Irrational Exuberance

Housing Bubbles and Cool Calculations

We are all aware that kiwis have willingly deluded themselves into thinking that residential housing is a yellow brick road to wealth. Actually, for a long, long time they have been quite right. But it is unsustainable. It is pyrrhic prosperity. Smart folk will be very aware of this and will be planning accordingly.

Now, in these matters timing is always critical. As Keynes once observed, "the market can stay irrational far longer than you can stay solvent". In other words, an investment market or asset may be way, way out of synch with fair value, but a return to reasonable prices may take years, decades, even generations. If you get exposed by betting the family farm or the household silver on the "market" pirouetting nimbly from irrationality to rationality--without considering that it may take decades to happen--you are speculating. Don't complain if the markets fail to perform within your required time frame.

Residential housing investment is a case in point. Let's be clear on what a rational market in residential housing would "look like". In case you missed it, a residential house is, well, a house, a building. And buildings depreciate over time, as does all plant and equipment. Houses eventually need maintenance and repairs. They wear out. They have to be replaced. This means that a ten year old house should be worth less than on the day it was first built. In general terms the land on which the house is built could be expected to appreciate in value over time because there is a finite and limited supply of land. There is only so much of it in NZ. Moreover, land never wears out (unless you are living in an area subject to coastal erosion).

So, a rational housing market should see the land on which the house is built increase in value over time, due to limited supply, while the house built upon the land decrease in value over time. But this is not the experience of New Zealanders in general. They have an expectation that whatever one pays for a house today, it will be worth more in three to five years time. This is a cultural axiom beyond dispute. It is a financial nostrum which only a fool would deny. Consequently, New Zealanders believe that housing is "safe" in financial terms. They are prepared to take considerable financial risks to own it. Even if they have to mortgage up their lives, in the end it will pay off as their house rises in value over time.

But it remains a fools paradise. Inflation--caused by a general increase in the supply of money--obscures the real fall in value of houses over time. A ten percent rise in market value of a house might actually be a five percent decline in real value by the time inflation is taken into account. Inflation is annoying in that it sends the wrong price signals that obscure real value.

But a far more significant factor distorting the housing market in this country, making it an irrational bubble, is the artificial limits upon the supply of housing. It is this which has worked more than any other factor to create a distorted, protected, housing market. The supply of houses has been artificially restrained not by a shortage of timber or other construction materials, but by local and central government restrictions upon house building. The Resource Management Act and local government town plans have restrained the supply of houses, reducing their supply, thereby jacking up prices of existing houses. This in turn has led to the nostrum that houses always rise in value. In the living memory of most people they have.

So, when you bet the family silver on a house you are probably going to be OK. Unless you are the one caught when the bubble bursts. But what would cause the bubble to burst?

A real depression. A really serious economic depression, lasting ten or so years, goes through phases. The first is the rapid contraction due to firms laying off staff and going bankrupt. Unemployment rises, spending falls, and credit contracts. The fall of demand and the turning off of the money-spigots means that prices fall, cash is king, bargains can be found. This is the first phase.

The second phase is the contraction of central and local government. Tax revenues drop sharply; limits upon government borrowing are reached; and government spending cuts begin.

It is at this point that local municipal governments start to wake up and smell the sewage. First up they realise that they have swathes of land which they had bought up in the halcyon days for one grand project or another. It is lying vacant; there is no revenue for the council being generated. Secondly, as indigent people are forced out of their houses, they "inherit" a bunch of houses due to non-payment of local government rates.

It gradually dawns on local bodies that a growing housing stock is a good thing. Querulous greenie voices fade to whimpers. Local bodies become pro-development and a building boom commences. But, every new residential house completed, lowers the value of the existing housing stock. Depreciation--a rational economic force--kicks in. A more sane and stable housing market develops--but one which sees the artificial wealth which people believed they held in ever appreciating residential property ebbs away. This is the third phase of a really serious depression.

Everyone is poorer. The fourth phase is when it dawns on the entire populace that the only way wealth can be created and sustained is to produce marketable goods and services at a profit. In other words, we have to work and earn our way out of economic recession. Then--and only then--a sustainable recovery begins.

In New Zealand, folks can makes lots of money from housing. If you are one of them, just keep reminding yourself that you have been fortunate and that it will not last. Warn your children.

Here's a good rule of thumb. Assume that the life of your current house is fifty years. Then it will be bulldozed and a new one constructed on the site. Look at your original QV statement and subtract the unimproved land value. The residual is the house value. If the house is ten years old, consider it depreciated by 20 percent. In other words the economic value of the house is worth one fifth less than its original sale price, if it is ten years old.

Such calculations will serve to keep you economically rational when you consider the residential housing market.