Viewing real estate as an investment creates volatility in housing markets

Most people who bought houses during the 00s did so with dreams of riches. Those dreams materialized in laughter for some, tears and financial slaughter for others.California_real_estate_billionaire

Bricks and slaughter

Property is widely seen as a safe asset. It is arguably the most dangerous of all, says Andrew Palmer

Mar 3rd 2011

… Why is property so dangerous? One obvious answer is the sheer size of the asset class. The aggregate value of property held by American households in the peak year of 2006 was $22.7 trillion, their biggest single asset by a wide margin (pension-fund reserves were next, at $12.8 trillion). Working out the figures in other countries involves much more guesswork. Back in 2002 this newspaper reckoned that residential property in the rich world as a whole was worth about $48 trillion and the commercial sort $15 trillion: if you allow for property-price changes in the intervening period, the current values, even after the bust, would be $52 trillion and $28 trillion (see chart 1), or 126% and 67% respectively of the rich countries’ combined GDP in 2010. Whatever the precise number, property is so big that when credit conditions loosen it is likely to absorb a lot of the extra liquidity; and when something goes wrong the effects will be serious.

An even bigger reason to beware of property is the amount of debt it involves. Most people do not borrow to buy shares and bonds, and if they do, the degree of leverage usually hovers around half the value of the investment. Moreover, when stock prices fall, borrowers can usually get their loan-to-value ratios back into balance by selling some of the shares. By contrast, in many pre-crisis housing markets buyers routinely took on loans worth 90% or more of the value of the property. Most had no way of bringing down their debt short of selling the whole house. …

The leverage in housing is great when prices go up, but when they go down…. Stocks are primarily investments held with discretionary income whereas houses are consumptive shelter — a necessary expense of living. When stock prices crash, people may lose some money, but their losses are generally limited to their investment. Even in leveraged investing, a brokerage will liquidate before equity dips below zero. In housing there is no such stoploss. In a housing crash, people are wiped out and go bankrupt.

With only a small sliver of their own capital to protect them, many owners were quickly pushed into negative equity when property prices fell. As borrowers defaulted, the banks’ losses started to erode their own thin layers of capital. “Banks are leveraged and property is leveraged, so there is double leverage,” says Brian Robertson, who runs HSBC’s British and European operations and used to be the bank’s chief risk officer. “That is why a property crash is a problem for the banks.”

In other words, the money banks lost is money they didn’t have.

Property bubbles almost always start because fundamentals such as population growth, interest rates and economic expansion are benign. A shrinking population weighs on Germany’s housing market, for example, and a rising one underpins long-term confidence in America’s. These fundamentals explain why many market participants are able to persuade themselves that huge price rises are justified and sustainable.

We see a microcosm of this phenomenon here where fools deny a housing bubble ever happened.

Chastened regulators now talk about a presumption of guilt, not innocence, when prices look frothy. That is because property markets are inefficient in several ways which make it more likely that they will overshoot.

Cycle paths

For the lenders, property is attractive in part because it attracts lower capital charges than most other assets. That makes sense—the loan is secured by a tangible asset that will retain some value if the borrower defaults—but it can also lead to overlending. Indeed, one of the bigger ironies of the property bubble was that lenders and investors probably thought they were being relatively prudent.

The investors buying toxic loans were usually purchasing them through collateralized debt obligations blessed by ratings agencies with AAA status.

Capital charges are higher for commercial property than for homes but banks can still be seduced by the apparent stability of a real asset producing predictable cash flows. “Commercial real estate is often a borrower of last resort,” says Bart Gysens, an analyst at Morgan Stanley. “It tends to be willing to absorb a bit more debt if and when banks and debt markets want to provide it.”

Collateralised lending offers a degree of protection to the individual lender, but it has some unfortunate systemic effects. One is the feedback loop between asset prices and the availability of credit. In a boom, rising property prices increase the value of the collateral held by banks, which makes them more willing to extend credit. Easier credit means that property can sell for more, driving up house prices further.

That is a fancy description of a banking Ponzi scheme.

The loop operates in reverse, too. As prices fall, lenders tighten their standards, forcing struggling borrowers to sell and speeding up the decline in prices. Since property accounts for so much of the financial system’s aggregate balance-sheet, losses from real-estate busts are likely to be synchronised across banks.

The credit cycle of boom and bust is just as the author describes. Once you understand the cycle, it is easy to foresee problems like the credit crunch of 2007 — the timing is always tough, but the inevitability is easy to see. It’s a bit like inflation is today. We all know its coming, but nobody is quite sure when it will arrive.

Borrowers, too, contribute to the inefficiency of property markets, particularly on the residential side. Some people think that renting will enjoy a renaissance as a result of the crisis (see article), but few expect a wholesale, permanent shift in attitudes. Unlike other assets, housing is seen both as an investment and something to consume. In its latest survey of consumer attitudes in July 2010, Fannie Mae, one of America’s two housing-finance giants, found that Americans wanted to buy houses for a range of reasons, from providing a safe environment for their children and having more control over their living space to making a financial return. In China there is another item to put on the list: for many young men owning a property is a prerequisite for attracting a wife.

This mixture of motives can be toxic for financial stability. If housing were like any other consumer good, rising prices should eventually dampen demand. But since it is also seen as a financial asset, higher values are a signal to buy.

That’s kool aid intoxication. What should be taken as a sign that prices are too high instead motivates more buying. Buy now or be priced out forever, right? Once that fear overcomes a market, the combination of greed and fear motivates some truly irrational buyer behavior. Remember when people used to write passionate letters to sellers to bestow them the honor of ownership?

And if housing were simply a financial investment, buyers might be clearer-eyed in their decision-making. People generally do not fall in love with government bonds, and Treasuries have no other use to compensate for a fall in value. Housing is different. Greg Davies, a behavioural-finance expert at Barclays Wealth, says the experience of buying a home is a largely emotional one, similar to that of buying art. That makes it likelier that people will pay over the odds. Commercial property is a more rational affair, although hubris can play a part: there is nothing like a picture of a trophy property to adorn a fund manager’s annual report.

Once house prices start to rise, the momentum can build up quickly. No single individual (except, perhaps, Warren Buffett) can push up a company’s share price by buying its stock at an inflated price, but the price of residential property is set locally by the latest transactions. The value of any particular home, and the amount that can be borrowed against it, is largely determined by whatever a similar house nearby sells for. One absurd bid can push up prices for lots of people.

I outlined a proposal to overhaul the appraisal system in the US to require cashflow valuations of properties in addition to the comparable value method. As the author notes, comparable value simply makes irrational behavior the standard of the market. it does nothing to curb the excesses or keep valuation in line with lender payment schedules. Markets trading at cashflow values don’t crash. What price levels would they crash down to?

As prices rise, property is arguably more likely than many other asset classes to encourage speculation. One reason is that property is so much part of everyday life. People do not gossip about the value of copper and tin, but they like to talk about how much the neighbour’s house went for. They watch endless TV shows about houses and fancy themselves as interior designers, able to raise the price of their home with a new sofa but sometimes is not necessary to get a new one. The pros at Eco Clean Solutions can take care of that old sofa and make it look as good as new. Eventually the temptation to take a punt on property becomes overwhelming. “Speculation is a bit like sex,” says Robert Shiller of Yale University, a long-standing observer of speculative bubbles. “People who have lots of sex are not approved of but they are thought to live life with gusto. People eventually decided to try for themselves.”

That is one of Dr. Shiller’s more interesting analogies.

Even the risk-averse may well respond to rising prices by entering the market. Everyone needs somewhere to live, and many want to own their own homes. The amount of space that people need increases predictably over time as they find partners and have children. James Banks, Richard Blundell and Zoë Oldfield of Britain’s Institute for Fiscal Studies and James Smith of RAND, an American think-tank, find that this gives people an incentive to buy early in order to protect themselves against the risk of future price increases that would make houses unaffordable.

These guys are talking about NAr fear mongering. The belief that you need to buy the most house you can afford today because it may be unaffordable in the future is exactly how we got into this mess. Overextended borrowers are the root of housing’s woes.

Another reason for momentum in property markets is the fact that there are no short-sellers. If you think property is overpriced, it is difficult to profit from that view. As Adam Levitin of Georgetown University Law Centre and Susan Wachter of the University of Pennsylvania pointed out in a recent paper on the causes of the housing bubble in America, it is impossible to borrow the Empire State Building in order to sell New York real estate short. HSBC probably came closest by selling its Canary Wharf tower in London for £1.1 billion ($2.18 billion) in 2007 and buying it back from its debt-laden Spanish owners for £250m less in late 2008—the greatest short sale in the history of property, says one observer.

That one is pretty good, but I know a local real estate developer who bought a property for $10M in 1999, sold it for $100M in 2005, and was negotiating to repurchase the property — with its $135M in improvements — for $40M in 2010. I don’t think he closed the deal, but it would be a remarkable short trade if it happens.

Some investors infamously did make money from betting against American subprime mortgages, but their real achievement was to find a way of doing so, by buying up credit-default swaps that paid out when mortgage-backed securities soured.

There have been attempts to create instruments that allow property to be hedged or shorted. Mr Shiller himself has been involved in launching derivatives linked to home-price indices for both large and small investors, but with limited success to date. Commercial-property derivatives, however, are gaining ground.

Such products are conceptually appealing but face several obstacles. Some are common to all financial innovations: new products lack enough liquidity to lure buyers in, for example. Others are more specific to property. Individual properties and neighbourhoods differ, which makes it hard to construct accurate hedges. Government interventions to shore up the housing market add an extra element of unpredictability. And since house-price cycles tend to last for a long time, says Mike Poulos of Oliver Wyman, a consultancy, it can be expensive to sustain a short position.

Short positions in real estate using futures contracts will likely never catch on. Who is going to buy a short futures contract to hedge any possible loss in their homes value? In reality, most people who buy believe house prices are going up, and if any such futures contract were widely traded, most people would take the long side and magnify their exposure to real estate rather than hedge it.

Up, up and away with the fairies

The effects of buying a home when prices are rising are insidious. A 2008 paper by Hugo Benitez-Silva, Selcuk Eren, Frank Heiland and Sergi Jiménez-Martín used the Health and Retirement Study, a biennial survey of Americans over the age of 50, to compare people’s estimates of the value of their homes with actual values when a sale took place. The authors found that homeowners overestimate the value of their homes by an average of 5-10%.

Even now, many in Irvine believe their house values never declined. People have a selection bias when it comes to comps for their own property. They will almost always conclude the asking price of a similar but nicer property represents the actual resale value of their own property. Comps that might inject a bit of reality are routinely ignored, and Pollyanna assessments of valuations and appreciation abound.

Those who had bought during good times tended to be more optimistic in their valuations, whereas those who had bought during a downturn were more realistic. Expectations of higher prices explain why bubble-era buyers were more willing to buy risky mortgage products and take on ever greater quantities of debt. The amount of mortgage debt in America almost doubled between 2001 and 2007, to $10.5 trillion.


The rich-world buyers of today ought to be more realistic about the future value of their homes, but attitudes are deeply entrenched. When asked to rate the safety of various investments, two-thirds of the respondents in the Fannie Mae survey classed homeownership as a safe investment, compared with just 15% for buying shares. Only savings accounts and money-market funds, both of which enjoyed an explicit government guarantee during the financial crisis, scored higher than homes. Homeowners who were “under water” on their mortgages (ie, they owed more than their properties were worth) were just as sure as everyone else that housing was a safe investment.

If the Burj Khalifa shows that memories of property cycles are short, the Fannie Mae survey suggests that some of the lessons are never taken on board at all. Given the state of residential property around the rich world, perhaps the victims are suffering from post-traumatic amnesia.

How do we explain that level of ignorance. How can people be underwater, facing the reality of what a poor investment housing can be, how can these people continue to remain in denial?

I suppose many refuse to admit their mistakes even when maintaining denial is barely tenable. Cashflow real estate can be a great investment. Betting on appreciation is a fool’s game more likely to be a great disaster.