Housing Market: Part 6
Valuing housing markets across the OECD. Where are the credit-induced residential property bubbles? What is the chance of significant financial distress?
A Recap of Where We Have Been
In Part 1, we established that there is a housing bubble.
In Part 2, we estimated how large this bubble is.
In Part 3, we compared the modern housing market to a Ponzi scheme (!?).
In Part 4, we speculated on what the future of the bubble might look like.
In Part 5, we addressed some of the most common objections to this analysis.
Today, in Part 6, we value the housing markets of all OECD countries to discover which, if any, markets have property bubbles, how big they are, and what is driving them?
The Valuation Model Output Summary - USA Average Residential Property
For each country separately, the following averages were considered:
% of Income Spent on Rent
Occupancy Rates, Marginal Tax Rate
Residential REIT Operating Margins
Risk-Free Interest Rate
Mortgage Interest Rate
Imputed Default Spread
Average LTV Ratios
Equity Risk Premium
As with all our property valuations, we have discounted the FCF to the asset at the weighted average cost of capital for each market.
Which OECD Residential Property Markets Are Over & Under Valued?
If reliable data wasn’t available for a particular market, the OECD average was used.
On a GDP-weighted average basis, the average residential property across the OECD is overvalued by 57.69%. Australia has the most overvalued market, with the average property costing 2.75x what it is worth, while the Hungarian and Finnish markets are undervalued.
Further, as Figure 2 illustrates, there is a correlation (0.57) between a country’s property market being overvalued and the level of household debt (as a % of GDP) they have.
As has been previously discussed, there is a self-fulfilling feedback loop between property prices and household debt/credit. As credit becomes more available, this drives house prices higher, which in turn reduces the risk-weighting of mortgages held by banks on their loan books, which allows them to extend credit further.
For the keen beans, here are our previous posts that go into these dynamics:
Debt, Credit & Monetary Policy: The Debt Burden & Credit Risk, Monetary & Fiscal Policy, Interest Rates & Growth
This relationship feeds on itself until one of the three legs - culture, financing & risk-weighting - of the credit bubble stool is removed. Then, these dynamics will feed on themselves in the other direction.
Surely We Can Continue Inflating These Bubbles By Extending Credit Forever?
Well, not really… In order to explore why this is not possible, we need to understand how debt works in a valuation sense.
There are two-sides to the debt coin. On the one side, debt lowers your cost of capital as the interest payment is usually tax-deductible and the leverage effect increases your Return on Equity Capital.
On the other side, debt increases your risk of financial distress because you have larger fixed costs - interest expenses - to cover and if these payments aren’t made then the seniority of collateralized debt capital kicks in and the assets are repossessed.
If households take on more debt, they become less creditworthy and have a greater chance of financial distress. If interest rates are lowered, this reduces the cost of debt and lowers the chance of financial distress. But, even with low interest-rates, an unlimited amount of debt cannot be taken on as the interest payments will still become too large at some stage.
In order to determine the chance of financial distress for the average household in each country given their amount of debt, income and interest payments, a synthetic credit-rating was estimated and the default probability imputed.
There is a correlation (0.47) between each country’s Household Debt-to-GDP ratio and its average households chance of default. The countries with the biggest debt problems are Australia (24.82% chance of distress), Switzerland (16.89%), Norway and Iceland. They have much larger chances of distress than the other countries as interest payments make up such a relatively enormous proportion of household income.