Housing Market: Part 2

How large is this bubble?

Dear Reader,

In Part 1 we established that there has developed a substantial disconnect between the average price of housing and the average intrinsic value. Now, we will look at how large this bubble is across the entire market.

As of last year, there were 27.6 million homes in the UK. This means that it would cost you £6.38 trillion (yes, trillion, with a ‘t’) to buy all the in-use housing stock in the UK. You would then be collecting all of the residential rent, but the intrinsic value (average intrinsic value, calculated above, multiplied by the number of houses) of your new portfolio, held forever, would be a meagre £2.56 trillion. This suggests that there is a £3.82 trillion housing bubble in the UK alone. 

If you do this same analysis for the 108 largest economies in the world and aggregate it, you find that the housing bubble is worth a whopping £83.04 trillion.

I hypothesise that there are three main factors that have inflated and continue to feed the inflation of this bubble. All three must hold concurrently, or the bubble cannot support itself. The first is the culture around housing, the second is financing as a product, and the third is the systematic ignorance of idiosyncratic risk. 

As we entered the post-war period, culturally and politically we saw housing as a necessity; an affordable, well built place for people to live. Over time, as fortunes were made, and retirements funded on the back of price increases, this expectation changed. No longer was property just a place for people to live, it became a way to build wealth and fund retirements without anything actually being created. 

We began to experience a sort of collective cognitive dissonance, where we held two contradictory statements to be simultaneously true: that 1) property is the best place to build long-term wealth through capital appreciation, and that 2) a home should be affordable to buy and live in. To bridge this ever-expanding heuristic canyon and buttress prices rather than letting them come down, we started doing increasingly complicated financial gymnastics to ensure there was a constant and ever-growing stream of credit and government assistance for potential buyers, while simultaneously restricting any meaningful increase in the supply.

This leads into the second point, that mortgage financing is a service/product. Banks and mortgage brokers benefit from housing schizophrenia. The biggest threat to their business is not from the competitive forces of other lenders, but rather the rental market. Banks collect fees when you: apply for a mortgage, buy the property, make your interest payments, sell and pay off the mortgage early, apply for a new mortgage, buy a new property, pay the interest, and then even if you default, they take the house and sell it to someone else who is financed within their ecosystem.

Further, residential backed mortgages are held on the bank’s balance sheet at fair market price, meaning that if you default in a rising market, the bank makes a profit as they repossess and liquidate to close out the credit/debt transaction. They are directly incentivized to encourage a culture of skittish housing speculation and rising prices as they don’t get paid unless you can’t afford the property and have to take out a mortgage. The bank is like a heroin dealer and we are the junkies. If you break the habit, they lose business. And, as the old saying goes: “Never ask the barber if you need a haircut.”

Finally, accounting and credit standards have systematically ignored the risks associated with leaseholds and private ownership. Up until last year, when a business signed a lease agreement to rent an office, factory, or retail space, they did not capitalise the legal financial commitment they were making to pay rents into the future. This means that they did not hold these lease-obligation debts as liabilities on the balance sheet. The IFRS Foundation is attempting to correct this with the IFRS16 changes to reporting standards for European businesses, but GAAP still needs to catch up.

“Debt is an obligation that requires one party, the debtor, to pay
money or other agreed-upon value to another party, the creditor.
Debt is a deferred payment or series of payments.”

Despite being the economic equivalent of debt, accounting standards have let companies treat lease commitments as operating, rather than capital, expenses. This understates the risk the business is taking, acts as an off-balance sheet form of leverage, and reduces the expected return that the business would otherwise demand from accepting this commitment. This provides unfounded risk-adjusted support to landlords of marginal commercial properties, which in turn inflates total rental incomes above their otherwise natural level and helps to finance, but never pay down, an ever-growing credit supply.

On the other side of this coin is the understatement of the idiosyncratic risk taken on by non-diversified private landlords. Let me explain...

When you own an asset, the total amount of risk you face is equal to the amount of intrinsic risk the asset itself has, plus the asset’s connection to risks facing the market as a whole. If you own many different assets the risk to you, associated with any one of them having individual problems, becomes small, while you still face the full amount of their combined market risk. We term the risks unique to that asset ‘idiosyncratic risks’ and the risks to all similar assets ‘market risks’.

Consider this example: If I own 1,000 rental properties across the world, the impact, to me, of any individual one of them having problems (fire, damage, flooding, destructive tenant) is small. But the impact of a recession, or interest rate movements, or inflation, or pandemic, is high because it will likely affect them all.

Modern theories of corporate finance operate under the assumption that we are all well-heeled investors who can diversify away idiosyncratic risks. But, for most people who own property, they are typically anything but diversified. They are usually extremely concentrated and highly leveraged to a single asset. If the asset faces problems, they feel the entire burden. As a result, quantitative estimates of ownership risk fail to account for this. If you include these idiosyncratic risks, then the risk-premium scaling factor (the unlevered, cash-adjusted beta for you capital market pricing model enthusiasts) for these private real estate investments should be, globally, roughly 3.85 times the size.

This result suggests that private landlords in the UK should demand a return on their equity capital (the deposit) of 14.51% rather than 3.45% (my estimated cost of equity for marginal real estate investors) to be adequately compensated for the level of risk they are taking. This difference is enormous and has profound implications on valuations. A house that is intrinsically worth £92,784 to the marginal, well-diversified investor, is only worth £27,281 to the private, concentrated investor. It is important to note that, in my above valuations of the housing market as a whole, I too have ignored this additional idiosyncratic risk as I have valued the real estate market as a whole and assumed that the buyer of the whole real estate market is, by nature of owning the entire market, well diversified. 

Until next time.

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