By Claudio Saputelli and Matthias Holzhey
The risk of real estate bubbles in major urban centers such as Toronto has increased significantly over the last five years, and real estate in “superstar cities” such as San Francisco remains overvalued.
Those are among the findings of the UBS Global Real Estate Bubble Index, released last week.
House prices in cities at risk of a bubble have climbed by almost 50% on average since 2011. By comparison, in other financial centers, prices have only risen by roughly 15%. This gap is grossly out of proportion to the differences in local economic growth and inflation rates. Moreover, real incomes and rents have climbed by less than 10% in the same period in the bubble cities. Buying an average apartment typically exceeds the financial means of even highly skilled workers in those cities.
Still, falling mortgage rates over the last decade have made buying a home vastly more attractive, raising the willingness of people to pay for home ownership. In European cities, for example, the annual usage costs for apartments are still below their 10-year averages, despite real prices escalating 30% since 2007. In Canada and Australia, too, a large part of higher purchase prices’ negative impact on affordability was cushioned by low mortgage rates.
In major urban markets, the expectation that prices will rise over the long term supports the demand for housing investment. Many market participants expect the best locations to reap most value growth in the long run – the “superstar” principle. The economics of superstars explains why in some professions like show business a small number of players can dominate internationally.
Something similar has been happening in the most attractive urban housing markets, which are expected to outperform average cities or rural areas in the long run. Hong Kong, London and San Francisco are examples of this theory.
The intuition is that the national and global growth of high-wealth households creates continued excess demand for real estate in the best locations. So, as long as supply cannot increase rapidly, prices in the so-called “superstar cities” may deviate from rents, incomes and the respective countrywide price level.
The superstar narrative has received additional impetus in the last couple of years from a surge in international demand, especially from China, which has crowded out local buyers. An average price growth of almost 20% in the last three years has confirmed the expectations of even the most optimistic investors.
The expectation of inevitably rising home prices has, at the same time, made the cities especially susceptible to exaggerations in boom periods, as those expectations are highly self-reinforcing. So world cities have regularly endured greater price corrections than entire countries. After widespread busts in the late 1980s, most cities did not recover until the early 2000s. For example, it took New York’s housing market 20 years to recover relative to US-wide prices. Similarly, a homebuyer in London in 1988 had to wait 25 years, until 2013, for the investment to outperform the UK average.
Looking back at boom-bust periods of housing markets in the last 35 years suggests that fundamentals matter. Nine out of 10 real estate crashes that led to drops of at least 15% were preceded by a distinct overvaluation signal based on the UBS Global Real Estate Bubble Index methodology. Real-time calculations derived from the Index for the period 1980 to 2010 estimated the likelihood of a crash within three years of a bubble-risk warning signal at 50–60%. By comparison, the forecast probability of a real estate crash was about 12% in a given quarter during that time.
The caveat is that the model has delivered warning signals too frequently and too early for some markets, especially in recent years when the unprecedented loose monetary policy of central banks have distorted market incentives. Risk-averse investors would have missed out on exceptional opportunities. Nevertheless, taking less risk in overheated markets has historically paid off on average. These markets delivered worse returns over a full boom-bust period than more balanced markets did.
Historically, investors have had to be alert to rising interest rates, which have served as the main trigger of real estate corrections. Most downward movement in prices in the past 40 years have been preceded by an increase in rates. But today’s pronounced dependence of prices on sentiment or foreign capital is a new and unpredictable phenomenon. Also, the current affordability crisis may trigger policy responses that could end the housing party rather abruptly.
So although the prices in wildly overvalued markets may be too high for some investors’ comfort, prices are unlikely to increase further in the medium to long run.