Residential Property Marches to a Different Beat Globally

Peter Churchouse, June 22, 2021

The coronavirus episode that kicked in around February/March last year, forced economists, bankers, and investors around the world to rapidly rethink their forecasts for economies and a wide range of investment assets. The big leaders in the global economic forecasting universe (World Bank, Central Banks, BIS, OECD etc.) scrambled to cut forecasts only to find themselves cutting them further a couple of months down the track.

Most investors quickly identified the core industries and sectors that were likely to be hit most obviously and hardest by the unfolding scenario. Tourism, hotels, airlines, travel industry generally, retail, restaurants, F&B outlets all came under the spotlight for big downgrades of earnings and business prospects. Most analysts included the property sector in their downgrade lists, particularly retail, hotels, and office but also residential. If economies are going to contract by 5% to 10%, unemployment rockets up, and household incomes are scaled down, then this must surely affect housing demand and prices the argument goes.

The stock markets crashed during the March 2020 period, many down by as much as 30%, and most investors were looking to a long drawn out recovery. But that was not to be. The turnaround in stock markets from such a big tumble were the fastest, most resounding that we have ever seen. It is hard to pinpoint a single or precise cause but the rapid ride of the cavalry to the rescue in the form of central bank monetary easing and big, fast fiscal responses by most governments in the developed world must explain much of the sharp recovery of stock and bond markets.

Views on property markets remained fairly negative though. Clearly retail tenants in a great many sectors were likely to suffer huge declines in sales, particularly in the food and beverage space. Rentals clearly came under pressure and landlords in many cities around the world found it necessary or wise to provide rental relief programs of one kind or other to their retail tenants.

The downward pressure has been less intense in the office sector but the work from home (WFM) revolution has raised the prospect of reduced demand for office space as a structural issue. Many office tenants have handed back space (Hong Kong experienced a record level of negative office take-up in 2020 for example), new company formations have fallen, and office vacancies around the world have risen, sometimes sharply.

The "Bubble" Label, for Once is Justified.

But a review of global housing markets tells a very different story. In fact, a story where many markets can be truly described as in a bubble.

The “Bubble” word is used far too frequently in investment markets, often being applied to situations that are merely buoyant, or in an up-phase. For a market to be described as in a bubble it has to be a situation where the metrics that an asset is normally measured by are trading at levels that are very elevated from historical averages. A valuation metric that is one or two standard deviations higher than its longer-term averages might validly be described as in bubble territory.

For stocks, those metrics might be the price/earnings ratio (PE ratio, or commonly used variations of this ratio), price to book value ratios (P/BV – or variations such as premium/discount to net asset value -NAV) or dividend yields. For bonds, it might be spreads of the asset in relation to a benchmark, say government bonds.

For housing there are a range of metrics that can be considered, and a few charts below begin to illustrate why we might suggest that a good many housing markets are in bubble territory.

Residential Prices Soar Way Beyond GDP Growth.

Chart 1 below plots residential property price performance for a range of large cities against GDP in the jurisdiction concerned. Over time residential prices have tended to rise faster than GDP – the GDP figure is real GDP while housing prices are in nominal terms. While it is not always the case that housing prices decline during a recession, the data shows a massive increase in housing prices for many countries during this latest very deep recession.

All cities here have shown housing price increases during 2020 except Bangkok. But the discrepancies between prices and GDP are huge in some areas. For example, the UK saw a decline of GDP of close to 10% but average house prices in the capital, London, rose by more than 6%. This is way higher than increases in that city over recent years when the economy has been doing relatively well.

New Zealand stands out here dramatically with residential prices rising by 17.9% and 20.6% for Auckland and Wellington respectively at a time when the overall economy shrank by 2.9% (and more in nominal terms). Vancouver, Toronto, San Francisco, New York and Berlin all saw housing prices rising from 7.1% to 10.3% (increases not seen in modern history) while economies shrank by 3.5% to 5.4% - again record economic contractions for modern times.

Chart 1: Property Soars as Economies Crumbleumble

Various Sources, Portwood Capital

Housing Prices Outpace Inflation Way More Than Normal.

Our second chart plots residential prices in 2020 against inflation. Again, over the long term we have found that house prices have typically outstripped inflation by around 1% or so for many developed country markets, and by as much as 3% - 4% in Hong Kong’s notoriously volatile housing market. Note that the long-term average spread between housing prices and inflation is around 1 to 4 percentage points. Of the 19 cities in our sample only four have a price/inflation spread even vaguely close to longer term averages. For the remainder the spreads of housing prices over inflation are way higher than historically, and some could be described as totally off the charts – multiple standard deviations from long term average spreads.

Chart 2: Housing Massively Outpaces Inflation.

Various Sources, Portwood Capital

And The Bull Keeps Raging in 2021.

The third chart tells us that for the most part, the raging bull market in housing prices we saw in 2020 is continuing in the first quarter of 2021, in several cases at an even greater clip than the highly elevated rates of increase of 2020. For example, take Melbourne in Australia. For 2020 housing prices rose a modest 2.8%. For the first quarter of this year, they have risen a further 6% - just in the first quarter. Annualised that equates to an increase of 24% for the full year.

Or Wellington, New Zealand which saw a blistering 20.6% increase in 2020, that pace has accelerated even further with a 13.5% increase in the first quarter of 2021.

For most of these markets the pace of increases in Q1, are trouncing the extraordinary price increases of last year on an annualised basis.

Various Sources, Portwood Capital

Our fourth chart comes from a Bloomberg article in the past week, using data from OECD work.

This clearly demonstrates our bubble assessment at a national level for a group of developed and emerging economies.?This work also uses variance of valuation metrics over and above longer-term averages.

The first metric is price to rental ratios.?This in effect measure the yield on investment in real estate.?What this shows is that prices have risen way faster than rentals and as a result yields have fallen sharply.?Investors are getting way smaller rental income returns from their property purchases.?Our own reviews suggest that residential rental yields in many cities around the world are at record lows.

The second metric is an affordability measure of sorts, expressed as price to income ratios.?Again, substantially more than 50% of countries are showing “red” on this metric.?Also note that this is for the country as a whole.?For major cities, the affordability metrics are likely to be much worse than for the country altogether.?

Chart 4: Housing Valuation Metrics in Bubble Zones

Bloomberg

Some Conclusions.

Possibly one of the more worrying aspects of this scenario in the global real estate space is the rapid rise in credit growth as shown in the final column of Chart 4. Most recessions around the world are precipitated or suffer even greater crisis as a result of defaults on borrowings that often comes with excess credit growth.?

Real estate and real estate debt have been at the heart of most recessions around the world over the past 50 years.?The global financial crisis of 2007/2008 was driven by real estate credit and lacklustre oversight by national authorities in the US.?And look what that has done to the global economy.?

The Asian financial crisis in 1997 was largely about real estate bubbles and real estate debt at its centre.?That proved devastating for millions of people and thousands of businesses around the region.

This chart alerts us to the risks of excess credit expansion in this group of countries, with numerous red flags being raised on the debt front.

But it’s Not All Bubbles and Champagne.

Despite residential property markets in many countries being justifiably given a “bubble” label, that is far from the case in residential real estate stocks for the most part around the world.?Stock market investors are certainly not attributing sky high valuations to property development stocks the way households are pushing prices on bricks and mortar. We simple do not see exaggerated valuations on developer stocks around the world in any way commensurate with the bubble conditions in the bricks and mortar markets.

Why is this? Stock markets tend to be discounting mechanisms.?They often look to expected future conditions for the asset category.?Stock markets may be telling us that current residential property prices and trends are not sustainable.?Perhaps investors expect inflationary pressures and interest rate increases are imminent. This could cool real estate markets (that is the subject of another debate).

The China Property Disconnect.

China property developer stocks are a good example of the disconnect between bricks and mortar and stocks.?There is much talk of bubble conditions in the China residential property market (a thesis that I would question for most cities), but China property stocks have been very much out of favour with investors. China property stocks listed in Hong Kong have been trading at or close to record low valuations for the best part of a couple of years.?The two most tracked valuation metrics are Price/Earnings ratios and Discount to net asset value (NAV).?Stocks are not buying the property bubble story that is much reported in the media.?Companies are still growing earnings in the range of 10% or so but are trading at very low valuations for the most part.

China property stocks are amongst the cheapest in the world.?It is very easy to find a great number of stocks that are trading at P/E ratios of low to mid-single digits with dividend yields of mid to upper single digits.?That is not possible anywhere else in any major market.

So, for yield seeking investors it is possible to buy a China property stock that is trading at say 4.5-time P/E ratio, and paying a dividend yield of say 6% or more, and growing earnings at more than 10%, and with a share price that is at around a 45% - 50% discount to underlying asset value.

We cannot find these kinds of valuations in this sector anywhere else in the world in any mainstream market.

Charts 5 and 6: China Property Stocks: At/Near Record Low Valuations While Property Uptrend Persists

Citibank

Morgan Stanley

Analysts: Thomas Tung, George Medd.?

June 22, 2021.

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