Now the end is in sight. The U.S. Federal Reserve last week raised interest rates for the first time in four years, signaling the close to an unprecedented era of cheap money. The lowest borrowing costs in four decades have fueled spending on everything from stocks to cars, but no market has benefited as much as housing, and none will feel the pinch of tight money more sharply.
Rising house prices were fueled worldwide by the reckless prosperity of the late ’90s, but also by the caution that followed. Stock prices started to collapse in 2000, and bonds began to slump in 2002, but that only accelerated the flow of money into real estate. Families burned by the markets came to see a house not only as a place to live but as a way to invest pension money–even to shield the nest egg from the risks of terror attacks. This idea of real estate as a safe haven is now firmly embedded in the global culture, says Yale economist Robert Shiller.
The question is, how safe is it? The answer depends on how fast and how far rates rise, because historically, property prices tend to plummet as rates go up. The good news is that Alan Greenspan has been telegraphing his intent to raise rates for more than a year, preparing the whole world for a soft landing. Central banks in Australia and Britain anticipated the move by a few months, and others in Europe and Asia are expected to follow suit, also gradually. The impact on the hottest bubble markets could be significant, but probably not shattering. In Hong Kong, the Ricacorp real-estate agency predicts that if Greenspan lifts rates as expected–by about 1 percent over the next year or so–monthly mortgage rates will rise from about 8.8 to 9.5 percent. That could have a dampening effect, but won’t stop the rise in Hong Kong house prices, which have climbed 50 percent since last fall.
The wild card here is the impact of tight money on consumer confidence. In many countries optimists have borrowed so aggressively, often against the rising value of their homes, that household debt as a share of disposable income is at record highs, reaching more than 100 percent in the United States, Britain, South Korea and elsewhere. Even small changes in interest rates could make these debts unmanageable, depressing consumer spending and global growth. The International Monetary Fund first warned of this danger last year and repeated its concern this April. Goldman Sachs cites the housing bubble–alongside high oil prices, a slowdown in China and terror–as a “risk to global recovery.” So many new homeowners have been given access to easy credit for the first time, history doesn’t tell us how they will react, says Paul Donovan, global economist for UBS. This “structural break” with the past creates a high degree of uncertainty.
The impact on consumer psychology is critical because it affects the world’s most successful economies. There is no global property bubble, because real estate is not a true international market in the same sense as stocks or currencies. Cash can move in an instant from dollars to euros, but not from a condo in Miami to one in Madrid. Many countries restrict foreign ownership of property, and there are all the usual closing hurdles, from financing to taxes. What unites the many potential bubbles worldwide is high demand for property in the most dynamic cities of the hottest economies–in short, the ones that are now sustaining global growth.
The property-bubble map of the world traces boom towns and regions, ignoring national boundaries. In India, prices are reaching dizzying heights in high-tech Mumbai, but not in Chennai or Kolkata (formerly Madras and Calcutta). In Europe, prices are sky-high in Dublin, London and Barcelona, as well as in major Dutch cities–but not in most other places. In the United States, prices have been rising as much as 60 percent faster than inflation in big cities on the East and West coasts but, with few exceptions (Denver, Chicago), not in the heartland.
Much of the debate about the impact of a housing bust focuses on how many local bubbles there are, and what happens if they all burst at once. One pessimist, Dean Baker, codirector of the Center for Economic Policy and Research in Washington D.C., expects a 20 to 30 percent correction in the United States and last month acted on his prediction. He sold his condo for nearly three times the $160,000 that he and his wife paid in 1997, moving to a rental two blocks away. “All housing markets clearly are local,” he says. “But when you have bubbles in as many areas as we do, this is a bubble that will have national impact.”
The world’s most stagnant nations can only wish they were attractive enough to inflate a housing bubble. German homes sell for less than they did three decades ago, when prices are adjusted for inflation. While Japan is recovering from a long period of stagnation and deflation, housing prices continued to fall during the first quarter this year, despite near zero real interest rates. In fact, no matter how low interest rates are, cheap money can’t fuel a bubble in a weak economy. That’s why low-growth Latin America does not boast a single housing bubble, and the number of construction jobs in its largest economy, Brazil, has fallen from 4 million in the mid-1990s to 1.2 million today. Says Alberto Bernal, chief Latin American analyst for Idea Global, a New York consulting firm, “Latin America is not in the same boat as the rest of the world.”
It’s probably no accident that Anglo-Saxon countries dominate the list of potential bubble markets (chart). The United States, Australia, Britain and Ireland have all grown fast in recent years by embracing free markets, but also by adopting what is euphemistically called “flexible finance.” Much of what is allowed now in home lending would have been unthinkable a decade ago. Americans can get a mortgage with no money down. Indeed, they can get the opposite: a mortgage with no money down, minimal monthly interest payments and a huge balloon payment on the principal 20 or 30 years off. Wall Street money boys have used these mortgages to finance multimillion-dollar party mansions in the Hamptons for monthly payments in the low five figures. It’s an enticing way to make yourself look superrich–unless the house price falls and you can’t pay the balloon bill.
The United States is the epicenter of such debt stretching, but it’s not alone. While even advanced Asian nations like South Korea are only beginning to introduce home mortgages, lending standards are falling fast in the West. In Ireland, a once strict formula capped the amount a couple could borrow at twice the first salary plus half the second salary; that has loosened in recent years to four times both salaries. (Even so, many young couples can no longer afford Dublin, even with help from parents.) In Hong Kong, the minimum down payment has fallen from 30 percent to 10 percent in recent years. One reason Ireland and Britain are vulnerable now is the prevalence of variable-rate mortgages, which have cheaper initial monthly payments than fixed-rate mortgages, but far greater risk if rates rise.
Perhaps the most unstable property bubble is in Australia, a leading economic star in Asia. Goldman Sachs global economist Michael Buchanan figures housing prices are overvalued in the United States by 10 percent, in Britain by 15 percent and in Australia by 29 percent. Prices Down Under eased in the first quarter of this year, triggered by a crackdown on dodgy seminars offering get-rich-quick schemes for speculators in property–and by two quarter-point rate hikes by the central bank since November. Investors, betting that rates don’t have much further to rise, have fueled a stock-market rally, but who knows how long it will last.
In Britain, the housing frenzy of recent years is clearly ready to peter out. The Bank of England has raised rates four times since November, in part to discourage new forms of speculation like “mouseholders”: cash-strapped urbanites who buy modest rural homes in which they have no intention of living, hoping to borrow against rising property values. Data for May show that mortgage lending and house-price rises are decelerating, but experts disagree sharply on what will happen next. John Wriglesworth, economist for Hometrack, a research firm, foresees a soft landing, while Roger Bootle of Capital Economics expects a “painful collapse” in prices of about 20 percent. Even if it sparks a recession, though, as economist Pelham Smithers predicts, a housing crash would mean “individual soap operas with little global impact.”
The fallout of a bust in China would be more complicated. Beijing has been largely isolated from the global cheap-money era, and will be protected from its demise, by an untradable currency and central-government control over bank lending. Yet with the economy officially growing at more than 9 percent, and probably even faster in reality, the vast sums pouring into Chinese property are fueling worldwide fears that the rising superpower is overheating. “China’s property sector is a vast, speculative bubble at every level of the market,” Morgan Stanley economist Andy Xie wrote recently. Since China only recently began to allow private home ownership, this is also the first bubble that could touch the masses, making it “quite hard to predict how the adjustment dynamics will look.”
There are actually two very different kinds of real-estate bubbles threatening China. One is driven by migration from poor rural areas to major coastal cities, where developers can’t build fast enough to keep up with demand. As a result, speculation has been rampant, particularly in Shanghai, where Dyfed Evans, managing director of Alchemy Capital, estimates that as much as 40 percent of recent sales were bought purely as an investment, and apartments often change hands several times before a building is even occupied. Frank Tzimas, an Australian living in Shanghai, began looking at 100-square- meter flats last fall that started at $120,000. Eight months and 40 apartment viewings later, he is still empty-handed. He’s been outbid on every offer he made, and prices have since shot up to $300,000. The government has recently taken measures to cool things down: tightening credit to builders, raising down payments, banning new villa projects and shifting construction to suburbs.
The other China bubble is driven by supply-side excess: inexperienced developers borrowing heavily to build spaces no one wants. Yu Xiaofeng, a sales manager at the Emerald Sea New City housing development in Renshou, a city of some 200,000 in Sichuan province, estimates that 40 percent of the city’s real estate is unoccupied. But that didn’t stop his boss, a local tycoon, from dropping $6 million into the 300-unit development complete with plastic palm trees and a “European style” central square. “A lot of people have lost money in real estate,” says Yu. “But we’re building the best and the biggest.” Of the two bubbles, supply-side excess is probably more threatening to growth in an economy that has become the local “engine” of Asia.
Other emerging markets enjoy varying degrees of immunity from rising global interest rates, due to local circumstances. In South Africa, home prices have risen by 24 percent in the last 12 months, but a decent house is still cheaper than a high-end Mercedes, and the growing middle class fuels steadily rising demand for both. In the Arab world, billions of dollars have fled the United States since 9/11, and are now feeding property bubbles around the region. In Mumbai, locals say prices for posh apartments have surged as much as 40 percent in the last two years, driven in part by multinationals seeking to tap India’s rising prowess in global outsourcing, but fueling family tensions. Children who inherit the family flat often want to sell out, over the objections of their siblings.
The stakes are higher in the United States because American consumers carried the global economy through the last recession. They are also particularly susceptible to the “wealth effect,” or the tendency to spend paper gains from the housing market. Buchanan, the Goldman Sachs economist, found that over the last decade, U.S. homeowners spent 11 percent of any gain in their property’s value on consumer goods, compared with 4 percent in Britain and 6 percent in Australia. If Americans react the same way to a fall in house prices, says Buchanan, “one can’t rule out the risk of overshooting.”
There are signs that U.S. real estate may be peaking. Rental prices have dropped in Seattle and San Francisco, and in some cities sellers are cutting asking prices. But consensus opinion remains sanguine. Next year Shiller will reissue “Irrational Exuberance,” his prescient 2000 warning against the stock bubble, with a new chapter on global property markets. He says he’s concerned about a housing bubble, “but just concerned.” Morgan Stanley’s U.S. economist Richard Berner says housing prices will “rust, not bust,” and that the threat of household debt is overblown. The chief economist for the National Association of Realtors, David Lereah, represents the optimistic extreme. He says that U.S. house prices have never ended a year with a nationwide decline since the data were first collected in 1978, and are not about to fall now. His upcoming book sums up the realtors’ view: “Are You Missing the Real Estate Boom?” In the world’s hottest markets, though, buyers may already have.
With Adam Piore in New York, Craig Simons in Beijing, Avraham Karshmer and Ginanne Brownell in London, Jen Lin-Liu in Shanghai and Mac Margolis in Rio
