Real estate bubbles: How worried should we be? - Worry centers on economic ripples from property prices

Real estate bubbles: How worried should we be? - Worry centers on economic ripples from property prices
By Shelley Emling
Copyright by The International Herald Tribune
Published: January 12, 2007


LONDON: Richard Donnell, director of research at the property tracking Web site Hometrack, called 2006 one giant "field day" for real estate agents in London. Prices went up as much as 20 percent in upmarket neighborhoods like Chelsea, so fast that sellers and their agents could pretty much name the price.

As 2007 dawns, however, the field day is looking more like a trudge. Rising interest rates around the world are starting to affect real estate markets, leading many economists to predict a slowdown in house-price escalation even in supply-starved areas like London. Donnell said that because of the higher cost of borrowing, "buyers might sit on their hands a bit."

In recent years, real estate markets throughout the world have been wilder than a toddler on ice skates, with residential property prices in many markets doubling or even tripling over the past decade as buyers took advantage of easy credit and the even easier gains promised by rising values.

These overheated markets have prompted warnings of property price bubbles in areas as far-flung as Australia and Spain, Hong Kong and Ireland, as well as much of the United States, which is still the engine of global growth. The warnings have been most acute where loose credit terms have encouraged consumers to buy bigger properties than they can afford, as in London, or in newly hot second-home markets like Spain or Croatia, where resale values are fragile.

In South Korea, home prices in Seoul surged nearly 19 percent last year, leading the government to pledge to build one million homes by 2012. In China, home prices have been climbing an average of 6 percent to 7 percent in recent months, pushing Beijing to tighten credit and reduce building project approvals.

How worried should the world be about a collapse in real estate prices? Very, according to many economists, who directly link property values to economic prosperity, real or imagined. Tamper with that feeling of prosperity, they argue, and watch consumer confidence drop off the cliff, along with consumer spending and economic growth.

Property markets have already begun to cool sharply in parts of Ireland, Australia and the United States. In October, the average price of a house in the United States dropped to $221,000, down 3.5 percent from a year earlier, the steepest annual decline since the National Association of Realtors began keeping records.

The alarmist view is not a fringe sentiment. Stephen Roach, chief economist at Morgan Stanley, said post-bubble adjustments were likely to be a big deal in 2007. The focus of his concern is the United States, where about 70 percent of gross domestic product is accounted for by consumer spending and about 5.5 percent of GDP is accounted for by residential construction.

But Roach is also worried about contagion. A drop in U.S. property values has ramifications, he said, for "a U.S.- centric global economy that remains overly reliant on the U.S. consumption dynamic as the sustenance for economic growth." Tobias Just, an analyst in Frankfurt with Deutsche Bank, also said he had real fears that Europe and other parts of the world would be negatively affected by the U.S. slowdown. "Weaker U.S. growth due to a deteriorating housing market leads to worsening prospects for Europe as well," he said.

A bubble forms when prices increase faster than can be explained by market fundamentals. Any deflation of the bubble, or decline in prices, can cause consumers to reduce spending and borrowing. Spending by consumers with an extra cushion of wealth thanks to rising house prices has spurred much of the economic growth seen in the United States since the late 1990s, as well as in Europe and Asia.

Evidence of this is the U.S. savings rate, which is below zero, compared with 2.5 percent in 2000. This means Americans have been paying out more than they are bringing in and so have been financing their spending with borrowed money. In Canada, too, debt levels have grown so high that the savings rate has fallen from 7 percent to 1.5 percent in the last few years.

At the same time, outstanding mortgage debt in the United States totaled about $12.8 trillion in September, a jump of more than $5 trillion since the start of the decade, according to the Treasury Department. This is partly the result of the easy credit offered by banks increasingly in competition to lend money. Other developed countries have shown similar jumps in mortgage debt.

Arguing that there is a real risk of recession, similar to the one that followed the collapse of the stock market bubble in 1999, Roach has predicted that the property slowdown will slice at least two percentage points off growth this year in the United States alone.

"Savings-short American consumers have been using increasingly overvalued homes to support excess consumption," he said. "As that option is now foreclosed in a softer house price climate, consumer demand should come under ever-greater pressure."

According to a recent report from Deutsche Bank — titled "U.S. house prices declining: Is Europe next?" — the link between the United States and Europe is deep and macroeconomic.

In Europe, Ireland is the country most at risk of a property crash because of "the effect of rising interest rates in a flexible mortgage system," said Just, the Deutsche Bank analyst. Spain is next, he said, because it faces "contagion risk" from drops in other economies, like Britain; foreign purchasers of second homes have fueled much of the Spanish property boom. Germany, where prices have stayed mostly flat since the mid-1990s, faces the least risk of a property crash, Just said, because prices do not have as far to fall.

The risk is not just from a wholesale collapse. Nathalie Girouard, a housing specialist in Paris at the Organization for Economic Cooperation and Development, said even a stabilization of house prices could affect consumer consumption, especially with ratios of household debt to income at historical highs in several countries.

"In the case of a major housing downturn, spillover effects may be large," she said. "In fact, any kind of downturn could affect consumption."

Girouard said some comfort might be drawn from recent experiences in markets like Australia, where "declines in real house price inflation occurred with seemingly little effect on macroeconomic activity." Prices doubled in most Australian cities from 1998 to 2004 but have slowed considerably over the past two years, yet the Australian economy still managed to expand more than 2 percent in 2006.

Going forward, and despite Just's concerns, economists in several markets remain fairly sanguine.

They expect a soft price landing that will have minimal effect on the economy.

But Charles Dumas, chief economist at Lombard Street Research in London, said property prices simply could not keep going up as fast as they had been.

"There's a bit of a bubble asserting itself," he said. "It's nothing to get too worried about. Yet."