PROPERTY

Even the housing boom can turn to bust

TIM CONGDON

The success of market-based, free- enterprise economies depends on people with long memories and a deeply-ingrained financial scepticism. If the majority of investors are instead always carried away by the enthusiasms of the moment, the economy is liable to suffer from wasteful excesses of over- or under-investment.

These remarks may seem trite. But it is remarkable how often they are forgotten. The most vivid, and the most socially costly, illustrations come from industries requiring large and bulky investments with long lead times. Property development brings out the general idea very clearly. The risk of a large error in calculating demand is compensated by the possibility of vast speculative gains for entrepreneurs who judge correctly. Over the last 20 years enormous personal fortunes (Donald Trump, the Reichmann brothers, Godfrey Bradman) have been made in real estate by borrowing to purchase cyclically unpopular and under-valued assets. The scale of these fortunes and the apparent ease of their acquisition have encouraged many imita- tors. Nowhere has this been more true than in North America, with the late 1970s and the early 1980s the peak period of excite- ment.

Office buildings received particularly favourable tax treatment in the early years of the Reagan presidency, partly as a by-product of the supply-siders' tax cuts, and were the focus of considerable tax- assisted speculation. By the second quarter of 1985 new office building in the USA was virtually three times higher than five years earlier. More space was coming onto the market than ever before. Unfortunately, the demand for new space did not stay in line. An office vacancy index compiled by Coldwell Banker, a Chicago-based real estate service, rose from five per cent in early 1982 to 11.7 per cent in 1983, 13.9 per cent in 1984 and 16.1 per cent in 1985. Not surprisingly, rental growth stopped. The price of office buildings, which had been rising (apart from minor regional variations and very temporary interrup- tions) for over 40 years, began to fall. Even worse, in 1986 Congress, dismayed by the grotesque waste evident in so many empty buildings, passed a tax reform package which ended the indulgent fiscal treatment enjoyed by the real estate industry.

Since then financial strains in cities with particularly high office-vacancy levels, not- ably such former models of Sun Belt prosperity as Houston and Dallas, have intensified. Today virtually the entire Tex- an banking industry is crippled by bad real estate loans. Whereas in the 1960s and 1970s many Texan families grew rich by the far from arduous practice of watching their office blocks increase in value by 20 per cent a year, they are now helpless as interest mounts remorselessly on old debts. In Texas the empty office blocks are known as `see-throughs'.

The moral of the Texan real estate misfortunes is that no asset price can forever rise faster than interest rates. The success of the astute (or lucky) few who borrow to buy at the bottom cannot be repeated by the mediocre (or unlucky) many. When the mediocre many do try to join in, they may further inflate a specula- tive bubble, but the bubble still has to burst sooner or later.

Empty office space in Texas may seem remote from the problems of the British economy today. But there is mounting evidence that a speculative boom is also under way in this country. It is not as wild or as extreme as the mania for Houston office blocks in the late 1970s. Nor will it be followed by such a precipitous slump in the value of the assets which are the object of the speculative excitement. But it is driven by a similarly unsustainable pattern of expectations. Moreover, whereas credit- based purchases of Houston office build- ings involved only the rich (or the once rich), the boom in the UK affects — at least indirectly — millions of people.

The boom is in credit to purchase houses and other forms of property, particularly in the southern half of England. The exist- ence of this credit boom, and of the related surge in property values, has been recog- nised by the media for some time. But they do not yet seem to have noticed that the boom, far from fading away, is set to gather extra momentum in the next few months.

In Greater London the price of residen- tial property rose on average by 17.3 per cent a year between 1982 and 1987. Over the same period the cost of borrowing to buy a house — as measured by the mort- gage rate adjusted for tax relief — aver- aged a little less than 8.5 per cent. In other words, someone who took out a 100 per cent mortgage in 1982 typically received, in each of the next five years, an increment in wealth equivalent to almost 10 per cent of the value of the property. If the mortgage was originally set at two-and-a-half times income (as would be common), this incre- ment in wealth amounted each year to about a quarter of income. This bonus was achieved without effort and was free of tax.

The potential for capital gains on re- sidential property in London is a matter of common observation. It is a constant topic of conversation at dinner parties and busi- ness lunches, and is encouraged by glossy controlled-circulation property magazines and estate agents' sales material. Outside London the enthusiasm for property is also intense, if a little less frenzied. In the south-east house prices rose by 14.8 per cent a year between 1982 and 1987, in East Anglia by 13.4 per cent, in the south-west by 12.3 per cent and in the East Midlands by 10.3 per cent. The numbers are lower than in London, but they are still above the post-tax mortgage rate.

Because of this background the middle class in the South of England takes it for granted that the rate of appreciation on their houses will always exceed the cost of borrowing to buy them. In other words, here is another example of a widespread expectation, indeed almost an assumption of thought, that a major asset price will continuously rise at a faster rate than the cost of borrowing. This set of beliefs has permeated so widely and become so firmly entrenched that mortgage credit has risen in every year since 1974. In 1987 net mortgage advances were five times higher than in 1979.

It might have been reasonable to expect that, in the first year of its third term, the Thatcher Government would want a cooling-off period in the housing market. However, because of the Chancellor's anxiety about the dangers of a strong pound for British industry, interest rates have been cut to the lowest level since 1978. In response, mortgage credit is grow- ing more rapidly than ever before. In February the building societies promised an astonishing 74.9 per cent more in new mortgage commitments than a year earlier. This seemed a bit freakish, but in March the figure approached 85 per cent. When account is taken of the role of the banks and specialist mortgage intermediaries, net mortgage advances in 1988 are likely to be £40 billion, £10 billion more than in 1987 and nearly seven times higher than 1979.

Of course, it would be far-fetched to claim that house prices in Southern Eng- land could behave in as erratic a fashion as the price of Texan office buildings. House prices have never fallen by much in the UK and their rate of change is sedate compared with most commodity or financial markets. It should be noted, nevertheless, that the bouyancy of the London property market has recently attracted an adventurous form of speculation, the property futures mar- ket. This is to put up the deposit (of, say, 10 per cent) on a flat or house still in the course of construction and then to sell it some months later when prices are higher. (If prices have risen 10 per cent, the profit is 100 per cent.) There is some similarity to highly-geared trading in American real estate particularly if the 'purchasers' of the properties are financing the deposits with borrowed money.

It is inescapable, almost as a matter of logic, that the mortgage credit boom of 1987 and 1988 will have to be followed by a few years in which house prices rise by less than the post-tax mortgage rate. Unless house price increases fall behind the cost of borrowing, the temptation to borrow more will overwhelm the Government's attempts to moderate credit demand and destroy its anti-inflationary monetary policies. The unfortunate truth is that the English mid- dle class looks on continually rising house prices with considerable affection. It does not want to understand that rising house prices are an aspect of more general inflation. Nor will it like to be told either by Mr Lawson's successor (whoever that may be) or by a Prime Minister who has extolled the virtues of home ownership — that a serious attempt to restore price stability must mean a few years with a less overheated housing market. But Conserva- tive Cabinet ministers with long memories and a deeply-ingrained political scepticism ought to have realised months ago (and perhaps even before June 1987) that the sequel to the current housing boom was bound to be electorally inconvenient. They must be hoping that the belt of affluence now covering most of Southern England does not end up in a financial mess similar, to that in such former bywords of economic dynamism as Houston and Dallas.

Tim Congdon is chief UK economist of Shearson Lehman Hutton, the securities house, and the author of The Debt Threat, published by Blackwell's. It is reviewed in the Books pages by Sir Kit McMahon.