Key Points:
- Mortgage rates have increased significantly in some countries, but residential real estate markets have not experienced distress.
- Assessing residential real estate as an asset class is complex due to various influencing factors.
- Supply and demand imbalances and speculation are key drivers of housing prices.
- Long-term outlook for residential real estate in many large economies is dismal due to declining populations.
- Fiscal and monetary policies can encourage real estate speculation.
- Interest rates have significantly impacted the appeal of residential real estate as an investment.
- Forecasting house prices is challenging and may be as futile as forecasting stock prices.
- Investors should consider countries with growing populations like India and Africa for potential opportunities.
Introduction
The increase in mortgage rates in some countries since 2021 has raised concerns about the state of residential real estate markets. However, despite the high home price-to-income ratios and borrowers facing difficulties in refinancing, these markets continue to remain resilient.
In the United Kingdom, the average home price-to-income ratio is currently at a staggering 9x, indicating that borrowers are allocating a significant portion of their income towards interest and amortization payments. With the rise in interest rates, many borrowers may default on their mortgages, potentially leading to a further decline in housing prices.
While the situation seems concerning, governments may intervene to support borrowers facing financial pressure. Additionally, a decrease in inflation could prompt central banks to lower interest rates, providing relief to borrowers.
Supply and Demand
The dynamics of residential real estate prices are influenced by both fundamental supply and demand imbalances, as well as speculation. Supply and demand imbalances occur when there is either a shortage or surplus of housing units relative to the population’s demand.
Factors such as population growth, immigration, urbanization, and regulatory restrictions play a role in shaping supply and demand dynamics. These factors can vary greatly between regions, making it challenging to accurately assess the true state of housing markets.
When evaluating real estate investments, it is crucial to differentiate between nominal and real post-inflation returns. For example, although residential real estate in China may seem like a lucrative investment due to the country’s economic growth, the nominal price appreciation has been modest compared to the annual GDP growth rate. In real terms, residential real estate may not have been as profitable as expected.
Speculation
Speculation is another significant driver of housing prices. In some countries, there is a cultural inclination towards homeownership and the belief in the property ladder concept. This mindset leads investors to view real estate as a long-term appreciating asset.
However, speculative bubbles can form when prices rise significantly due to an imbalance in supply and demand. The subsequent bursting of such bubbles can result in prolonged bear markets, as seen in Japan during the 1980s.
Fiscal and monetary policies also play a role in encouraging real estate speculation. In the aftermath of the global financial crisis, governments implemented programs and accommodative measures to stimulate the housing market. As a result, real estate became an attractive alternative to bonds for investors.
Nevertheless, the landscape has changed in recent years, with rising interest rates dampening the appeal of owning a home as an investment. Financing home purchases has become more expensive, and with higher yields in the fixed-income market, residential real estate holds less appeal.
Further Thoughts
Given the challenging outlook for residential real estate in many large economies, investors may question the wisdom of allocating to this asset class.
Predicting house prices is notoriously difficult, similar to predicting stock prices. However, longer-term investors may want to avoid countries with larger demographic challenges and focus on those with expected population growth. Countries like India and Africa, as well as the United States, may present opportunities for investors looking for potential growth.
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All opinions expressed in this article are those of the author and do not necessarily reflect the views of pankajsihag.com or CFA Institute.
