I was in London last week. Investors and the political community there are in a smug mood. They accept that the United States is probably heading into a recession, but this is of little importance to them. Compared with the U.S. stock market, European stock markets appear modestly valued (their optimism here is also somewhat misplaced), and current economic forecasts have the EU growing in 2001 at a faster rate than the U.S. Particularly among those of the New Labour persuasion, there is a feeling that the Third Way is about to show its superiority to old fashioned capitalism, even of the Clintonian variety, with Blair heading for re-election and Britain heading for continued, albeit modest growth and apparent low inflation.
In Continental Europe, the feeling of schadenfreude is palpable. Europeans see the Euro’s recovery against the dollar, and the rapid growth rates achieved in countries such as Spain and Ireland which have historically been economic backwaters. The dot-com collapse has had its casualties, particularly in the German Neuer Markt, down over 60 percent from its early 2000 high, but in general it is felt that over-valuation is a U.S. problem, and that correcting it, if necessary, will also be a U.S. problem.
They are forgetting the effect of the Other Bubble – real estate. Historically, European investors have not invested in stocks. Some, particularly in Germany, have invested in bonds or in income-producing properties. This essentially defensive strategy does little for the economy, but works well for the individual investor provided inflation remains at low Germanic levels. It also leads to great economic stability, historically a priority for a German investor population that remembered the hyper-inflation of 1923 and the economic collapse of 1945-48.
In the remainder of Europe, however, investable funds have increasingly been dedicated to residential real estate, particularly lavish primary residences and in many cases resort properties. This strategy has also been seen in the United States, but only in certain areas; one thinks of Manhattan and the urban coast of California, in particular. The U.K., particularly the south-eastern U.K., has an advanced form of this disease.
So, of course, did Japan in 1989. We all remember the story of the Japanese Emperor’s palace garden being worth more than the state of California. Needless to say, while Tokyo real estate remains expensive by world standards, this extreme over-valuation ceased to be true in the 1990’s; indeed, prices for prime residential real estate have in some cases dropped by 80 per cent since the 1990 peak. The 100 year mortgage loans which Japanese consumers took out to buy their apartments have ended in default.
A good illustration is the price performance of a modest townhouse in an Islington square, for a portion of whose life I was the proud owner. The house was built in 1832 in what was then a modest middle-class suburb, and sold for 600 pounds, equivalent to about 30,000 pounds ($45,000) today. By 1960, the area was close to a slum, and the house was sold, unmodernized (basic indoor plumbing had been added in the 1920’s) for 2,500 pounds, equivalent to 25,000 pounds ($37,500) today. In 1983, the house had been modernized, the area had greatly “gentrified” (it is only 2 miles from the Bank of England) and it was sold to me for 106,000 pounds, about 250,000 ($375,000) today. I started selling it in 1988, but ran into a nightmare of London real estate illiquidity, and was able to unload it only in 1994, for 300,000 pounds (the profit felt good, but 6½ years unanticipated carrying costs, at variable home mortgage rates up to 17 percent per annum, ate up most of it.) It is now about to be sold again. The price? 800,000 pounds ($1.2 million.)
Yes, Tony Blair lives nearby, when he’s not in Downing Street, but so do a lot of other even less desirable people, and the house itself has an area of less than 1,800 square feet (160 square meters), which may sound substantial to our Japanese readers, but not to our American ones. Before readers sneer and tell stories of $25 million Park Avenue penthouses I repeat: this is not Park Avenue, you wouldn’t really want to live here, and the house is rather too small to bring up a family in (no garden, only a patio). If rented, the house would fetch $9,000 a month – not a number affordable by the middle class, the upper middle class, or even most bankers.
What you are seeing is a real estate bubble, which looks less inflated than the Nasdaq stock market bubble only because it follows on the previous real estate bubble, in the 1980’s, which ended in disaster and 6½ year house sale campaigns. One need only look at London house prices earlier in the 20th Century, before the easy finance and rapid inflation of the period after 1970, to see that by long term historical standards London residential real estate, which doubled in price in 1995-2000, according to Land Registry data, is far above its sustainable value. The Japanese stock market, in 1989, also did not look more than moderately excessive, because that bubble, also, had been inflating for over a decade. Nevertheless, the deflation of the bubble is inevitable; it is merely that in the U.K., unlike in the U.S., the inverse wealth effect will take place through deflating real estate values rather than through deflating stock values.
On the Continent, too, real estate is an asset of choice for the wealthy investor, with Spanish resort property, German city office property and residential property in the larger cities of Central and Eastern Europe all showing rapid price gains. Financing real estate purchase is a lot easier than it used to be; even in continental Europe, commercial banks are no longer the finance source of first resort for major corporations, and consequently must seek elsewhere for lending opportunities. Real estate lending, if you haven’t been through a downturn, appears attractive.
It is, in the end, the availability of finance that fuels a real estate bubble. In the UK, mortgage interest deductibility for tax purposes has now been abolished, but the home loan market is highly competitive, so much so that 100 percent finance for variable rate mortgages is regularly available at almost all price levels. Of course, the downside of this is the possibility of 17 percent interest rates but hell, that was almost a decade ago when the young, rich and stupid were in college.
In the U.S., home mortgage lending is a national scandal waiting to happen. The government guarantees almost all home mortgages up to $250,000, and the institutions which underwrite such mortgages securitise the proceeds, and live fat, happy lives justifying the outrageous stock option plans of their executives. The risk of loss, in this case, is borne by the taxpayer, as was the case in the S&L disaster ten years ago.
Most overbought real estate markets?
Number three – Hong Kong office property – the scarcity value of Hong Kong land is now gone; it’s part of a vast quasi-Communist country heading for an economic crisis.
Number Two – Marbella, Spain resort property. The entire area is now so overbuilt with luxury homes and golf courses as to be thoroughly unpleasant for anyone of discernment; consequently, even for those with no discernment but only money, it will soon fall out of fashion.
Number One? Not Islington real estate – that’s Number Four – but California residential real estate. A state which attempts to have population growth without electric power production has lived in cuckoo land for too long, and the reckoning is due. Nobody will pay fancy prices for a house in Los Angeles in which the air conditioning browns out several days a week. Californian economic growth must await not only a U.S. recovery which could be long delayed) but a wholesale redevelopment of the state’s infrastructure. Without economic growth, house prices will shrink to very low levels indeed – the $1.2 million house becomes once again the $45,000 house, as Marin County reverts to Levittown.
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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)
This article originally appeared on United Press International.