Tuesday, April 15, 2008

Overvalued Housing Markets

In the past 12 months, US house prices have fallen by nearly 15%. This reflects a correction to a period of rapidly rising house prices, fuelled by cheap lending. However, the concern over house prices is not limited to the US. In fact, a study by the IMF suggests that many other countries have house prices that are overvalued relative to earnings, rent prices and other long term house price trends.

According to the IMF, house prices are most overvalued in Ireland (30%), Netherlands and Britain (29%) America by contrast have house prices overvalued by only 10%. Therefore, there is a real possibility of housing slumps in other countries; if these housing slumps occur it could trigger slowdown in global growth, especially in Europe and OECD economies.

Graph of House Price Overvaluation

Source: Economist

Why House Prices are Overvalued.

Era of Cheap Borrowing. In the past 10 years, lenders have been keen to extend mortgages to consumers who were previously thought to be high risk. Examples, include subprime mortgages and lending upto 5 times incomes. The competitive mortgage industry made mortgages cheaper than usual and encouraged more groups of households to take out mortgages. However, the subprime crisis has dramatically altered the mortgage industry. The number of mortgage products has substantially fallen, making it much more difficult to get a mortgage unless you have a large deposit. (see: credit crisis 2008)

Supply Constraints in Many Countries. The supply of housing is notoriously inelastic in many western economies. There is a shortage of land and a difficulty of gaining planning permits; this means housing supply struggles to meet with growing demand. However, the supply constraints do not explain all the house price increases.

Speculation. The era of rising house prices encouraged people to 'buy to let'. Landlords bought houses to gain income from both rent and capital gains. For example, in the UK, the proportion of mortgages held by landlords has risen from 1% to 10%. It may be that as the market turns this new group of homeowners will be much keener to sell.

Ratio of Earnings to House prices. The ratio of House prices to earnings shows that house prices have increased above long term trends and makes house prices susceptible to a substantial fall to correct the lack of affordability. This is particularly notable amongst first time buyers who are struggling to get on the property ladder.

Graph of House Price to Earning


Is the End Nigh? - Why the Housing Crash may be less Severe Than Feared

Despite the grim prognosis of many analysts, the UK and other European economies may still be able to avoid a slump in housing prices similar to the US. These are some factors which may prevent a housing slump as bad as the US.
  1. Ratio of Mortgage payments to Earnings is below historical highs. Long term Interest rates are lower than in the early 1990s and this has made the cost of paying for a mortgage relatively cheaper.
  2. Prospect of Lower Interest rates. If house prices do fall and western economies slow down this will lead to lower inflation and therefore, there can be cuts in interest rates. This will make buying a house seem more attractive. It is also worth noting UK interest rates are much lower than the last time we had a housing slump. However, there are 2 complications
  • Credit crisis is causing bank interest rates to be more expensive. Therefore, base rate cuts may not lead to cheaper mortgages
  • Cost push inflation due to rising oil and food prices makes interest rates cuts more difficult.
    1. Negative Equity will be concentrated on a small % of the housing market. Because UK house prices have risen by 217%, even a 15% fall in house prices would leave most people with positive equity. Experian, a credit-scoring firm, reckons that if house prices fell by 20%, only 78,000 households would have mortgages worth more than their homes [ source]
    2. Supply constraints are more serious in Europe, UK than in America
    3. The American housing bust was related to a large oversupply in houses. The housing boom caused a big rise in the supply of housing and this was a key factor in pushing US house prices down. In the UK, housing shortages are still a problem
    4. America had the highest % of risky, unaffordable mortgages. The American mortgage industry was the least regulated, offering subprime mortgages to people who had a high chance of defaulting on their mortgage. Generally, european mortgage industries were better regulated. At the moment, defaults in the UK are not at a critical level and are unlikely to get worse.
    5. Move to Longer Term mortgages and borrowing from parents. As people move to longer term mortgages and borrow from parents for a deposit, it facilitates a rise in house price to earnings ratio in the long term. This does not necessarily mean it justifies the rise from 2.5% to 5% we have seen. But, there is no law the long term house price to earnings ratio has to remain the same.

    The unprecedented rise in house prices do have some fundamental economic reasons behind them. Nevertheless there is also clear evidence that, at least part of the rise, is due to speculative buying, and this creates the potential for significant house price falls as the market turns. The extent of the house price slump may not be as severe as the worst predictions. (I don't think the European markets are precarious as the US, but, there were many who said US house prices would never fall. Also if conditions in the credit markets continue to worsen it will further worsen the prospects for house prices.


    Anonymous said...

    Will 2012 have an affect on the London's housing values?

    Tejvan Pettinger said...

    I Don't Think it will be significant

    see my housing blog

    Lawrence Low said...

    How come Netherland is not affected much by the housing bubble. By looking at the graph they should have equal exposure just like Ireland & UK.


    Tejvan Pettinger said...

    I'm not sure about Netherlands. I haven't read much about their economy. But, I'd be surprised if they are not affected in a similar way

    Anonymous said...

    Despite almost similar figures for France, prices may be overvalued for a very different reason than for UK. When a house goes for sale, the price is always on the 'up' side because it will almost always be bargained by the potential buyers.

    In France there's no 'auction' system like I've seen in UK ('offers starts at x£') or at least very uncommon. The first interested buyer to make an offer accepted by the buyer'locks' the transaction i.e. no other buyer can come after and overbid the price. Buyers will always try to get the price down because mortgages are very difficult to get.

    tomnightingale said...

    Might be useful if original post showed date (or did I just miss it?).

    "Overvalued" implies a knowledge of the "correct" value.Can historical data tell us that? To an extent, houses are luxury goods. Most people (UK) use more housing than they need...we could live in smaller houses with smaller gardens but (mostly) we would like bigger of both (we watch USA TV!). It might mean that as incomes rise, house prices will rise more than proportionately*, given space restrictions on new building. Add to that a rising population and perhaps rising affluence in specific groups (e.g. recent immigrants are often young, ambitious and hard working), models based on historical data may be inadequate.

    Tejvan Pettinger said...

    The Date is the URL at top of post. 2008/04