The global housing market Checking the thermostat

Sep 7th 2006
From The Economist print edition
Property prices are cooling fast in America, but heating up elsewhere

HOUSES are not just places to live in; they are increasingly important to whole economies, which is why The Economist started publishing global house-price indicators in 2002. This has allowed us to track the biggest global property-price boom in history. The latest gloomy news from America may suggest that the world is on the brink of its biggest ever house-price bust. However, our latest quarterly update suggests that, outside America, prices are perking up. (Note how little Canada has gone up compared to the US, UK, and Australia)

America's housing market has certainly caught a chill. According to the Office of Federal Housing Enterprise Oversight (OFHEO), the average price of a house rose by only 1.2% in the second quarter, the smallest gain since 1999. The past year has seen the sharpest slowdown in the rate of growth since the series started in 1975. Even so, average prices are still up by 10.1% on a year ago. This is much stronger than the series published by the National Association of Realtors (NAR), which showed a rise of only 0.9% in the year to July.

The OFHEO index is thought to be more reliable because it tracks price changes in successive sales of the same houses, and so unlike the NAR series is not distorted by a shift in the mix of sales to cheaper homes. The snag is that the data take time to appear. Prices for this quarter, which will not be published until December, may well be much weaker. A record level of unsold homes is also likely to weigh prices down. The housing futures contract traded on the Chicago Mercantile Exchange is predicting a fall of 5% next year.

Elsewhere, our global house-price indicators signal a cheerier story. House-price inflation is faster than a year ago in roughly half of the 20 countries we track (see table). Apart from America, only Spain, Hong Kong and South Africa have seen big slowdowns. In ten of the countries, prices are rising at double-digit rates, compared with only seven countries last year.

European housing markets—notably Denmark, Belgium, Ireland, France and Sweden—now dominate the top of the league. Anecdotal evidence suggests that even the German market is starting to wake up after more than a decade of flat or falling prices, but this has yet to show up the index that we use, which is published with a long lag (there are no figures for 2006). If any readers know of a more timely index, please let us know.

Some economists have suggested that Britain and Australia are “the canaries in the coal mine”, giving early warning of the fate of America's housing market. The annual rate of increase in house prices in both countries slowed from around 20% in 2003 to close to zero last summer. However, the canaries have started to chirp again. In Australia average prices have picked up by 6.4% over the past year, although this is partly due to a 35% surge in Perth on the back of the commodities boom. Likewise British home prices have perked up this year, to be 6.6% higher, on average, than they were a year ago. Thus it is claimed that housing markets in Britain and Australia have had a soft landing.

Better still, their economies shrugged off the abrupt slowdown in prices last year. Consumer spending slowed sharply, but did not slump. If the British and Aussie canaries have survived, it is argued, then this bodes well for American homes—and for the American economy.

That might be the wrong lesson to draw. The housing boom has been responsible for a bigger chunk of growth in America than it was in Britain. America's saving rate has plunged, and consumer spending surged as homeowners borrowed with gusto against their capital gains. Britain's saving rate fell more modestly, so when prices flattened, the impact on consumer spending was smaller than it is likely to be in America. In Australia the slowdown in housing did make a big dent in construction and consumer spending but this was masked by the commodity boom and exports to China. The risk is that a flattening of house prices in America could prove much more painful it has been so far in Britain or Australia.

Not yet on terra firma

In any case, it is misleading to talk about a soft landing for house prices in Britain and Australia. The market has not really landed yet: prices are still sky-high relative to incomes and rents. The ratio of house prices to rents is a sort of price/earnings ratio for property. Just as the price of a share should equal the discounted present value of future dividends, so the price of a house should reflect the future benefits of ownership, either as rental income or as rent saved by an owner-occupier. Calculations by The Economist show that in Britain and Australia the ratios of prices to rents are respectively 55% and 70% above the long-term average (see chart). By the same gauge property is “overvalued” by 50% in America. Lower real interest rates than in the past would justify higher ratios, but nowhere near all of the rise in house prices.

An OECD study published last year adjusted the price/rent ratio for interest rates and other factors, to estimate how overvalued home prices were around the globe. Updating those figures to take account of price rises since then suggests that housing is now 35-50% overvalued in Britain and Australia and perhaps 20% too dear in America. A return to fair value will mean either rising rents or falling prices. If rents continue to rise at today's pace, many years of stagnant prices will be required to bring the price/rent ratio back to its long-term average. Especially after a giddy ascent, it is too soon to talk about a soft landing before a return to firm ground.