February 3, 2002

House prices: up or down?

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Ms Rice Davis and her pal Christine Keeler — both call girls — had been sleeping with Profumo, who was Harold McMillan’s defence secretary. When he was rumbled, Profumo, a married man, denied ever meeting Ms Rice Davis and she responded with the line above.

On hearing estate agents, banks or mortgage peddlers forecasting a return to the good old days in the housing market, I am reminded of Ms Rice Davis’s words. If you are in the business of flogging houses, it is in your financial interest to talk the market up. So forecasts will naturally be biased on the upside.

Likewise, if you are in the business of selling stocks, there is always an incentive to look on the bright side. This may explain why, in the Enron scandal, it took an article in the Wall Street Journal last year to alert punters to irregular accounting practices. Investors may yet be thankful that a similar article on Elan appeared this week. Time will tell.

The point is that there can be nothing objective about analysis that comes from sources with a vested interest in keeping the market bubbling. So a charitable interpretation of these forecasters’ mistakes last year would be that their hands were tied by the institutions paying their wages (rather than their own ‘independent’ analysis being flawed).

Last year the consensus view was that the housing market would rise by 10 to 15 per cent. Likewise, those with a vested interest forecast strength in commercial property and a strong rise in land prices. As we know, house prices fell last year, despite low interest rates, rising incomes and a rising population. Commercial prices fell further and, according to one survey, zoned commercial land values dropped by 50 per cent.

Anyone who suggested that prices could fall in January 2001 was regarded as contrary in the extreme. Yet it was the cosy consensus that was way off the mark. Now the same guys are saying there is nothing to worry about and prices should rise from here (well they would say that wouldn’t they?) so let’s look forward to this year: property prices up or down?

To answer this question, it is important to state that contrary to the spiel put out by estate agents and their lackeys, supply and demand is not the sole determinant of land prices. The market is much more complicated.

For example, last year the population continued to rise and apparently the supply response was adequate, yet prices fell. So the demand and supply merchants don’t have a leg to stand on.

Arguably, still the most comprehensive report carried out on the Irish housing market was the final Bacon Report. Dr Bacon, like many economists, uses all the black arts of the economics profession and explains the model underpinning his analysis using the impenetrable veil of econometrics. This statistical approach is regarded by most commentators as mathematical mumbo jumbo and is usually ignored in the media coverage. Yet it is crucial.

Luckily, there are a few sad cases, like myself, who spent years doing this stuff for a living and we cannot read a report without being dragged to the economic modelling section.

In the Bacon report of 2000, this section is very revealing in explaining almost everything that happened last year. It is a good place to start for this year’s forecasts.

Dr Bacon indicates that up to 1997, the fundamentals such as income, demographics and housing stock, determined the market. However, after 1998 he identifies a speculative bubble building. He writes that “expectations appear to have become more important in the past few years. It is considered that this outcome is consistent with the emergence of a significant speculative or transitory demand factor in the Irish housing market — for example, prior to 1997 a one per cent increase in disposable income would lead to a 1.2 per pent increase in house prices.

“More recently, however, the same one per cent increase in income would lead to a four per cent increase in house prices. This suggests that individuals are increasingly buying houses in anticipation of a capital gain. This effect has the potential to make the market unstable.”

The good doctor goes on to suggest that by 2000, the fundamental model based on supply and demand was predicting that average house prices should have been around £70,000 but the actual figure was £130,000. He believed the £60,000 difference was a bubble building up in the market.

Aware of this bubble he offered various scenarios for the period 2000-2005. He warned that the biggest threat to prices might be building too many houses too quickly and if, for example, unemployment were to rise, there could be tears.

A major concern of Dr Bacon’s is that when you have a bubble, any price falls tend to be reinforcing because people sell quickly to avoid a capital loss. This process is what estate agents fear most. He states that when “individuals buy a product (typically an asset such as housing) in anticipation of a capital gain, a dynamic relationship can arise causing prices to spiral upwards leading to the so-called ‘irrational exuberance’ that the Chairman of the US Federal Reserve, Alan Greenspan, spoke about.

“However, just as this exuberance can drive a market forward when prices are increasing, the reverse is also possible in a downturn. Individuals anxious to avoid making a capital loss sell for a lower price than they would otherwise do. A similar situation could arise in the Irish housing market.”

Dr Bacon’s warnings seem remarkably prescient. Looking at the housing market today, there seems to be an inconsistent triplet. For falling prices to reverse, demand has to rise, supply has to fall and incomes have to go up.

For supply to fall, building work must stop, allowing the bubble to deflate naturally as real homebuyers buy the properties now owned by investors. This would allow investors an exit strategy. However, this implies that a recession in the building trade is needed.

But the building trade is one of the biggest single employers in the country, so a recession in this market would impact negatively on wages, incomes and demand. So we can’t have a recession in the building trade and strong domestic demand, the industry is simply too important.

Yet if supply keeps growing, it will just reinforce people’s incentive to hold off buying for longer while causing prices to fall further. As prices fall, more investors who were in for the ride will try to sell to preserve their capital gain. Prices fall again.

So looking at the big picture, it is hard to see why prices should rise at all. When all hired guns are singing from the same hymn sheet just as they were this time last year, alarm bells should ring.

Dr Bacon has revealed that there is no such thing as equilibrium in the market; rather, the market is in a constant state of flux with confidence about the future one of the most important factors.

Like all these things, common sense rather than hype will prevail. So the next time a forecaster tells you house prices must rise, ask yourself who pays his wages. If he passes the Mandy Rice Davis test for credibility, then it is time to listen.

David McWilliams presents Agenda today at noon and again at 6pm on TV3

‘Well he would say that, wouldn’t he?” — the immortal lines of Mandy Rice Davis which sank the political career of John Profumo. 

  1. chris

    Bacon estimates the income elasticity of housing from
    historical housing as 1.2. However, it is not clear that
    this figure is still appropriate today. If you increase
    the income of a poor person by 100% his demand for housing
    may not increase at all – He still cant afford to buy a
    house! Furthermore, as incomes rise above the level where
    necessities can be afforded with relative ease, housing
    demand may become very income elastic. The Irish boom and
    the rising incomes that accompanied it may have pushed
    many Irish people above some threshold income, after which
    income elasticity of housing demand rises dramatically.
    Furthermore, preferances and behavioural patterns may
    change over time. It might be more advisabe to use
    international measures of income elasticity from countries
    with similar home ownership percentages

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