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. 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. 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. 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.