just another cost, like electricity bills, and not a promising investment? Or would they limit their aspirations?

When the price of something more than doubles, and people want more instead of less, we should strongly suspect that the market is in a bubble. Perhaps the UK market will not fall precipitately unless or until we see a major economic crisis such as a serious downturn or a new inflation scare. Neither look imminent. And if the economy slows further, perhaps cuts in interest rates will cushion a faltering market and prevent major price falls.

But the very best scenario, in my view, given current overvaluations, is that house prices in 8-10 years time are at about the same level as today. That is exactly what happened last time. Prices fell 20% between 1989 and 1993 and only recovered their 1989 level in 1998, after nine years.


Regards,

John Calverley
for The Daily Reckoning

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