The unburst property bubble

By Felix Salmon
February 5, 2010
Brett Arends is in London, and, like most visitors to London, is shocked at the prices for everything from taxis to houses.

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Brett Arends is in London, and, like most visitors, is shocked at the prices for everything from taxis to houses.

If London real estate is buoyed by the uniqueness of the town’s economy, there is a disturbing degree to which the reverse is also true. This is a ridiculously expensive city to visit. I seem to hemorrhage money with every step I take. I was wondering, as I got out of a taxi the other night and severed the requisite two limbs to pay the fare, how I ever afforded to live here all those years.

The answer is, I couldn’t—even though I earned a perfectly good salary. What made a difference was the money I made on my apartment, which doubled in value between 1997 and 2003. Two years after I sold it, in 2005, it had nearly doubled again. Remove this alchemy from the equation of ordinary Londoners, and the bars and restaurants and theaters would be a lot emptier.

It’s not clear to me how living in an appreciating apartment makes it easier to spend money on bars and restaurants and theaters. In the UK, which was never big on home equity lines of credit, Arends could live off his house-price appreciation in essentially one of three ways. Either he could do periodic cash-out refinancings, or else he could take out an occasional second mortgage, or else he could simply rack up revolving credit and personal loans, safe in the knowledge that he could pay off all that debt when he sold his house and moved back to the US.

All of which helps explain the enormous rise in personal debt in the UK: essentially a very large segment of the homeowning population embarked on a mass conversion of home equity to personal debt over the course of the past decade. Since debt is more liquid than home equity, and since liquidity is a key ingredient of bubbles, house prices started soaring unsustainably.

On the other hand, the UK avoided two aspects of the US bubble: the originate-to-distribute business model, which destroyed underwriting standards; and the soaring ratio between the cost of buying and the cost of renting, which is a huge incentive to default when your home equity drops below zero. What’s more, a lot of the housing bubble in central London, as Arends notes, is a function of properties “bought up by tycoons from Russia, the Middle East and elsewhere”. Those tycoons tend to pay cash, and a bubble without debt is relatively harmless.

Arends asks in his piece whether the crisis is really over, or whether there are other bubbles — like London property — which have yet to really burst. It’s a germane question, and I suspect that his worries are well founded, and that there’s a lot more crisis yet to come. My feeling is that there probably is. On the other hand, the next stage of the crisis might well be slow and protracted, as in Japan, rather than chaotic and devastating, as in 2008. The main difference, I think, lies in default rates. If international capital markets are rocked by another big wave of defaults (Greece, or Spain, or California, or commercial real-estate, say), then we could easily slide back into chaos. On the other hand, if all we see is a long and slow decline in property values in countries where homeowners are still able to pay their mortgages, the next stage of the crisis might take a lot longer to resolve.

11 comments

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London property is far from uniform (to a large extend that is true of all real estate – houses aren’t all the same, unlike say stock). London is certainly expensive. And I share some of the worries about property prices. But looking at mayfair, notting hill or south kensington prices is fairly pointless. These places are a bit like Geneva lake side or Manhattan on the edges of Central park or Courchevel. They are the most sought after location for the global plutocracy. And I doubt that will change any time soon. Yes some property prices in London are high – and they might fall in those neighbourhood where “real” people live, but as for those flats/houses bought by foreigners as crash pads or tax residence for the global plutocracy, their price movement is frankly irrelevant. A bit like the price of a Picasso or a Ferrari – whether that goes up or down 50% is just irrelevant for most people. (granted, that changes the level of absolute GDP, but what really matters is median GDP per capita)

Posted by fxtrader14 | Report as abusive

We certainly had originate to distribute models and underwriting standards were terrible. The “liar loans” self-cert were at no discount to cert loans so there was plenty to fuel the boom there.

The incentive to default is almost entirely unrelated to the cost of renting vs. owning.
Here in the UK our debts follow us. If you default on your mortgage they will simply take every penny you earn until you have paid back the difference.
We are NOT a non-recourse state.
That is the real incentive to keep paying while under-water.

Posted by TinyTim1 | Report as abusive

Just because the asking price is high doesn’t mean that anyone is buying. The market may be locking up without a lot of visible symptoms– one needs to look at the number of properties on the market, how long they stay on the market, and whether they actually ever sell.

Posted by MattF | Report as abusive

“I got out of a taxi the other night and severed the requisite two limbs to pay the fare, how I ever afforded to live here all those years.”

Er..maybe he took the tube, or buses? 8 million people live in London, most of them happily, after all. Some things are very expensive, but others are quite cheap by international standards.

Also I am sceptical about his prices. He’s converted them into dollars, yet claims they are the same as they were in 2006. But the pound’s down 20% against the dollar on 2006, so I find it hard to believe.

Posted by mjturner | Report as abusive

Felix-

To take a shot at answering your question regarding how appreciating apartment prices make it easier to spend money on discretionary items…

I think of it by looking at 2 scenarios:

A- buying a home in an area w/ modest prices & modest appreciation (e.g. Iowa, Kansas)

B – buying a home in an areas w/ high prices & high appreciation (e.g. London, Manhattan)

In scenario A, you have an reasonably affordable mortgage payment. But realizing you’ll only experience modest apprecation on the home (or series of homes) you own over the next 30 years, you have retirement savings of, say 10 to 20% of your income.

In scenario B, you have a large mortgage payment that makes discretionary spending & retirement savings become nearly mutually exclusive. But realizing you’ll experience huge apprecation on the home (or series of homes) you own over the next 30 years, you have retirement savings of, say -5 to 5% of your income.

I could see a scenario in which discretionary spending in the 2 scenarios would be equal.

I personally would be much more comfortable living in scenario A so I don’t stake my retirement on real estate appreciation. But maybe those that receive a huge amount of happiness/satisfcation from living in London/Manhattan are willing to take that risk.

Posted by glenngulia | Report as abusive

In response to fxtrader14 and Felix’s idea about collecting property gains when you move out…

I don’t know London but I do know New York. Sure, beautiful apartments on Central Park will always sell for crazy prices, and the fluctuations in them are not too relevant. What concerns me about New York is the fact that lousy apartments on dingy blocks of Chelsea or the Lower East Side sell for close to $1 million. Consider 250 West 15th Street:

http://www.realtor.com/realestateandhome s-detail/250-West-15Th-Street-Unit-1-C_N ew-York_NY_10011_1100741155

Who would buy this apartment? It’s 800 SF with one bedroom. The bedroom is essentially in the basement (those garden levels are never as sunny as they are for realtors). The apartment is almost entirely undecorated and unrenovated (the realtor thinks that’s a selling point). You can’t live here if you have kids. It would be very difficult to support the cost on a single income. Try to describe to me the DINKs making ~250k/year who want to really stretch to be able to afford this apartment. Or, if you prefer to see this as a rental, find me the rational people who are thrilled to pay somewhere in the range of $3500+ a month for the privilege of living in a place that hasn’t been updated in 20 years and won’t be updated as long as the landlord is carrying a $4000/month mortgage.

Of course, in the short run there may be someone who will pay the price, because Manhattan real estate remains that crazy. What I’m concerned about is that the people buying or renting this sort of apartment are highly leveraged and highly dependent on continued employment. It’s not a luxury pad for a high-roller who wants a pied-a-terre in a fancy city – it’s a very basic apartment for people with jobs. Manhattan, Queens and Brooklyn have an enormous stock of these apartments in neighborhoods that upper-middle class people can tolerate. As long as a greater fool comes along every few years so that the people who buy it as a starter apartment can sell it when they have kids, everyone can pretend that the price levels make sense – but they don’t. This would be a fine apartment for a young couple that makes 60-100k/year and is looking to move up over time, who are quite solidly upper-middle-class by national standards – but they will never be able to afford it.

In normal America, for this much money you could buy any amount of house that you would reasonably need to raise a family in comfort. In New York you can get a lame 1-bedroom with numerous flaws and renovation needs. Something is awry here, and the ridiculous pricing isn’t limited to a few neighborhoods – it extends basically throughout Manhattan excluding the far Northern reaches and out to all the decent parts of Brooklyn and Queens. Millions of people are paying these costs with huge leverage because they are living the NYC dream. I don’t see how it is possibly sustainable. The emigrants and retirees who plan to fix their financial position with home-sale gains are entirely dependent on a steady stream of arriving young people with ever-increasing amounts of cash in hand and dependable cash-flows. Sure there will always be some wealthy lawyers, bankers, doctors, etc…but enough to fill this much real estate at these prices?

Posted by najdorf | Report as abusive

Najdorf above has a great exposé of the situation.

If you know anything about real estate, the rule of thumb is that nobody should spend much more then one out of three dollars on lodging. And that includes paying for utilities. Of course we are talking about a sane world here…

Posted by lemarin | Report as abusive

So, wait, underwriting standards in the UK were not destroyed like they were in the US? That is untrue. What could’ve pushed up house values if not bad underwriting? It wasn’t incomes, for crying out loud. Also, citing the anecdotal evidence of oligarchs buying places in central London is silly as a means of differentiating the US & UK bubbles. Most Park Avenue & Fifth Avenue necessitate all-cash purchases, but that hardly means debt didn’t prop up the broader Manhattan real estate market. You criticize other journalists for making unfounded assumptions, Felix, but you are pretty darn good at doing that yourself.

Posted by JoeP | Report as abusive

Why would you think Londons should be cheaper. Its a major financial hub like NYC, its a art and culture magnet, like NYC and most of the business is in the city centre therefore driving central housing up and avoiding more distributed living closer to work. Paris much the same. Is it that you presume that the nice old England should have ye-olde prices? When companies relocate closer to where the vast majority of their employees live rather than the CEO and the boards favorite restaurant then we might see changes. The opposite is Detroit- city centre devoid of life and ringed by where people live and socialise. Something attracts you to London- you are not alone and therefore demand and dreams take precedence.

Posted by Doherty | Report as abusive

Many of the major cities within the capitalist countries are over priced and almost impossible for the average wage earner to survive beyond the basic standard of living.

Mat

Posted by MathieuBCN | Report as abusive

Many of the major cities within the capitalist countries are over priced and almost impossible for the average wage earner to survive beyond the basic standard of living.

Mathieu
http://www.cocoonbarcelona.com/

Posted by MathieuBCN | Report as abusive