Strategy team: Victor Balfour
…according to Andy Haldane, the outgoing Bank of England Chief Economist. Indeed, residential real estate – or more specifically house prices – across much of the developed world is on a tear, buoyed by ultra-low interest rates, shifting preferences and a scarcity of homes. In the US, for example, the cost of single-family dwellings surged 23% over the past year alone; in New Zealand the comparable figure is approaching one third.
Such statistics are often accompanied by fearful warnings: bubbles, debt burdens and inequality are once again moving up the wall of worry. In part this reflects the sheer size of global residential property and its use of leverage – it has deep linkages with the real economy and the financial system. For many this resurrects fears of economic instability and the excessive securitisation of the noughties.
We do not see this as the precipice of another crisis. The economic revival is well underway and bank lending (and any subsequent securitisation) could be described as conservative relative to the heady days of the GFC. Equally, outright property "bubbles" are rare (Japan aside) and even household debt burdens, in relative terms, are subdued.
House prices had little time to respond to the events of 2020 – the market was initially incapacitated as lockdowns ensued, but the economy quickly started to rebound. Of course, the property cycle doesn’t neatly follow the economic cycle, with longer-term trends in demographics and the supply of houses playing an important role, alongside sentiment. Subdued supply in particular has helped squeeze prices higher as low mortgage rates have fostered resurgent private demand. Supply is often restrained by regulatory obstacles, ineffective policy, and nimbyism.
In addition, as the crisis progressed, remote working arrangements and a long period of introspection have reportedly encouraged some homeowners urgently to reappraise their living arrangements. This has driven something of a development boom – notably in the US, where supply tends to be more flexible anyway. Construction labour shortages are appearing, alongside the rising cost of key raw materials – US lumber futures surged some 400% in May relative to same period last year (though they have eased in the past month).
However, one risk indicator – affordability – is now flashing ‘red’, even as mortgage rates have collapsed to all-time lows, simply because prices have risen so far. The OECD gauge of housing affordability - the average of house price-to-income and house price-to-rent indexes – has now surpassed the previous 2007 high.
Our attachment to housing is an emotional one, and complicated by its quasi investment status. A house is first and foremost a place to live, but it is also most owners’ biggest single asset, dominating their personal balance sheet. Would-be occupiers and speculators can have competing interests: local residents often find themselves excluded as investment-led prices surge higher.
The recent run up in prices does indeed seem to have attracted more institutional and speculative buyers into an already frothy market – a very visible beneficiary of financial repression, as ever-lower yields drive portfolio shifts. Prices need to fall, or incomes rise (or both), if the inequity is to be reduced.
Residential property stands currently in marked contrast to commercial property, which was facing something of an existential crisis last year – a consequence of working from home, social distancing, unpaid rents, and foreclosures. Though most segments are slowly returning to normal now, there was a clear bifurcation between downtrodden bricks-and-mortar retail, hotel, and office space, relative to warehouses and industrial units which have faced insatiable demand.
Even investors in REITs – Real Estate Investment Trusts, which are part of the equity market – faced a particularly difficult environment in 2020, as many of their assets traded implicitly at fire-sale discounts: the MSCI US REITs index, for example, was one of only three sub-sectors to deliver negative returns last year.
For investors in so-called ‘open-ended’ real estate funds, the reality was even more precarious: liquidity evaporated, leaving many funds suspended, with investors effectively gated and unable to sell positions.
Looking ahead, after a fairly tumultuous 12 months, commercial real estate markets seem to be stabilising. Last year’s trends are slowly reversing – demand for warehouses is ebbing, while high streets slowly resume trading.
As for ‘red hot’ residential property markets, some distortive policies are due to expire – such as the UK’s stamp duty holiday – while forward looking measures, such as US housing permits, suggest that we may have passed the recent peak in this housing boom.
While direct investment in real estate can offer a different, and often uncorrelated, third source of investment return to go with interest income and company profits, and can offer some protection against inflation, it is difficult to go much beyond the macro observations outlined here. In our context, the most importance aspect of the strengthening real estate markets has been their contribution to wider economic recovery – a contribution which seems unlikely to end in tears just yet.
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