As much of the industrialised world emerges from a financial crisis and recession that had its roots in the US housing market, the role of property in economic activity generally is getting a closer look.
In the US, house prices, as measured by the Case-Schiller 20-city composite index, hit a high of 206.53 in April 2006 and bottomed out at 140.83 in May 2009, wiping out nearly a third of the value of house prices since their peak. Although there has been some improvement since then, prices are still bumping along the bottom and some analysts believe that the indices understate a recent fall in prices.
The fall in US house prices comes after what was clearly a period of explosive growth, especially in certain markets; from 2000 to the peak, prices rose more than 170 per cent in Miami, 150 per cent in San Diego and roughly 140 per cent in Tampa, Florida.
The US was not alone in seeing house prices shoot up and collapse; after rising by double digits through the early part of the decade, UK house prices fell more than 20 per cent between the autumn of 2007 and their trough in April 2009. Spain and Ireland had even more exaggerated rises and falls.
Moreover, it was not just housing where the balloon has popped. Commercial real estate – offices, shopping malls, hotels and industrial parks, has also followed the trend.
From peak to trough, commercial real estate values fell on average by more than 40 per cent in the US and the UK, two of the world’s most active markets for real estate investors.
Of course, real estate is hardly the only asset class to experience boom and bust; stock markets do it all the time. But when real estate markets experience these extremes, the knock-on effects appear more damaging to the wider economy than for any other asset class. The bursting of the dotcom bubble in 2000, for example, did not produce anything like the current recession.
Lawrence White, professor of economics at NYU’s Stern School of Business, says falling house prices cause such wide ripples partly because so much household wealth is tied up in them. In 2006, at the peak of the market, US housing wealth totalled $22,000bn and, on average, a home represents 25 per cent of each household’s net wealth. Given that home ownership rates were around 66-70 per cent at the height of the market, a fall in house prices significantly reduces homeowners’ wealth. “It has an effect on household confidence,” says Prof White.
Consumers are likely to cut consumption when they are less confident about their future wealth, he says, and this leads to slowing demand overall.
Not all economists are convinced that the link between house prices and consumption is so clear cut; a Bank of England study in 2005 concluded that those who did not own homes in the early part of the decade, when house prices were rising strongly, were increasing spending as rapidly as those who did.
Peter Hobbs, head of business development at Investment Property Databank, says commercial real estate is significant to the broader economy because of several factors; for one, it is a unit of production. The price of real estate is an important factor in determining relative productivity costs across markets.
But the real, and single most important, reason why property prices matter is because of their ability to send shockwaves through what economists call “the credit channel”.
“Property is leveraged,” Prof White notes. Even when cash rich investors buy property, they generally do so using money borrowed from banks. Even more so do homeowners.
According to data from the US Federal Reserve, lending to the US household sector totalled $13,802bn in 2007. Of that, $11,166bn was in the form of residential mortgages, collateralised by homes whose prices were already falling.
Commercial mortgage lending, including to apartment developers, totalled $3,088bn. So, of the $31,708bn in domestic bank lending in the US in 2007, just under half of it – $14,254bn – was collateralised by assets about to plummet in value.
Erik Britton, economist at UK-based Fathom Consulting, describes how the credit channel works. As house prices fall, recorded loan-to-value ratios rise. This, in turn, requires banks to set aside higher reserves against those loans, even if borrowers are still paying interest and principal.
Lenders then become more cautious about extending loans to new borrowers – note how UK lenders are now insisting that borrowers have deposits of at least 25 per cent of the purchase price – and the pool of available investors begins to shrink.
As a result, the number of buyers dries up and those who are forced to sell must do so at a loss. Each new forced sale drives the price of similar properties down. Lenders take yet more write-offs and are forced to put up even more capital for reserves.
And if house prices in large economies are showing signs of stability, commercial real estate prices are more dubious.
Although key indices such as that developed by IPD are showing recovery, professional investors say those reflect a handful of transactions involving prime properties.
“The real concern is for secondary properties,” says a principal at an international real estate opportunity fund. “It is the biggest part of the market and it is the part that got hit the hardest. It is the iceberg below the water.”
Banks are sitting on vast portfolios of loans against commercial property that are in breach of loan covenants, the fund manager noted.
Until they can clear those loans off their books, their ability to make new loans to any part of the economy will be restricted, he says.
