Thursday, September 09, 2004

The sun also sets

The Economist

Never before have real house prices been rising so fast in so many countries

SYDNEY HARBOUR is one of the most stunning sights in the world. Over the next year, it may also provide a reflection of global property markets. In recent years the prices of waterfront homes, like the whole Australian housing market, have soared. Now the national boom seems to be over. The only question for Australia—and for many other countries—is whether prices will fall.

Average house prices, as reported by the Australian Bureau of Statistics, fell by 1.2% in the second quarter; prices in Sydney dropped by 5.4%. Other sources suggest a steeper decline. The Commonwealth Bank of Australia reckons that house prices nationwide fell at an annual rate of 13% in the first half of 2004. Even so, by all measures Australian homes are still worth more than a year ago. But whereas Australia topped The Economist's global house-price league last year, it has now dropped to about half-way down the list.

Since launching our global house-price indicators in 2002 we have focused on OECD countries, but in our latest quarterly update we have added China, Hong Kong, Singapore and South Africa. Home prices are rising at double-digit rates in 11 of our 20 countries. Hong Kong is top of the table, with an average gain of 28.7% in the year to the second quarter, a dramatic turnaround from a decline of 17% in the previous 12 months. The price of apartments on Hong Kong island has leapt by 40% in the past year. However, following the bursting of a mid-1990s bubble, average prices are still 55% lower than in 1997.

In second place is South Africa (with a gain of 25.5%), followed by New Zealand (22.1%). In both countries prices have been rising rapidly for several years. Property markets have also been climbing briskly in China. Speculation has been rampant in Shanghai, pushing prices up by 21% over the past year. Nationwide, however, city prices have risen by a more modest 10.4%.

American house-price inflation quickened to 9.4% in the year to the second quarter, the highest since the 1970s. American prices have risen by less in recent years than those in Australia or Britain, but this is still by far the biggest boom in American history. Since the mid-1990s prices have increased more than twice as much in real terms (ie, after adjusting for inflation) as in the 1970s or the 1980s.

In the euro area, more countries have joined the party. Housing markets have long been at dizzy heights in Ireland, the Netherlands and Spain, but recently they have spurted in France, Italy and Belgium. French prices have jumped by 14.5% in the past year; by contrast, prices have fallen in Germany, which largely explains why consumer spending has been so much weaker there. In Asia, prices have also continued to fall in Japan and Singapore.

Many people now reckon that British house prices could fall in the next year. According to figures published by the Office of the Deputy Prime Minister, prices in Britain rose by 13.8% in the year to July, down from 25% at the end of 2002. Other surveys suggest that prices are already edging down, and estate agents have reported an abrupt drop in interest from buyers.

Calculations by The Economist show that home prices are now at record levels in relation to average incomes in America, Australia, Britain, France, Ireland, the Netherlands, New Zealand and Spain; on current trends, Italy will join this group by the end of the year. In other words, houses are more overvalued today than at previous peaks, from which prices typically fell sharply in real terms. Add in China and South Africa, and two-thirds (by economic weight) of the world that we track now has a potential housing bubble.

A year ago, most economic commentators in Britain and Australia denied that homes were seriously overvalued; today many more admit that markets do look frothy. America, though, is still in denial about house prices, judging by our favourite measure of whether homes are fairly valued, the ratio of house prices to rents. This is a sort of price-earnings ratio for housing. Just as the value of a company's shares should equal the discounted present value of its future profits, so the price of a house should reflect the future benefits of ownership, either as rental income or in the rent saved by an owner-occupier. America's ratio of house prices to rents is at a record high, 26% above its average over the 25 years to 2000 (see chart). To bring the market back to fair value, prices need to fall; alternatively, if rents continue to rise at their recent pace, prices will have to stagnate for as long as eight years.

Most American commentators, however, insist that their housing market is different and does not suffer from British or Australian irrational exuberance. Alan Greenspan, chairman of the Federal Reserve, has argued that while America has regional housing hotspots, such as in California and New York, a national bubble is highly unlikely because prices are determined largely by local factors. However, a recent study of America's housing market by Ian Morris, an economist at HSBC, concludes that home prices look overvalued in 20 states that account for over half of America's population.

A second myth is that rising house prices reflect America's strong immigration and population growth. However, the supply of housing has also been rising fast. Vacancy rates are at their highest since at least 1965. If house prices were being driven up mainly by population growth, then rents should also be rising rapidly. In fact, they have lagged far behind.

A third argument is that, unlike in Britain and Australia, most American mortgages are at fixed interest rates, so the housing market is immune to a tightening of monetary policy. But the British and Australian markets have stalled not because homeowners cannot afford to pay their mortgages, but mainly because first-time buyers have been priced out of the market. The same may happen in America.

It is true that house prices in America are less overvalued than in Britain or Australia, so that any fall is likely to be more modest. Still, it could harm the economy. A recent study by Goldman Sachs finds that swings in house prices lead to much bigger changes in consumer spending in America than in Britain. Furthermore, America already has much lower short-term interest rates and a bigger budget deficit than Australia or Britain, so if the housing market did take a tumble, policymakers would be less capable of fending off an economic downturn.

Even a mere levelling-off of house prices could trigger a sharp slowdown in consumer spending, as the recent experience of the Netherlands shows. The rate of Dutch house-price inflation slowed from 20% in 2000 to virtually zero by 2003. This appeared to be the perfect soft landing; prices did not fall. Yet consumer spending dropped by 1.2% last year, the biggest fall in any developed country in the past decade, pushing the economy into recession.

Although house prices did not fall, borrowing against the capital gains on homes to finance other spending, which had surged in step with rising prices, declined after 2001. This removed a powerful stimulus to spending. Since such borrowing has provided similar support to consumer spending in America, as well as in Britain and Australia, economists—and policymakers—would be wise to take heed.