Well, there is no denying inflation is the topic of the day. But there is another rumour, about a real estate price inflation monster.

For the longest period in history real estate prices have been on an upward trajectory and there is talk about a bubble. The very idea scares us because bubbles have a tendency to burst eventually

But, what does this real-estate price inflation monster really means?

Bad memories

Let´s face it there is an elephant in the room – there is no denying it anymore the newest research shows we are entering the bubbly territory.

However, we are all really scared to even talk about this because the last time there was a bubble it ended in a global economic crisis.

Remember 2007, real estate prices were inflated and house owners had more debts on their house than the house was worth.

This resulted in the biggest debt crisis the modern economy has seen – the Suprime Crisis or Great Recession.

Banks and monetary policy

What had happened? The tech bubble and the 9/11 terrorist attacks had caused economic trauma. The FED stimulated the struggling U.S. economy by cutting interest rates to historically low levels.

Low-interest rates and increased demand for homes prompted many lenders to offer home loans to individuals with poor credit scores.

Investment firms were eager to buy these loans. They repackaged them as mortgage-backed securities (MBSs) and other structured credit products. 

Many of these mortgages were adjustable-rate loans. When interest rates began to rise, many of the subprime adjustable-rate mortgages were set to higher interest rates.

Quickly, credit and liquidity dried up, and as a result, the number of loans issued declined and the housing market crashed. Borrowers were unable to pay their mortgages and this left banks saddled with the loan losses on their balance sheets. 

As a consequence investors pulled their money from banks and investment firms which led to many international financial institutions facing bankruptcy.

crash facts

Despite general assumptions, economists from the World Economic Forum found that the loose policy in the pre-crisis build-up was a small component of other contributing factors.

The underlying factor for the 2007 crash was the deregulation of the banking system. Since 1999, the Financial Services Act allowed banks to use deposits to invest in derivates. Now, big banks had the resources to become very sophisticated in the use of these complicated derivatives. 

Another contributor was toxic subprime mortgages that banks had distributed to investment banks. Investment banks securitized them. Credit rating agencies rated them and investors acquired them based partly on these ratings.

The third important factor, the Fed had cut interest rates in Q1 2001 from 5,6% to 1% only to raise them again to 5,25% in Q2 2004. This kind of interest rate leap is suicidal for any economy, especially the banking system.

Investors as drivers

Between 2001 and 2007 institutional investors sought higher returns in a relatively low-interest rate era. This increased the demand for highly rated securities.

Banks were incentivized by this external demand and met it by originating, distributing and securitizing residential property mortgage loans. The quality of the underlying assets was difficult to ascertain by investors as the originators were focused on the volume as opposed to the quality of the mortgages.

The rest is history, investment banks started repackaging and selling mortgage-backed securities on the secondary market as collateralized debt obligations (CDOs).

These financial instruments combined multiple loans of varying quality into one product, divided into segments, or tranches, each with its own risk levels suitable for different types of investors.

Subprime lenders bundled loans together-securitization-and sold them to investment banks and they sold them to investors around the world as mortgage-backed securities (MBS). 

The conclusion: Without investors seeking high returns, the MBS market would have been less lucrative but also less risky.

the 2022 price inflation

The German Central Bank recently published a paper stating that real estate prices are worryingly high and house prices are up 40% “unhinged from fundamentals”. The German banking watchdog recently raised the countercyclical capital buffer (CCyB) from zero to 0,75%.

The Federal Reserve Bank of Dallas states “our evidence points to abnormal housing market behaviour for the first time since the boom in the early 2000s”.

The Guardian observed that property prices had grown at their fastest rate in 17 years. In May 2022 Halifax reported record property prices and the longest consecutive rise in UK property prices since 2016.

Real estate prices in the Asia-Pacific region had a “breakneck growth” in 2021, Bloomberg however noticed markets starting to cooler of. Sydney’s prices soared almost 27% last year, while values in Singapore jumped the most in more than a decade and Hong Kong remained the world’s least affordable place to buy a home. 

There is a fear that prices may be rising to a point economists call “exuberance” which means prices are increasingly out of sync with the fundamentals underpinning the market. This is not good news as this implies the markets will either slowly cool down or in the worst-case, crash.

How did we get there?

Answer#1

Supply and demand imbalance due to the pandemic. There was a desire for a bigger home was a key driver during the lockdown.

Answer#2

Rising labour and construction costs – for example timber prices skyrocketed during the pandemic

Answer#3

FOMO, buyers expect prices to keep climbing and fear they will get stuck paying more for a property later

Answer#4

Investments based on distorted expectations of returns

Answer#5

Low-interest rates, never before have reference rates been so low for so long. This phenomenon is widespread across many countries.

Answer#6

Too much liquidity – too few opportunities and investors seeking opportunities, this leads to speculative buying.

Answer#7

33% of properties were bought by institutional investors. They have vast sums to spend and focus on appreciation when it sells. Due to high demand and a shortage of opportunities prices keep going up.

Plot and Cast 2022

N° 1 Central Banks: Over-generous money policies. The US, Japan, Great Britain and the European had the longest low to zero interest rate period in modern history. This led to an abundance of cheap money and investors taking higher risks to generate higher yields.

N°2 Banks and lenders: Lenders and financial institutions supposedly cleaned up their act and regulations are múch tighter this time around. Sadly, banks are the victims of zero interest rate policies. Again, more “creative” ways to earn money were adopted by many. A kind of new form of generous lending “the creation of funds, from nothing” came into practice. Since the 2007 disaster new banking laws required banks not only to hold “collateral” against the loans given. But, borrowers require a certain amount of funds before they qualify to take up a loan. The more “creative” version aimed at easing requirements for borrowers who were willing to pay the right price.

N°3 Investors: With all the cheap money provided courtesy of the central bank, investors again had to seek worthwhile opportunities. For some cost, leverage and risk factors became irrelevant. Investors and including institutional investors would buy anything at any price. Apartments in NY Steinway Tower, a 91 storey super-luxury tower and the world’s thinnest skyscraper is one example. A crazy investment considering a price range between $7.75for the smallest apartment and $66 Million for the penthouse. But demand and supply issues are driving the prices

Price inflation monster

Price surges don’t necessarily mean we’re in a bubble, and despite a property price inflation monster, it is unlikely that we´ll see another crisis caused by a dysfunctional banking system.

It will not be lenders or banks that default. Nor will there be investors who withdraw capital as soon as some shady mortgage securities start to lose money.

This time it will be investors who miscalculated the risks, or those who got the fundamentals wrong and invested in an overpriced luxury property with a “luxurious” loan.

Those who invested in value will be alright and have to fear little. However, assessing the portfolio and staying alert is never wrong.

Yet, policymakers need to intervene to curb the flow of money into real estate. A market correction is overdue. This time, however, the global economy will not crash due to falling property prices

First steps have been taken, the US FED raised interest rates twice already to cool off markets.

Rumours from the ECB headquarters in Frankfurt talk about an interest-rate hike in June. The Brits have done so three times already. Asia-Pacific countries see no need to raise interest rates.

Crash or Correction

In general, real estate has proven very resilient, with median property prices declining in just eight of the past 60 years. Remember, property prices will only fall if the demand falls.

A recession or deflation due to high inflation rates and/or rising interest rates will most likely cool markets. This correction is overdue, as a correction in the financial markets as well. In recent years prices rose not by fundamentals and actual value but due to speculation.

The imbalance between supply and demand however will continue for a while, and soften the blow of rising interest rates and a possible recession. There is still an insufficient number of new properties coming onto the market to meet the needs of prospective buyers.

Strong competition to secure properties will keep driving up prices however the price hikes of the past last two years will not be repeated.

The pace of property price appreciation will be slowing down in the months ahead as interest rates rise and high inflation depreciates the value of money. Nobody knows for sure what will happen in the long term, as interest rates could be raised further or there could be a prolonged recession.

What we do know, however, the property price inflation monster does not lead to a crash in property prices or a major global economic crisis – but to an overdue correction of property markets.

Property investor‘s takeaway

Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas.”

Paul Samuelson, 1915-2009, US Economist