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Global property values still too high on fundamentals

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Everybody loves to be an expert on property valuation, particularly after becoming a homeowner for the first time.

But right now there is a simple and obvious truth that nobody cares to acknowledge: property values around the world are being held up by artificially low interest rates that we know can not last forever, and rental yields are, partly as a consequence, far too low.

Once interest rates again reflect market forces of supply and demand for capital, and not the artificial and always and inevitably temporary intervention of central banks, then the only way for property values to go is down.

Property fundamentals

For let us not forget the fundamentals of property ownership and mortgages. Namely that when money costs more to borrow then this decreases the ability to pay higher property prices, and exercises downward pressure on real estate prices.

Now when interest rates go up this also has an impact on rental yields. For a start less people will be able to afford to buy so that pushes rents up. Then investors in property will also demand a higher rental yield to pay the higher cost of money, or to at least to compensate them for what their money could be earning in a bank deposit.

But let us step back. Seeing an old friend of 30 years this holiday – who has a large and geographically diversified property portfolio – just got me thinking about long-term price trends in property, and whether we have just past something of a peak in a long-wave of over-valuation.

Liquidity flow

Over the past few decades the global banking system has worked to make it easier and easier to borrow money. And central banks have been suppressing interest rates for the past 10 years to avoid recessions. This has just kept property prices going up and up.

Yet in real terms we all know that property has become very expensive on any measure. For example, if you look at income after taxation compared to house prices these are still at historic highs, even after the price correction that began in the USA in 2006 and the UK in late 2007.

Now I will admit that US house prices do look far cheaper than a few years ago. The correction from the peak is ongoing, however, and markets generally overcorrect.

Indeed, the great unwinding of the US housing bubble is continuing and the resetting of millions of mortgages over the next couple of years is likely the final debacle of this long saga. But in many places around the world this process is only just getting underway, and if you think in terms of a 30-year up cycle in prices then the down cycle could take quite a number of years too.

Interest rate manipulation

In fact this process looks inevitable. Interest rates around the world are being artificially suppressed by central banks to prop up their economies, and we will not have seen the low point of real estate prices until interest rates have actually peaked. Real estate is always priced most cheaply when interest rates are highest.

That does seem a long way off with the Fed rates at close to zero, and 30-year mortgages at a record low!

Until this correction is done then investors should be weary of real estate. Trying to catch a falling knife is not something to do. Of course, buying a home to live in and avoid rent is different, although if substantial capital value falls are in prospect then renting makes good financial sense, even if your partner has a penchant for home ownership.

But on fundamentals it is hard to argue against low interest rates and low yields as reasons not to buy real estate, and as signals of overvaluation. The time to buy is when prices are low, rents high, and interest rates at the peak. Real estate cycles are simple. There is no reason to get them wrong. But cities may be in different phases of the same long-wave cycle.

And what about Dubai?

In Dubai you might argue that mortgage rates are peaking now, and are likely to fall when a new federally backed home lender is finally agreed. Prices have certainly adjusted downwards in Dubai – with the world’s worst price fall this year – but upcoming supply is a big issue. And rental yields in Dubai are high by global standards, although empty units have a zero yield and that is what over-supply will mean.

This would tend to support the argument that a further correction in prices is coming in 2010 in Dubai but the bottom in this market could be closer than some think.

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Written by Peter Cooper

December 30, 2009 at 10:49 am

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