Global house prices: are they about to plummet?

The Economist recently looked at house-price indicators for 16 developed economies. Their conclusion was that prices are now at "record levels in relation to average wages and rents" in America, Australia, Britain, Ireland, the Netherlands, New Zealand and Spain", and "frothy" in China, South Africa and Dubai. Not only that, but even in traditionally sober markets, like those in France and Italy (where home ownership is not considered the be-all-and-end-all of life, as it is here), prices have risen at double-digit speeds in the past year as well. So what's made this extraordinary and co-ordinated move happen? The answer is simple: super-low interest rates.

As the Economist also noted, "the average short-term interest rate in the G7 economies is at its lowest in recorded history". And low rates mean high house prices. This is because so many house buyers care only about what it will cost per month to service the debt; as falling rates mean falling interest payments they'll buy more expensive houses. But when everyone does this, the result is merely that all house prices rise. Simply put, if rates halve, house prices double.

Is the boom nearly over?

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The problem now - and the thing that suggests the global boom might be nearly over - is that rates are on the rise. And just as house prices rise when rates fall, so they fall as rates rise. Indeed, the first signs of trouble are already apparent. In Australia, according to Australian Property Monitors, the first quarter saw Sydney prices fall 7.5% and Melbourne prices slump 12.9% quarter on quarter. Also, property sales have halved in the last three months: at a recent auction in Sydney - the standard sales method in Australia - only one third of properties were sold, compared to a market norm of 70% or more. It isn't just in Australia: Cally Law reports in The Sunday Times that in Liverpool, "where, a few months ago, security guards were employed to control crowds", last month many lots failed even to reach reserve prices.

Rates will keep rising

While rates are yet to rise in euroland, Federal Reserve chairman Alan Greenspan raised US Fed Funds rates for the first time in four years at the end of June from 50-year lows of just 1%. Our own Monetary Policy Committee started raising rates last autumn, and the Reserve Bank of Australia has been raising rates since early 2002. The challenge facing the world's central bankers is whether they can raise rates enough to deflate the bubble rather than burst it. Early signs aren't good. In Australia, where economic growth had been running at 1.3% in the fourth quarter, there was a dramatic slowdown to just 0.2% in the first quarter, as "a consequence rather than a cause of the housing market slowdown", according to Allister Heath in The Business. And last weekend, the accountants PricewaterhouseCoopers became the latest of a small band of UK research houses to warn that house-price drops of 15%-20% were on the horizon.

Complacency Rules O.K. in the UKHowever, even if a few analysts are worried, no one else seems to be. A recent survey by YouGov showed that 65% of homeowners expect property prices to rise over the next 12 months. This may not be all that surprising, since the most important factor affecting the decision to buy property was "job security". UK unemployment is at a 30-year low and still heading south, thanks to fast-rising public sector recruitment.

What the property bulls say

Most commentators believe that there will be no real fall in house prices. Instead, they say the rate of house-price growth will simply slow to more sustainable levels. This is partly because of the solid employment data mentioned above, but there are seven more reasons that are worth mentioning (and refuting)

1. Human nature

Behavioural studies generally show that market participants place too much weight on recent trends. We are biased to complacency. Thus at any particular time, most commentators will expect things to continue in the direction that they have done recently, but at a slower rate. Most forecasts now, for example, are for house price inflation to continue but to slow to a single-digit rate of increase. That's exactly what most people forecast for house prices in 1989 too (see box below). They were very wrong then. Between 1989 and 1996, house prices as a multiple of income fell 42%.

2. The strong economy

The bulls also cite strong economic growth and firm consumption, noting that the crash of the early 1990s occurred because of the recession and resultant job losses. But to me, this just looks like very bad history. House prices had already started to fall (especially in London) long before the recession kicked in. And in fact it was falling house prices that kicked off recession: 1988-1989 was typified by mortgage equity withdrawal (MEW) far outpacing mortgage borrowing for new home purchase. As rates went up and house prices fell, this huge sop to consumption disappeared, hitting growth. This is pretty much what is happening in Australia now, and there is once again a danger of it here. MEW in the UK is currently 50% higher than genuine mortgage demand and equal to a whopping 8% of GDP. Right now, house prices are driving consumption and holding up the economy. When house prices fall, the opposite will be true.

3. Rates won't rise much

The third reason not to be alarmed about the situation, or so we're told, is that even though economic growth is strong, interest rates won't rise much. Most economists surveyed by Ideaglobal.com expect rates to peak at just 5.25% early next year. But this seems unlikely, given that business failures are low and falling, unemployment is at a 30-year low, wages are rising at well over 4%, the old RPI inflation indicator is already at 3% and commodity prices are at 20-year highs. It also blithely ignores the fact that even back in the pre-inflationary days of the 1950s and 1960s, normal cyclical peak rates were always 7% or more. Anyway, those who have to put their money where their mouth is are less confident: money markets are pricing in rates of 5.5% by the end of 2005.

4. Debtors can cope with rising rateSome say that rampant house-price inflation hasn't created an affordability issue yet. Gordon Brown, for example, points to interest-only payments still being the same proportion of disposable income they were ten years ago. However, ten years ago interest rates were double what they are now, so this means that debt has doubled, even compared to rising incomes. This is the crucial element missing from the thinking of those who believe that there can't be a problem even if rates do rise, as long as they're still at relatively low historic levels. The implicit assumption they are making is that the debt service burden can't be as onerous as it was when rates were much higher.

A recent study by Capital Economics shows that including repayment costs and uncollateralised loans, the debt service burden is about 20% in the UK, which is pretty much the same as at the 1989 peak (it is also at record levels in Australia and the US). What this means is that interest rates hardly have to rise at all before households face the same levels of actual financial pain that have historically triggered consumption cutbacks, debt repayment, an increasein precautionary saving and horrible house-price slides.

5. Pent-up first-time buyer demand

A recent FPDSavills report reveals that it is now cheaper to rent than to buy (an average two-bed flat) in every single major city in Britain (see column). According to Halifax, 80% of Britain's 667 main towns were unaffordable for first-time buyers last year. No wonder the number of first-time buyers dropped to a record low of just 29% of all property purchases last year. It seems unlikely that first-time buyers will re-enter the market until a significant price discount becomes the norm. Any pent-up demand' is going to stay that way for now.

6. Buy-to-Let

The slack left behind by the miserable first-time buyer over the last few years has famously been taken up by the buy-to-let investor. But they won't be able to do it for ever. Last year, according to FPDSavills, average gross yields were 7.5%, easily providing enough rental income to cover mortgages priced off an average base rate of 3.7%. But all that has changed very fast. Today, average gross yields are below 6% (and falling) and base rates are 4.5% (and rising). Assuming a 90% loan to value, a mortgage rate of 5.5% and a net yield of 80% of the gross, the average buy-to-let investor buying today must be banking on further capital gains, because he's already cash-flow negative.

7. Chronic housing shortage

At the higher end of the market, where buyers don't have to worry about mortgages and many are rich foreigners, it is argued that rising rates can't dent prices. More importantly, years of government neglect have left us with a chronic undersupply of new housing and land for development. These arguments are very seductive. But they're also of little use. Why? Because they're structural rather than cyclical, and as such have been around a long time. Interestingly and depressingly, both of these arguments were also put forward in 1989 as reasons why house prices in general, and higher-priced ones in central London in particular, wouldn't come off much. They were wrong then and I see no reason not to believe they'll be wrong again now.

Conclusion

While few of the reasons cited for complacency are convincing, many of the other signals that have historically coincided with bubble peaks are flashing red. My seven deadly signs are: a record house price to earnings ratio, a record debt service burden, a record low proportion of first-time buyers, a record high proportion of MEW, a record level of household debt to GDP, 20-year high commodity inflation, all stacked up against record low interest rates. They're all there.

"The arguments against a crash," says Geoff Marsh, director of London Residential Research in The Times, "can be summarised under the banner of this time it's different'", but as these are the four most expensive words in investing, it probably isn't. As Marsh says, "the housing market feels like a bubble, looks like a bubble", and he concludes, "in my opinion is a bubble". I think he's right, but it's more than an ordinary bubble. This one has sucked in virtually the entire population of the developed world.