Dear Reader,
So far we have established that there is a housing bubble, that this bubble is large and likely has been caused by systemic factors, and that the modern version of this market is Ponzi-scheme-like.
The logical follow up to this is to ask: Is this bubble going to burst?
The honest answer is: who knows? But it is likely that when it happens it will be a protracted and drawn-out process over years rather than the immediacy we have come to expect when dealing in financial markets. We have already seen this happen to a degree in Japan.
From 1970 to 1991, Japanese housing prices, as in the rest of the world, became increasingly separated from the underlying rental value, as the amount of household debt and credit grew. The financial crisis of 1991 kicked-off a slow household deleveraging in Japan and a steady decline in the house price index as the speculative mania abated and prices became more linked to their underlying productive capacity: rents.
Interestingly, we find that as with other countries, the relationship between interest rates and rental growth (through incomes) in Japan has been highly correlated (0.88).
Real estate is an illiquid market where price discovery happens slowly. Participants have designed the market pricing mechanism to support price increases, rather than reflect intrinsic values at any given stage. No one in this chain, bar the starry-eyed buyer, has any incentive to value these assets correctly, but this could soon change. We may be seeing the beginning of the end of this bubble as the pandemic continues to reveal more of the under-appreciated risks taken on by investors - though a deflation would require the removal of one or more of the aforementioned spokes (culture, credit supply, underestimating risk).
If this pandemic shifts real estate investment culture from focusing on speculative capital appreciation back to the fundamental purpose of real estate, as a consumable asset to be lived in or rented out, then willingness to pay speculative prices will abate. If incomes drop substantially enough that banks and non-bank lenders spigot the flow of credit, this will restrict the ammunition of future buyers and force current real estate owners to eventually assess the fundamental productive value of what they own.
We are already witnessing the realisation of many of the risks associated with treating leases as an expense rather than debt and underestimating idiosyncratic risk . Retail and other high-street businesses are closing down en masse. Commercial landlords are only collecting 10-15% of the rents they were hoping for. How will they cover their expenses and service their interest payments?
The political response to this thus far has been to coerce lenders into delaying interest payments. But this puts pressure on bank loan-books and restricts their ability to pay the interest they in turn owe. What happens then? We can follow this daisy-chain around and around, but the point is illustrated: in an economy you can never hold everything else constant. Eventually, a hair-cut must be had and a deleveraging occurs. Further, how can owners of these assets expect to receive any kind of meaningful cash return on their capital in future? Who would be willing to buy these unproductive assets at such high prices?
In the words of Winston Churchill:
“Now this is not the end.
It is not even the beginning of the end.
But it is, perhaps, the end of the beginning.”
Until next time.
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Japan popped it's asset price bubble by raising interest rates too fast, all this after loosening its monetary policy too quickly, business valuations on the Japanese stock index inflated primarily due to assets.
The UK HPI has tracked UK GDP since data records began, Japan had a property market bubble because the JP HPI rose to approximately double GDP, there simply wasn't enough capital to service the debt allocated to property. They are not comparable in support of your bubble hypothesis, as long as there is capital to service debt related to property purchasing there is no problem. Provided the BOE doesn't raise rates faster than economic expansion then the issue of servicing property debt is curtailed, secondly the BOE is now targeting an inflation rate to erode the debt (whether they can actually meet that target is a separate debate).
Ponzi schemes collapse because they expand at a magnitude faster than available capital, there is no sign of this in the UK property market for the foreseeable future. As the saying goes "shit or get off the pot". The only way to take advantage of a correction is to sell before and buy afterwards, most people do not live their lives around corrections of the housing market and if their house decreases in value so simply does the house they buy in replacement. The only people likely to speculate in this fashion are multiple home owners and even then only a select proportion. 63% of properties are allocated to home owners.