What’s driving global real estate higher? It’s the money, stupid. That’s a concise summary of research from the Bank of International Settlements (BIS). Known as the central bank for central banks, the BIS warned risks to global home prices are forming. Their researchers argue the majority of gains made since 2020 are due to monetary policy. Similar policies were replicated across countries, forming a synchronization risk. Without higher rates and less leverage, these risks can turn into a big economic threat.
Global Real Estate Price Gains Are Unusual
Most people seem to be under the impression home prices rise when interest rates fall. Naturally, when a recession began to form it was a prime opportunity to buy a home. That has never been the case prior to the recent recession.
Over the past 40 years, economic downturns have been followed by a drop in home prices. The researchers found this decline usually lasts 4 quarters, following an economic shock. During the pandemic, home prices launched higher and completely ignored the downturn. Not even a temporary dip, wrote the researchers — you can almost hear the shocked tone.
Another anomaly occurred during this recent recession as well — credit contraction. Or rather, a lack of credit contraction. Typically people reduce the amount of leverage they carry during a recession. Rather than pulling back though, central banks injected mass liquidity. They essentially flooded the market with cheap credit, resulting in rising liabilities. This may have been the only recession in history where households came out even more levered up.
To say this was an unusual path for home prices during a recession would be downplaying how unusual it was. In at least 40 years, home prices have never reacted this way.
Global Home Prices Surged As Easy Money and Investors Flooded The Market
Global real estate prices inflated for a few reasons, explain the researchers. Economies bounced back much faster than expected, after the induced recession. Household savings soared as there were few opportunities to spend your disposable income. Fiscal supports were nice, but excessive use may have created moral hazard. Supply chain bottlenecks are real, even contributing to inflation to some degree. Still, all of these played a minor role in driving home prices compared to … anyone? Bueller? Bueller?
That’s right — easy money. Essentially the plan involved flooding the financial system with cheap and easy debt. Many countries didn’t even wait to see how easy credit policies needed to be. Some just guessed at the beginning and didn’t make changes until two years later. To say it was imprecise would be generous. This cheap money sent demand for housing soaring in most Western economies.
“Above all, exceptionally easy financing conditions have boosted demand for housing further amid the strong liquid asset positions of households and support from other factors,” the researchers wrote.
“Households looking to be owner-occupiers can borrow at historically low nominal and real interest rates. In addition, gross rental yields are well above bond market returns in AEs, turning dwellings into attractive assets, including in the buy-to-let segment,” explains the researchers
Cheap debt didn’t just incentivize owner-occupied home sales, as the narrative goes. Investors saw an arbitrage opportunity to borrow at low rates and turn it into rental yield. It’s a part of yield hunting, a trend that exploded in growth after the Global Financial Crisis (GFC). Suppressing market bond yields forced investors to turn Millennial rent payments into regular payments.
The investor trend kicked into high gear after the 2020 Rate Cut Extravaganza. Countries like Canada now have over a quarter of home sales driven by investors. A quick search on TikTok will show no shortage of popular accounts explaining how to invest in real estate. How could they not take this opportunity?
The BIS also warns, “…the inflation-hedging properties of housing may also have played a role.” This was a popular play for housing in the late 70s and early 80s. People tried to escape soaring inflation and interest rates, which some did successfully. Normalization of inflation turned that bubble into a crash fairly fast. On that note, let’s talk about risks.
Global Real Estate Prices Are Synchronizing and That’s Usually Bad News
BIS researchers observed a global synchronization of home prices — never a great sign. We’ve talked about this before, but the gist is synchronization is when assets begin behaving similarly. It’s typical of a non-productive economy with excess capital and few places to park. Once there’s so much money that it can’t be effectively navigated, everything inflates. In this case, it doesn’t matter where the home is, suburb or city, Vancouver or Poughkeepsie — prices are rising.
Synchronization in finance almost always means amplified risks are forming. If assets have a similar driver, they tend to respond in the same way. It’s the exact opposite of diversification, which mitigates impact by spreading exposure. Synchronization turns an asset group into a series of dominoes, waiting for one to tip and take out the rest.
“… the international synchronization of house prices has strengthened. More than 60% of house price movements can now be explained by a common global factor. One reason for this much higher synchronization is that the pandemic has been truly global, thus inducing similar policy reactions and flattening yield curves worldwide,” wrote the researchers.
In other words, monetary policy drove home prices in these regions. It wasn’t local conditions but similar policy reactions forming similar environments. This is a similar issue we’ve observed with inflation. While global factors have contributed, countries that adopted similar policies are worse off.
Global Real Estate Downside Risks Are Rising Fast
The BIS warns transitioning from this frothy environment to a more stable one won’t be easy. Downside risks to growth are on the rise, and this can play out one of three ways:
1. Home prices stall and incomes catch up.
It’s not practical in markets that have seen prices rise more than 50% since 2020, like in Canada. However, markets with just a small disconnect can likely ride it out if home prices stall. This would result in minimal economic fallout.
2. Home prices continue to rise and the boom goes on.
For this to occur, inflation would have to taper very fast so interest rates can be lower. This would be good in the short-term, boosting construction and the economy for a while.
However, it would increase speculative demand and resource misallocation, causing bigger issues. Capital Economics recently warned if Canada went this route, it would turn a small correction into a large crash. It also risks the possibility of creating a financial crisis in the country.
3. Home prices make an abrupt and substantial reversal.
Home prices will make an abrupt and big reversal if inflation rises with rates. This would combine monetary tightening with unwinding financial excess. It’s the worst possible outcome, and tends to occur with slow rate hikes.
Pop The Global Real Estate Bubble With Higher Rates and Less Leverage
The BIS suggests the best outcome is achieved by higher rates and reduced leverage. Tax policies to discourage speculation and debt-financed ownership are two plans they mention. The combination would help mitigate the need for a more abrupt, market-driven correction. Countries like Canada have already promised to do the opposite, embracing more demand-schemes.
Canada isn’t the only country working against all logic these days, the UK is joining them. The UK is currently looking into adopting a Canadian-style leverage scheme for buyers. It would see high ratio loans secured by the taxpayer and reduce lender liability. Clearly relieving lenders from the fallout of bad high leverage loans has no obvious flaw.
Despite policymakers trying to engineer the worst outcome possible, central banks may come to the rescue. Stop laughing. Remember, it’s the “central bank for central banks” coming up with these solutions.
“Gradual increases in interest rates, beyond stabilizing inflation, could help contain excesses and stem tail risks emanating from the housing market. Maintaining expansionary policies for longer could shore up demand amidst greater short-term uncertainty, but would risk increasing the vulnerabilities further,” suggests the researchers.
In other words, raise rates higher than the terminal rate to eliminate the worst outcome. A gradual reduction of leverage is the best way to reverse flooding the market with leverage. Who would have thought?