Saturday, March 24, 2007

It's a strange (property) world (1)

In some parts of the world we are currently seeing signs of very weak or falling downward property prices. Parts of the United States can be used as examples. The very long down trend in Japanese real estate prices also comes to mind.

In other places we are seeing property prices continue to march upwards in spite of prices looking expensive when measured against incomes, rental yields and historic prices. London and Australia illustrate this situation.

So why do property prices keep going up when they have already reached levels where (i) younger and less affluent people are struggling to afford either a down payment or to service a mortgage and (ii) yields are significantly below bank deposit rates (note: this is not the case in Hong Kong)?

As with most economic questions, the answer is supply and demand.

This post looks at the demand part of the equation. There appear to be four factors driving demand for residential property:

1. population: populations in these cities are growing. More people means that more accommodation is needed to house them;

2. declining household size: not only are populations growing, but the size of the average household is falling. This means that even if the population remained static in absolute terms, the total number of housing units needed would continue to rise;

3. investment demand: the demand for investment property by (in particular) middle class families has been a noticeable feature of the last decade or so. I have no data to refer to, but looking at all the books, web sites, TV shows and other materials devoted to property investment I would guess that a meaningful percentage of the demand for residential property purchases is driven by investors. This does not change the number of people living in a city but it does add to the demand;

4. liquidity: the ease of obtaining a mortgage (even one that is of questionable affordability) is also a factor. The current problems faced by sub-prime lenders in the US give a good indication of how lax lending standards have become in some markets (and what happens when things go wrong).

Factors #1 and #2 are long term demographic trends. In spite of aging populations in some countries, I do not expect these to change anytime soon. Factors #3 and #4 can be a bit more fickle, but even if investment demand goes away (or reverses itself with investors being net sellers), it is a fairly safe bet that it will come back. The only question is when. It took Hong Kong about six years for the market to bottom out after the 1997 peak. Japanese investors had to wait about sixteen years from the top of the bubble to be told that property prices had at last shown a statistical increase. Other markets have recovered from slumps after much shorter periods. I have not heard of anyway to reliably predict the bottom of a market slump, but based on my (limited) experience, anytime you can by a property with a reasonable deposit (30% is typical in Hong Kong) and have the payments on a P+I mortgage being less than the rental return, it is a good time to buy.


Adventures In Money Making said...

sadly, asset prices are not a function of value, but a measure of how much money is chasing them.

excess liquidity is ruining the party.

traineeinvestor said...

The global glut of liquidity has been driving asset valuations for a number of years now. In a sense I understand and agree that the excess liquidity has pushed asset prices above levels which can be justified by valuation models (e.g. it has been a long long time since I came accross a property in Hong Kong that could support the standard 70% 20 year mortgage and still show a positive cash flow).

I suppose this leads on to the question of "what is value". In absolute terms, valuations of many assets look high. However, if excess liquidity means a lot of cash looking for a home, then valuations should be viewed on a relative basis - the money has to go somehwere and will (or should) end up going to the asset class offering the best risk adjusted valuation compared to all other asset classes. The fact that all asset classes are at high valuations becomes less relevant.

Of course, this is a gross over simplification and is not an approach I am too comfortable following with my own investments, but it does help to explain why many asset prices have got to where they are today.