High Interest Rates Encourage Speculative Investment in Housing
by Keith Rankin
24 April 2007
There has been a lot of misinformation about what has been driving the New Zealand housing market since 2004. It's time to look at the fundamentals of that market, to see what putative causes of the extended bubble can be dismissed, and to see why the housing market cannot settle under present conditions.
It is only from 2005 that the housing investment market has departed from historical precedent. So we must focus on what is specifically different in the period 2005-2007.
Normal experience, at least from the 1970s, is that over a period of 7-9 years, real estate values jump ahead of the wider economy for a few years of above average GDP growth, and then pause as the rest of the national economy catches up. The residential property boom of 2002-04 fitted that pattern. The 'second-wind' property boom from 2005 does not.
Housing costs are determined simultaneously in three separate markets: accommodation (essentially a rented good), real estate (a financial asset, like equities, that appreciates as the economy grows), and mortgage finance.
For the basic fundamentals, we have to look to the first of these three markets, namely housing as a rented good. An owner occupier is simultaneously both a tenant and a landlord; a consumer of housing and an investor in real estate. This reality is fully recognised in our GDP data, which include a component for the rental value of all housing, including owner occupied housing.
Owner-occupied housing therefore includes both a rental component and an investment component in its price. The current bubble is in the investment component only.
House prices should be determined essentially by market rents, just as share prices should be determined by dividends and bond prices are determined by interest rates. The fundamentals of the rental market for housing are (i) the demand for roofs over our heads and pieces of land to use for private recreation, and (ii) the supply of houses, apartments and land for subdivision.
The demand for places to live has been soft since 2003. Net migration fell sharply in 2004. For the three years 2001-03, net migration was 147,000. For 2004-06, it was 35,000. Further, New Zealand suffered a baby bust from 1975. Birth rates were lowest from 1976 to 1986. Thus, based on demographic fundamentals, new household formation is relatively slow at present.
A number of commentators have turned to supply-side arguments to support the assumption that underlying rental values are too high. Restrictions in the supply of new land for housing is said to be the cause of continued rapid increases in property prices. But what has changed? There have been no sudden changes to laws and by-laws that have restricted supply since 2004.
We must acknowledge that this is not a housing crisis. It's an investment phenomenon; a bubble in asset values, much like a sharemarket bubble. Investors, who already have somewhere to live, see continued unexploited profit opportunities in real estate, much as they saw continued unexploited profit opportunities in equities in 1985-86. So they purchase additional properties.
Rational expectations theory tells us that market mechanism itself closes such unexploited profit opportunities. Underpriced assets should appreciate quickly, while overpriced assets depreciate in relative terms. This is clearly not happening, suggesting that there is a counter-force that prevents the real estate market from working as free financial markets are supposed to work.
That counter-force is fuelling demand for investment housing by fuelling expectations of capital gain in excess of interest rates. That force arises from an oversupplied mortgage market.
The economics textbook that I teach from gives the following example: "if mortgage rates rise from 5% to 10%, but the expected rate of increase in housing prices rises from 2% to 9%, are people more or less likely to buy houses"? The answer is obvious when put that way.
The problem clearly is that the expected rate of increase of house prices is much higher than it would be in a healthy balanced economy. What drives those expectations?
Expectations of the immediate future are formed adaptively, from consistent experience over the previous five years or so. In 2004, expectations were that the bubble had run its course and that the housing investment market would slow down, in line with past experience.
That expectation was not realised, because banks increased their mortgage lending relative to other forms of lending while also increasing lending overall.
Indeed, as New Zealand interest rates increased, banks had access to increased quantities of foreign savings seeking higher fixed interest returns than were available in their countries of origin. We can hardly blame the banks. Like other firms we expect them to maximise profits. Under free-market conditions, the interest rate gap between countries narrows as investors profit from exploiting that gap. But interest rates are set by monetary policy rather than free markets.
Why were the banks more keen to expand mortgage lending than other types of lending?
In the process of banks increasing their New Zealand assets and their foreign liabilities, the exchange rate became grossly overvalued. And, because the exchange rate has been so overvalued, the banks reduced their lending to the struggling tradeable goods and services sectors (especially the non-farm tradeable sector which has less collateral than the farm sector). Less lending to one sector means more lending to another: investment housing.
It all boils down to New Zealand having high interest-rates (and expected interest rates) that are determined by the Reserve Bank.
The frustrating irony is that the very reason, we are told, that the Reserve Bank keeps interest rates high is that these high interest rates are supposed to cool down the housing market. Yet high interest rates have not cooled down the housing market.
Rather, as I have shown, high policy driven interest rates create the conditions that keep the banks flush with foreign money, and that discourage the banks from lending to anyone without collateral. What else are the banks to do, under these circumstances created by monetary policy, other than to feed the markets that give them the greatest possible returns?
The Reserve Bank, by keeping interest rates high and assuring investors that New Zealand interest rates will stay high, is fuelling rather than dowsing the investment housing fire. Economics is supposed to be an evidence-based discipline. We have more than enough factual evidence now that rising interest rates throughout this decade have preceded unexpectedly high increases in real estate prices.
How will it end? It will end when it becomes favourable for banks to re-orient their lending towards the foreign-exchange earning and foreign-exchange saving sectors. In other words, it will end when supported interest rates are allowed to fall to appropriate market levels, and when the exchange rate follows a similar downward path.
Of course, when that happens, many of those property investors who require immediate capital gains will have to put their properties on the market, leading to capital losses until housing prices more accurately reflect the rental value of housing.