From “irrational” to “unsustainable”

Never before in history have 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. The global boom in house prices has been driven by several factors:

  1. Historically low interest rates – which have encouraged homebuyers to borrow more money than ever before.

  2. Households have lost faith in equities – following the stock market plunge of 2000, making property look attractive.

  3. Cheap energy costs – which is an aberration in the United States among other industrial nations, but not any longer as $60-plus oil and $3 gasoline has now arrived stateside.

Fed Chairman Alan Greenspan recently stated “signs of froth have clearly emerged in some local markets where home prices seem to have risen to “unsustainable levels.” Back in 1996, during the dot-com craze, he also used a similar carefully worded statement to describe the stock-market bubble – “irrational exuberance” – just before it burst.

Is this global 21st-century housing boom “unsustainable” and headed for an ugly ending? Or, are spiking housing prices worldwide just a slight aberration from the normal cycle and will most likely end in a “No problem soft-landing”? What can we glean from recent headlines?

  • “Home prices rising $222 A DAY!” boasts a Vancouver, B.C., newspaper headline.

  • “Prepare for the economic pain when the biggest bubble in history pops,” warns Economist magazine.

  • “Slowing seen in N.Y. and Boston housing prices,” admits the New York Times.

  • “Top home builders insider stock sales prompts concern,” reports CNN-Money.

Real-estate agents, builders and developers all hope Americans will tune out the recent wave of negative housing-bubble-talk, which they say is overblown by media pundits. After all, they are the experts in the real-estate market, right? If there were a bubble they would surely warn us before it bursts – right? Hah!

My goal is to help readers steer clear of as much “economic pain” in the future as possible by examining the facts and ignoring the hype. Let’s face it, the more people who hold a distorted perspective of the downside risk of the real-estate “wealth effect,” the greater the risk is to all U.S. homeowners.

According to the Economist, rising property prices helped to prop up the world economy after the stock-market bubble burst in 2000. 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 percent of those countries’ combined GDPs.

Will America’s red-hot housing boom now turn to a bust? If so, what, if anything, can be done to hedge a housing crash which could lead to record foreclosures, bankruptcies and collateral damage to the global financial markets?

Here’s a partial list of the biggest risks facing the U.S. housing market today:

  1. Economic consequences of consumer overspending

    Because the housing market played such a big role in propping up America’s economy, a sharp slowdown in house prices is likely to have severe consequences. Over the past four years, consumer spending and residential construction together accounted for 90 percent of the total growth in GDP. Over 40 percent of all private-sector jobs created since 2001 have been in housing-related sectors, such as construction, real estate and mortgage brokering. Those who financially “live” off a real-estate boom are at the greatest risk in a real estate bust.

  2. Living largely … way beyond our means

    New, riskier forms of mortgage finance also allow buyers to borrow more. According to the National Association of Realtors, 42 percent of first-time homebuyers and 25 percent of all homebuyers made no down payment on their home purchase last year. Indeed, homebuyers can get 105 percent loans to cover buying costs. Interest-only mortgages are all the rage, along with so-called “negative amortization loans.” After an initial period, payments surge as principal repayment kicks in. This year, ARMs have risen to 50 percent of all mortgages in those states with the biggest price rises. As interest rates rise, so will foreclosure rates, further depressing prices.

  3. The price-to-rent ratio out of whack

    Just as the stock market has a gauge for measuring the value of companies based upon the ratio of price-to-earnings, one can view real estate with the same perspective. It’s called the “price-to-rent ratio.” Just like the NASDAQ, which went into unchartered waters in the late 1990s, real estate has now entered into never before seen levels of valuation. 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 overvalued than at previous peaks, from which prices typically fell. House prices are also at record levels in relation to incomes in these nine countries.

Nevertheless, the real-estate boom is not without some solid underpinning. They don’t call it “real property” for nothing – it has great human utility as well as investment appeal. Houses can be nicer to look at and cozier to occupy than a bond, stock certificate or even a gold brick.

Speaking of gold bricks, next week I’ll cover some other major risks including: rampant speculation, homeowner denial, when realtors start warning, lessons from overseas and how to put a golden hedge around your dream home.

Beyond the “asset inflation” bubble

Boom or bust, bubble or not, the real-estate price explosion of the last five years is a powerful example of “asset inflation.” Asset inflation generates phony collateral for runaway consumer indebtedness, luring the consumer into unprecedented debt excesses.

Runaway housing and commodities prices are the proverbial “canary in the coal mine,” warning us of much higher inflation – which is never reflected in government statistics until it’s too late. The rapid house-price inflation of recent years is clearly unsustainable, yet economists cling to the hope that house prices will flatten rather than collapse.

If housing does begin to hiss or even pop, there are a few pluses. First-time homebuyers may not be priced out of the market, savings rates may go up and we’ll buy less from foreigners and owe them less. Perhaps a housing bust is nature’s way of stopping the U.S. debt bubble from growing any faster, for the sake of the next generation.

Here’s a final Greenspanism worth remembering: “Newly abundant liquidity can readily disappear” – which is a slight rephrasing of Proverbs (13:11) warning, “Wealth from vanity becometh little …”

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