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Tuesday, March 11, 2003

Housing: On Bubble Business Bound

Does the current housing market constitute another case of bubbleitis. This week it's the turn of the Economist to worry. They look at all sides of the argument, and as usual these days stay firmly on the fence. Certainly the evidence for the existence of a bubble is unclear. Three cases, however, do stand out: the UK, Spain and Australia. Others like the US, Italy, Sweden and France are less obvious, really we will only know with hindsight. But the connection with the peak in stock market values is evident. With the equity collapse and low interest rates all round, second homes or more expensive first homes have become for many a safe haven source of saving or investment. True in the past house prices have not fallen subsequently as much as equity prices. But in the past housing was not converted so feverishly into a financial instrument. It's important to note that it's a lot quicker to get your money quickly out of the bank than it is out of concrete.

Many argue that the increased values only reflect the reduced repayments. This is also true, but a lot depends on the future direction of general prices. If we are making a transition from an inflationary to a deflationary envirnoment then this will have importance for the way these increased repayments may or may not be sweat off. If there is no inflation to reduce the real capital value of the debt, and wages and prices are sticky but downward bound, then those increased premium payments are going to weigh heavy on all those newly indebted young people, who will it should be remembered be paying for all those extra pensions coming on line. A sticky situation all round.

America's boom is already slowing: the average price of a home rose by 7% in the year to December, compared with an 11% gain during 2001. In the fourth quarter prices rose at an annual rate of only 3.3%, the slowest since 1997. However, according to The Economist's global house-price indicators, markets in many other countries continue to bubble merrily. (We launched these indices a year ago, and plan to update them every six months.)

Australia, Britain, Ireland and Spain all saw double-digit increases in house prices in 2002. House-price inflation rose in eight of the 13 countries covered in the year to the fourth quarter, but fell in five. Prices fell in Germany and Japan, which have yet to recover from the bursting of property bubbles in the 1990s. In both countries prices are lower than in 1995.

Britain, Ireland and the Netherlands have seen average annual price rises of more than 10% since 1995 (chart 2). But the Dutch bubble is now bursting: prices fell late last year. House prices are also falling in London, if not yet in the rest of Britain. The Irish housing market, which saw a brief fall in prices in 2001, has taken off again. The average Irish home now costs three times as much as in 1995.

The commonest argument for why house prices are not overvalued is that low interest rates allow people to borrow more, so they are willing to pay more for their homes. But is it possible to work out some sort of fundamental value of a home? Edward Leamer, an economist at the University of California in Los Angeles, argues that the price of a house, like that of any other asset, should reflect its future income stream. Just as analysts and investors seemed to believe during the dotcom boom that the link between share prices and profits was irrelevant, people today may have forgotten the link between house prices and the rental income that can be earned if homes are let.
Mr Leamer argues that a price/earnings (p/e) ratio can be calculated for houses, as for shares, by dividing average house prices by average rents. John Krainer, an economist at the Federal Reserve Bank of San Francisco, has calculated this ratio for America's housing market, covering the past two decades. He uses an index of average house prices and the imputed rent paid by owner-occupiers that goes into the consumer-price index. As home prices have outpaced rents, the p/e ratio has soared

Mr Krainer estimates that house prices would have to fall by 11% to bring the ratio back to its long-run average. In contrast, the p/e ratio for America's S&P 500 stockmarket index suggested in early 2000 that share prices needed to fall by more than 50%. Alternatively, if house prices instead remain constant and rents grow at their average pace of 4% a year, the ratio would revert to its long-term average by the end of 2005, with no need for a price decline. Mr Krainer concludes that, nationally, American house prices are not dramatically out of line with rental values. But there are two caveats. First, after a boom the housing p/e ratio usually undershoots. That implies either a bigger fall in prices or a longer period of stagnation. Second, it may be too optimistic to assume that rents will rise by 4% a year.
Source: The Economist

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