A Global Property Bubble?

Property will be the most important investment decision many people will make in their lives, yet they may be buying into a property bubble right now that could leave them with negative equity for years to come. Alternatively, holding off from buying could enable speculators to make far more once the global property market deflates. After all market bubbles always burst and then those market prices revert to their starting positions or travel lower.

Firstly, how can we determine the price at which a house ought to be valued at? From a fundamental perspective, we can look at four measures: price to rent ratio (yield), relative prices comparison, affordability, and price to replacement cost.

·         The price to rent ratio is the housing parallel to the stock market’s price/earnings ratio. The ratio indicates the years of rent which would be required to buy such a house. A ratio of around 5 to 10 (20% to 8% gross rental yield) denotes that the housing market is undervalued, 10 to 20 (8% to 5% gross rental yield) denotes a housing market that is relatively fairly priced, and 20 to 50 (5% to 2% gross rental yield) signals an overvalued market. Furthermore when strong future growth in value is expected (such as houses in an area where infrastructure is being upgraded) then relatively weak present earnings can be acceptable. In any case, low price to rent ratios/high rental yield levels push house prices higher. This is because with high rental yield levels, the interest cost of buying a house is low compared to the cost of renting a house. Potential buyers have to pay less interest to get a mortgage from the bank than they pay when renting a house and so many potential buyers will transfer from being renters to buyers. Entrepreneurs will also find it worthwhile to buy houses to rent in order to generate money. Conversely high price to rent ratios/low rental yield levels put downward pressure on the housing market. This is because low rental yield levels mean that the interest cost of buying a house is high compared to the cost of renting a house. Potential buyers will have to pay much more to the bank in terms of interest in order to buy a house than it costs to rent a house. Banks will also be worried about over-lending at loan-to-income ratios, meaning that a slight increase in interest rates will result in a financial crisis for potential buyers borrowing money. Entrepreneurs will also find that buying to let is not the next best alternative use for their cash. Housing markets tend to revolve around a price to rent ratio range, which moves in a circle. From an international perspective ranges will likely be quite similar in different countries as real interest rates are broadly similar. Yet, countries with higher nominal interest rates and countries with weak mortgage markets will have relatively low price to rent ratios (think Eastern Europe whose housing markets are in the process of developing with a concurrent increase in their house prices). As every housing market has a range, when one can imagine a market escaping totally from its range of price to rent ratios this is the sign of bubble mentality.

·         Relative prices comparison is useful as buyers actively seek cheaper and better alternatives, particularly when houses are highly priced. Therefore comparing internationally, Brussels’ property seems undervalued with prices similar to Eastern Europe despite being located in a high-income country. On the other hand, the average urban dweller in Moscow will have a lower real wage than Parisians or Romans and so Moscow’s apartment prices at around US$4,250 per square foot, seem overvalued. Anomalies can last a long time, yet once an economic or currency crisis hits house prices will fall in line with reality.

·         Affordability concerns the ability of the majority of people living in an area to afford property when house prices are so high. To examine affordability we can look at a country’s GDP per capita as a multiple of house prices per square meter. Where a country’s ratio of house prices to GDP per capita is high, houses will likely be overvalued, and vice versa. The GDP per capita as a multiple of house prices per square meter measure is best used to compare countries at the same GDP levels because housing in poor countries tends to be relatively expensive when juxtaposed with the local living standard as most of the people are poor.

·         Price-to-replacement cost is useful to examine because if house prices are much higher than the cost of building then developers are motivated by increased profit to construct more buildings. Yet this profit motivation will ensure increased supply of houses on the market which will put downward pressure on prices. However there is one caveat to this downward pressure on prices – in the case where regulations restrict construction of new buildings (such as Europe). In Europe is inundated with all kinds of building regulations and permits that limit the quantity of new housing supply and means that house prices tend to be above new build costs merely because it is the system.  

·         Housing debt to income ratio (or debt-service ratio) is the ratio of mortgage payments to disposable income. When the ratio gets too high, households become increasingly dependent on rising house fair values to service their debt.

To see what causes a bubble let’s look at the most famous financial bubble in history – the tulip bulb bubble of 1636-1637. These flowers, introduced into the Netherlands from the Ottoman Empire around the 1550s, quickly built up much admiration from the Dutch who initiated a sophisticated derivatives market to trade the tulip bulbs (which would blossom 7 to 12 years later). With their growing popularity, tulip bulb prices rose in unison and the number of speculators in the market increased. From 1634 to 1637, an index of Dutch tulip prices soared from approximately one guilder per bulb to a haughty sixty guilders per bulb. Some merchants sold all their belongings in order to buy a few tulip bulbs to speculate for more profit than they would ever make as a merchant. The tulip bulb bubble increased further and the already expensive tulip bulbs were propelled to a multiple of twenty in a single month in 1636. By February 1637, a single tulip bulb was worth ten times the average Dutchman’s annual income. Successful Dutch tulip bulb traders could earn up to 60,000 florins in a month– approximately US$62,000 in today’s terms. The catalyst for the bursting of the tulip bulb bubble was a default on a tulip bulb contract by a buyer in Haarlem in the winter of 1637, which caused sellers to overwhelm the market whilst buyers disappeared. In just a few days, tulip bulbs were worth a hundredth of their former prices, resulting in panic throughout the Netherlands as dealers refused to honour contracts. The government was eventually forced to step in and offer to honour contracts at 10% of their face value, which far from inspiring confidence sent the market plummeting further. The bursting of the tulip bulb bubble ended the Netherlands’ Golden Age and plunged the country into an economic depression lasting several years.

So is there a contemporary global property bubble? Core properties in major cities around the world have increased in price even though economic fundamentals are weak. One reason is because investors are seeking a safe haven asset class with a good yield but ostensibly low risk. Property prices have therefore been bid up whilst yields have decreased markedly. The most expensive property in the world is currently found in:

·         Hong Kong – US$11,000 per square foot;

·         Tokyo – US$7,600;

·         London – US$5,300;

·         Paris – US$4,400;

·         Moscow – US$4,250;

·         New York City – US$4,100;

·         Geneva – US$3,000;

·         Shanghai – US$2,125;

·         Singapore – US$1,820;

·         Beijing – US$1,600;

·         Mumbai – US$970;

·         Sydney – US$880;

·         Kuala Lumpur – US$500;

·         Dubai – US$425;

·         Istanbul US$122.

Shanghai housing market is sitting on the greatest bubble globally as its market has soared by 525% since 2000. Mumbai (400%), Dubai (300%), and Seoul (205%) are other cities that have experienced major increases since 2000. Meanwhile in developed markets, Brisbane has increased by 210%, Miami by 180%, Los Angeles by 170%, London by 170% and Vancouver by 165%. Many investors continue to pile money into these major metropolises and these cities seem to regard their housing markets as impervious to bursting. However, as the Dutch tulip bubble demonstrates, bubbles always burst. In fact (generally), the greater the bubble, the greater the burst. California’s major cities such as San Francisco, Los Angeles, and San Diego saw their housing bubble burst in 2006 with prices ten times real wages. Other major American cities such as Las Vegas, Phoenix and Atlanta have already had their bubbles burst in 2006 after house prices had increased 130% since 2000 before falling 34%. No other major bubbles have burst back to where home prices are affordable again. House prices should always be a multiple of around five times real wages.

By contrast, Shanghai, for example, looks to be in danger of a major bubble bursting with prices at thirty times real wages currently. What is driving the bubble higher are a range of factors from a fast-growing middle-class, rapid urbanization, the hunt for more yield from investment assets, desire for global investment diversification, and the rise of international megacities. However investors should be warned that it is the most attractive global cities with the scarcest land that are typically the last to reach the peak of their housing bubbles and the ones that will experience the most volatile bursts. In particular, real estate bubbles take longer to deflate (as compared to stock market bubbles) due to prices declining slower as real estate is less liquid.

I would postulate that we are in a global property bubble which is mostly affecting megacities. In the developing world’s megacities, their property markets are being supported by the glut of money floating around. Prices have risen so high (80% since 2008) in Asia’s financial capital, Hong Kong, that the Hong Kong government has instituted a tax duty in order to cool housing price growth. Meanwhile in the developed world megacities, it is the international brand recognition and perceived safe haven status that buoys the housing markets. London’s housing prices have increased 40% since 2008 and central London’s prices are so divorced from reality that the average Londoner would need to triple their salary to £87,000 in order to fund a mortgage for an average priced property. As such, the London housing market is vulnerable to bursting of emerging market bubbles as well as the lack of rising real wages for City of London workers. This is a phenomenon seen all over Europe with high valuations revealing places like Amsterdam have average property overvalued by 45% according to price-to-income and price-to-rent ratios. The boon of the developed world has been the mortgage-borrowing binge which sent property prices soaring, and simultaneously elevated household debts to unsustainable levels (240% of disposal income for the Netherlands). Yet interestingly the UK government seem intent on supporting a housing bubble with their “Help to Buy” scheme, in the form of £12 billion in mortgage guarantees to aid first-time buyers. The only exception is Germany, which avoided the housing boom before the financial crisis and therefore its property is evaluated to be undervalued according to property valuation ratios.

Housing markets are notorious for fulfilling the boom-bust cycle. And there is an ominous feeling that we will begin to see a massive bursting of the global property bubble. In future, the global financial crisis will be remembered hand-in-hand with the ensuing global property bubble that it engendered. The USA, despite being the progenitors of the global financial crisis, will emerge pretty much unscathed from this global property bubble. Despite London and New York boasting comparable international city status, London property has outperformed New York’s with prices 5% over their prior peak in 2007 whilst New York prices are 25% below their 2007 peak. This is clearly not sustainable. The world, bar the USA and Japan, will feel the pain of the global property bubble. China will be particularly hard-hit. Their massive US$586 billion stimulus program to help boost their economy during the global economic downturn successfully staved off the effects of the downturn yet has fuelled their housing bubble, a manifestation of the inflation engendered by stimulus cash, China’s fast economic growth and its burgeoning credit bubble. This high inflation coupled with negative real interest rates and limits on investing in other asset classes incentivized Chinese to purchase real estate as a hedge. Housing prices have increased 800% in Beijing since 2003 and 140% nationally. Meanwhile in Canada and Australia, a commodities export boom drove a sustained rise in the property market as well as mortgage debt with economists hypothesizing that these prices are high to stay. Yet with slowing growth from China it won’t be long before Vancouver’s new-found reputation, of pricier homes than New York City with median prices 10 times median household income, comes crashing down. Furthermore, megacities in emerging countries are experiencing lightning-fast middle-class growth, yet the average household cannot afford to buy a house in a major city within their country.

All this points to a major bust as global housing markets fulfil their natural cycle. The cycle is evident in Japan’s 1991 experience of a housing bubble after prices increased 160% from 1985 and then fell 65%. House prices are still at this level now due to a much smaller generation following a large baby boomer generation. I would guess that developed property markets would follow a similar pattern after the ensuing global property crash. The problem is exacerbated by the experience in the USA after their housing bubbles bursted in 2006-2007 when banks found that many owners held mortgages exceeding the fair value of their homes and therefore shunned holding large amounts of property-backed debt. As the world’s major economy, this is holding back a worldwide recovery and will affect a recovery further in the event that the world experiences a housing bubble.