Saturday, December 17, 2005

In Come the Waves

There is an excellent article at The Economist. It's from June, 2005 (I missed it as I started blogging in July, 2005). It makes all the same points that you have seen here and on other blogs. I highly recommend reading it. I quote a lot of it (too much, really), below.

Here is a graph from the article I found shocking:

Some choice quotes:
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.

...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...

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...House-price inflation has also slowed significantly in Ireland, the Netherlands and New Zealand over the past year.

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)...Rental yields have fallen to well below current mortgage rates, making it impossible for many landlords to make money.

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.

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...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.

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...over the next five years, several countries are likely to experience price falls of 20% or more.

...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 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...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.

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.


Anonymous Anonymous said...

The curve of the "US" is based on the nonexistant "national real estate market". If only the west coast or only the east coast were plotted, the results would closely mirror the higher flying anglobubbleland prices.

Dec 18, 2005, 8:47:00 AM  
Blogger Marinite said...


Dec 18, 2005, 9:47:00 AM  
Anonymous Anonymous said...

2002-2005 the global boom in house prices are caused by
1)low interest rate,
2)China effect (this might explain sharp rise of housing prices in the US bi-costal cities.)
3)steady economic growth
4)favorable tax deduction

2006 - and beyond: Variables that will influence the housing market:
1)China effect aftermath, especially after 2008 Olympic game (hosted in China)
2)interest rates movement
3)potential oil supply shortage
5)changes in tax law

Dec 18, 2005, 10:40:00 AM  
Blogger sf jack said...

by_palladium -

Very true, what you say about the (mainly) bi-coastal bubble here in the US.

As we know, those prices are beginning to greatly feel the effects of gravity.

Dec 18, 2005, 6:43:00 PM  
Anonymous Anonymous said...

The tax treatment of real estate varies from country to country as do the loan options and building rules and regulations. As a resident of Sydney during the housing boom there from 1999-2001 (that actually continued for 2 years thereafter), low interest rates were definitely a factor as was slack lending practices and the perception that the All Ordinaries (the Aussie equivalent of the Dow Jones Industrials) was languishing.

Sydney's median was around A$500k while I was there and is the least affordable and fastest appreciating city in Australia. Everyone there was complaining about how young people could not get a toehold and that speculation was driving up prices, that people were moving away to other states, etc., etc. It has a familiar ring to what I hear in California today.

However, a 30 year fixed rate loan is not available there (the longest you can fix is 10 years) and you cannot deduct mortgage interest on your own residence. There are also steep transfer taxes, somewhere in the region of 4%. And interest rates never got as low as the 5% range we saw here.

As an investor in Australia, you can write off all expenses in excess of income on the property (as you can do here) but the tax benefits are considerably higher as the top tax rate there is 48% (which kicks in at a relatively low A$80K/year). So, whereas Uncle Sam gives you a 30-35% break on your negative cash flow, in Australia, it gets sliced in half. Also, construction was going gangbusters in Sydney, causing an oversupply problem, which we do not have here (only in the rental market is that the case).

I remember, as I paid my $1900/month rent for my two bedroom apartment there (sky high rents are not just a SF phenomenon), that was on the market for $500k, that it would make more sense to rent and own rental property, then it would be to buy and live in your own home, thanks to the much more favorable tax treatment of investment property. The system encouraged this behavior and there were lots of people doing exactly that, causing a glut of rental properties available and worsening the PE ratio. From my own numbers as a landlord here, that is definitely not the case in the US.

The landing in Sydney has been relatively soft -- I think prices went backward in the low single digits in 2004 but they are up again now (again in the low single digits). Interest rates are around 7% and any amateur landlords have unloaded their properties. In other words, the market has become more balanced, price gains are lower, the glut of rental housing has gone away.

That is probably what the next few years look like for Marin.

Dec 20, 2005, 10:21:00 AM  
Anonymous Anonymous said...

Chinese investors have been quite active in New Zealand, and Australia for some time. Usually they paid cash and took on little mortgage. Some investors also bought up properties in Paris, London, New York, Los Angeles, and San Francisco.

Dec 20, 2005, 11:35:00 AM  
Anonymous Anonymous said...

Yes, as a "world" city, San Francisco, like Sydney, London, Paris, Hong Kong, New York, etc., potentially attracts international buyers, which can again skew affordability. In most cities, it is assumed that the buying pool is made up of locals -- in San Francisco it ain't necessarily so.

Compared to London or Paris, $1.5m for a fixer is cheap. In fact, I read a quote in the Chronicle by a London couple looking to buy a vacation home in SF -- a modest Pac Heights condo with bridge-to-bridge views -- commenting that at $1.5m, it was half the price of its London equivalent.

This could also be a contributing factor to the real estate bubble.

Dec 20, 2005, 8:33:00 PM  
Anonymous Anonymous said...

Also, with weakening US dollars, the US assets are "relatively" cheap compared to other countries with "strong" currencies such as China, European and Middle East oil rich countries. Didn't US just see a record high inflow of foreign funds in November?

However, there is also record amount of money going into China now. Investors are buying up properties in adjacent cities close to Beijing ahead of Olympics game in 2008. We definitely live in a global economy.

Dec 20, 2005, 10:01:00 PM  
Anonymous Anonymous said...

US is not the only country flooding its monetary system with lots of money. Chinese monetary expansion is growing more than 10% annually.

They are building their infrastructures like crazy to prepare for the 2008 Olympics games. It would be interesting to see whether the Chinese government will curb their monetary expansion after year 2008.

Dec 21, 2005, 10:17:00 AM  
Anonymous Anonymous said...

...And here we are today ...and the bust really has little to do with taxes. It has to do with derivatives and liar loans and unscrupulous Wall Street bankers and others who were just plain greedy.

Jan 17, 2009, 8:39:00 AM  

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