Housing bubbles

Is the New York (indeed, the US) housing bubble going to burst? A look at the situation in the UK would suggest that it isn't. Interest rates have already started rising there – but a new report says that 25 or 50 basis points here or there is going to make no difference, and that rates will have to double before the mania is controlled.

What's going on? The average UK house price is now increasing at a rate of £1,100 a week: that's $2,000, near enough. Capital gains on housing are generally tax-free, which means that a worker would have to be earning a six-figure salary – in pounds sterling – just to match the amount that the average homeowner is making from just sitting in their property as it appreciates.

It's worth remembering, too, that all these numbers are UK averages: insert whatever insane multiplier you like to get the equivalent numbers for London. But to take Tony Blair's old house as an example, the PM sold in 1997, when he moved to Downing Street, for £615,000; it's now back on the market, listed at £1.69 million. In other words, if he'd retired instead of becoming prime minister, he'd've made £1.08 million – just under $2 million – from owning a six-bedroom in Islington. That's more than he's made as PM.

The bubble is being driven, it would seem, by people known in the UK as "buy-to-let investors" – basically, individuals who buy houses not in order to live in them, but rather to rent them out. Historically, this market has behaved rather like a bond market: given a set rental income and a set mortgage rate, it's easy to calculate how much a house should be worth. More recently, however, buy-to-let investors have been behaving more like equity investors, who treat rental income more like a welcome stock dividend than as the main reason for buying the asset in the first place.

Whenever there's a housing bubble, prices always rise faster than rents. We're seeing that in New York: it's been a long time since you could cover mortgage and maintenance costs by renting a place out. The UK is the same way, but the buyers don't care: even if they have to pay some of the mortgage costs themselves, they're making so much money in capital appreciation that it doesn't matter.

This kind of thing isn't really happening in the US to nearly the same extent. The housing market is something touted in late-night get-rich-quick schemes on the television, not a respectable way to build a nest egg. But consider a student who's just graduating from NYU. If that student, or her parents, had bought a place four years ago and sold it now, there's a good chance that the profit could cover not only the mortgage and maintenance costs, but tuition fees as well. If you start off rich enough, it would seem, you can essentially go to college in New York for nothing these days.

Just like any other asset bubble, the longer this kind of unsustainable situation goes on, the more people pile in, trying to get rich quick. It's easy: buy a $1 million apartment today, with $100,000 down and a 90% mortgage at 6%. Watch it go up by 75% in two years, and sell it for $1.75 million in two years' time. You've spent $108,000 on mortgage costs, say another $24,000 in maintenance costs, and a bunch more in legal fees – say $150,000 all in all. Your total investment: $250,000, including down-payment and costs. Your total return: $1.75 million minus $900,000 in mortgage equals $850,000. Net profit: $600,000, or $300,000 a year: call it $25,000 a month. Oh, and you spent nothing on rent the entire time. Sound attractive?

Of course, you'd make even more if the mortgage were smaller and you paid more of the upfront cost in cash. So you take your $600,000 and use it as the down payment on somewhere else – and so the cycle continues. Even if you allow yourself $100,000 a year for living expenses, you can rapidly make millions by flipping properties in a bubble economy.

This sort of behaviour is quite common in the UK; it's barely even beginning here in the US. Very few Americans buy property in order to become rich; most still do it for the old-fashioned reason of needing somewhere to live. The frenzy of apartment-buyers in Manhattan is not a slathering horde of speculators falling over themselves to get a piece of the property-market action: rather, it's a bunch of stressed-out professionals desperately trying to find somewhere they can afford to buy.

Look at those UK base rates again. They're at 4.25%, compared to just 1% in the US. Even if we get 325 basis points of tightening, we'll only be at the same place that the UK is now, and the UK's rates are clearly well below the level needed to decelerate house-price inflation. In other words, don't count on the Fed to precipitate a housing-market correction.

Sooner or later, of course, property prices will come down: they can't keep on running away from rental incomes indefinitely. But they're a bit like the US current-account deficit: unsustainable in the long term, but showing no sign of decreasing any time soon. So long as the economy continues to expand, my guess is that people will continue to feel comfortable putting their money into bricks and mortar – and increasingly, they'll be doing so as an investment. After all, we're four years on from the dot-com crash, and property is the only asset class which has done very well in good years and bad.

So, what would I do in this market? Buying property is very expensive – and, in the long term, I believe, it could prove to be extremely painful. Does anybody remember negative equity? Maybe the best thing to do would be to start a new blog, devoted to the excesses of the New York property market. That should be bound to do well. I'm not good at coming up with names, but curbed.com has a nice ring to it. I haven't checked it out, though: maybe someone else has got there before me?

Posted by Felix at 23:38 EST

Comments

way to astro-turf your own site for Messr. Steele. The new site looks nice, but unfortunately, I'm one of those people he mentioned who hates it how all NYC conversations turn to real estate. it's the new weather.

Posted by: mike at 9:50 EST, May 24, 2004

I don't know how it is in London but there is so much friction in the new york mktplace that makes it difficult to buy property for speculation. Mortgage tax, move-in / move-out fees... and more importantly coop boards, many which outright forbid the practice, would make it very hard to be sucessful.

Posted by: nate at 22:22 EST, May 25, 2004

Short REITs.

Posted by: Jame at 6:56 EST, June 01, 2004

there is so much friction in the new york mktplace that makes it difficult to buy property for speculation.

Just means the price has to move up enough to be worth it. Might mean you have to hold it longer, but as long as it's moving up, somebody will be willing to do it.

Don't think you can effectively forbid the practice of investing in real estate. And how do you differentiate between investors and speculators?

Posted by: fling93 at 14:59 EST, June 03, 2004