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 "I think that we can get some insight into the Australian property market by closely watching the US market. They currently have the same issues to sort out - a property bubble, low interest rates, high national debt. The article below has a close look at some of the 'bubble' signs and gives a more moderate interpretation of the potential outcome." - Mark |
| United States: Bubble Trouble? |
| By Richard Berner (New York) |
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June 04, 2004 Now that interest rates seem to be firmly on an upward path, the great housing bubble debate is back in vogue. US consumers are widely perceived to be overleveraged and to expect that they will always be able borrow against the equity in their homes to finance spending. Were home prices to decline, much less tumble, so the story goes, the hapless American consumer would be toast (see Steve Roach’s accompanying Forum, “The Mother of All Carry Trades”). Those perceptions simply don’t square with reality, in my view. Most important, income and job growth remain the cornerstones of consumer spending, and both are improving. Already in the first half of 2004, there’s been enough income to finance a moderate spending pace and increase saving despite soaring energy quotes and disappointing tax refunds, and further improvement lies ahead (see “The Case for Stronger Second-Half Growth,” Global Economic Forum, May 28, 2004). Moreover, I think tapping the equity in housing and the additional wherewithal from lower mortgage debt service have been plusses for consumers, but Fed studies and my own indicate that the common belief in the magnitude of their impact is much too high (see for example, “The ‘Refi’ Bust Won’t Cripple Consumer Spending,” Global Economic Forum, August 1, 2003). Finally, I think that US housing prices will rust, not bust in coming years. To be sure, pent-up demand for housing is largely satisfied for now, and rising mortgage rates will further cool demand. But I think fears of a housing price bust are overblown, as housing valuations are at the lower end of historical ranges, and healthy job and income gains will support consumers’ capacity to service debt. Still, the pessimists have become more convinced than ever that the seemingly endless upward spiral in home prices is merely a by-product of our addiction to debt — an accident waiting to happen as soon as rates reverse course. In my view, a nationwide housing bubble never happened, so a bursting bubble is not a threat. Three times in the past two and a half years I argued that housing prices were likely to decelerate sharply to 2% to 4% in the next few years, or to stagnate in real terms, but that I saw scant sign of a national housing bubble (see “Housing Prices: A Bubble Ready to Burst?”, “Serial Bubble Alert,” and “False Bubble Alarm,” Global Economic Forum, January 28, 2002, September 13, 2002, and June 27, 2003, respectively). While I saw the pace of home price appreciation as unsustainable, I rejected the notion that either the pace or level of prices was prima facie evidence of a bubble. Rather, favorable demographics supported long-term demand, and changes in construction financing limited new supply, promoting a better balance between them. I haven’t changed my view, despite the fact that home prices have only decelerated slightly. Over 2002-03, the pace measured by the house price indexes from the Office of Federal Housing Enterprise Oversight (OFHEO) slowed from nominal increases of 8%-plus to 6½%, but has since rebounded back to 8%, year-over-year. Of course, housing markets are local, and we can partly trace the rebound to some locales that deflated somewhat in the tech bust and have since recovered. For example, home prices in San Jose and San Francisco, California, decelerated dramatically through last summer, from 24% in 2000 to 0-3%, but are now rising by 3-5%. But the contrasts across markets are strong: Frothy markets in southern California, like San Diego and Los Angeles, and in Miami, Florida, never missed a beat and are rising by 14-17%. In other parts of the South and Southwest, prices in Atlanta, Austin, Dallas, Houston, and Denver have decelerated significantly, to 0-3½%. As I see it, nationwide housing ‘valuations’ are only back to neutral from being undervalued. My valuation metric — a crude ‘price-earnings’ ratio for housing — corroborates that view. It compares home values with owners’ rental income to approximate how much homeowners are paying for a dollar of such income. I proxy home values as the product of the OFHEO home price index, the number of single family owner-occupied houses, and $64,000 — the value of typical house in 1980, the base year for the price index. I proxy the ‘earnings’ from housing just as the Commerce Department does, using rental income of persons — a measure that nets from gross rents such charges as mortgage interest and property taxes. This denominator is far from perfect: Some of the incomes are imputations from farm and nonfarm non-profit non-residential property, and royalties. But as long as the share of those imputations is roughly constant, it will not affect the valuation calculus. The rental income measure is hostage to statistical quirks, so we’ve made an adjustment. During the mortgage refi boom, the housing P/E ratio jumped, because the Commerce Department reckons the cost of mortgage refinancing as an upfront charge against rental income, depressing the denominator. Others use the ratio of home prices to the consumer price index for owners’ equivalent rent (OER) to judge valuation, but that metric fails to take account of ‘share count’ — the stock of housing — and reduced charges against earnings. And the OER methodology is questionable, with single family housing rents essentially imputed from apartment rents. My P/E ratio shows that valuations have moved up, but there is little hint of overvaluation, especially compared with the high-inflation 1970s. Using published data for rental income, the ratio has risen from 100% to 112% in the past two and a half years (the level of the ratio seems high, but the units of measurement are somewhat arbitrary). That’s 22% above the level of the mid-1990s, when housing by this metric was undervalued, but well below the 250-300% level of the 1980s — a level that clearly foreshadowed the housing bust of 1989-93. Amortizing refinancing charges over time, as most borrowers do, levelled rental income over that period, and leaves the ratio at 107% in the first quarter. An alternative comparison over a longer time horizon also suggests that home price growth hardly seems excessive: Annualized growth in prices since the trough in 1991 Q1 is 4.6% compared with a 5.3% annualized rise in nominal GDP over this period. The bottom line is that a rise in prices per se is hardly evidence of a bubble, and when correctly measured, housing valuations show little sign of excess. Of course, that does not mean that home prices will be unaffected by rising interest rates; far from it. The jump in homeownership rates, from 63.8% in 1993 to 68.6% in the first quarter of 2004, amounts to an 11 million increase in households owning their own home. That unprecedented leap suggests that powerful, immigration-led demographics fueled pent-up demand for housing over the past decade, and are likely to fade. Waning pent-up housing demand and rising rates suggest that both housing demand and prices will likely cool significantly. And that does mean more limited opportunities for home equity extraction, significantly lower mortgage originations, and deterioration in mortgage credit quality even though income and job growth are improving. Far from obsessing about the macroeconomic implications for the American consumer, therefore, investors should regard these developments as a yellow flag for those who lend to consumers. Reference: Morgan Stanley website. 
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