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Excerpts from presentation by Barak Geffen - Executive Director of Sotheby’s International Realty

As you all know its been a great boom for the SA property market and for Sotheby’s International Realty for a number of years now and I thought it would be a good time to reflect a bit on our past successes and share with you a global view on the whole ‘bubble’ scenario.

My focus today is on the US economy, which will no doubt have an impact on not only economies globally but also on their property markets.

Many investors feel the surge in the US property market, which has been on an sharp upward trend largely driven by low interest rates, could turn soon. And, having visited the States last week and interacted with many US market experts, I believe the possibility of a sudden downturn is more remote than many think.

According to ABSA, last year the ratio of US house prices to income increased to its highest level in history, with many analysts believing the market is overvalued and set for a sharp downward correction.

Over the past few years, residential prices have surged to record highs in many countries across the globe – real price growth of more than 50% in total has been recorded since the mid -1990s in countries like the US, Australia and Ireland, among others. And, as is well known, SA achieved phenomenal 34% growth in the space of one year in 2004.

Two important factors are cited as the main reasons for this global housing boom, namely low interest rates as a result of low inflation and the strong performance of property because of the underperformance of other asset classes.

As a result, home buyers have taken out larger loans as prices soared and existing homeowners have increased their mortgages to spend more on movable property. Ratios of household and mortgage debt-to-disposable income in most of these booming countries have increased to levels never seen before.

In view of these developments the global housing boom is regarded in some circles as the biggest potential bubble in history.

When I was in the US, I met with many of the top real estate principals from across the world, as well as many from the US. Although there is evidence that there are factors creating increasing concern surrounding a looming sharp market downturn, including decreasing affordability and the over utilisation of debt in the US, inflation is the bigger concern, which is causing the Federal Reserve to hike interest rates.

This in turn will cause the SA Reserve Bank to hike interest rates further. However these hikes will be marginal compared to the worst case scenario of a US market crash.

The US Federal Reserve has raised interest rates by a total of 4% since the bottoming of rates at 1% in 2004—they now stand at 5% and could go higher, with the US Treasuries market now factoring in a 40% chance of another quarter-percent rate hike at the next Fed meeting in late June. 

Higher interest rates are discouraging new home buyers and investors in the residential market, while putting an increasing number of families under stress to repay their increasing mortgage repayments and reducing discretionary spending. Data from the Federal Reserve shows that the ratio of household debt to disposable income rose to a record 120% early in 2005.

Rising interest rates are also driving up the cost of capital for business. This, combined with lower consumer spending levels, has caused a significant and considerable correction in the US housing market to date.

However the US housing market experts believe that there is sufficient demand to prevent a housing market crash in spite of the corrections to date. The variables that are attributable to this are the large amount of legal immigrants entering the US on a daily basis. One in five property owners is foreign born, giving minorities a 25% share in the real estate market in the US.

The NAR (National Association of Realtors) predicts in the coming decade 50-something baby boomers will continue to snap up around 150 000 second homes per year.

Plus the ‘echo’ generation, kids of ‘baby boomers’ are now reaching home-buying age with larger disposable incomes than their parents ever had at their age due to the ease of creating wealth through business enhanced by the technology revolution..

In addition, a high fertility rate in the US will ensure that demand is sustained. If the current rate of 2.1335 births/woman continues, experts expect the US population to double every 35 years.

According to the IMF, the pace of US economic growth is forecast to slow to 3.4% in 2006 from 3.5% last year. The US dollar is also widely expected to remain under pressure from the twin deficits of a soaring government budget deficit and widening trade deficit. The spectre of skyrocketing energy prices should also weigh on the world’s largest energy consumer.  

Finally, inflationary pressures, the weaker dollar and higher oil prices should keep the new Federal Reserve Chairman biased toward further interest rate hikes, or at least steady rates, for the foreseeable future. 

Population trends remain supportive, and property continues to be a popular asset class for investors relative to equities. More than ever before in history are increasing numbers of citizens using residential property as their primary wealth creation vehicle. 

The numerous corporate scandals like the Enron debacle have pushed would-be investors away from the stock exchanges of the world and property (where one can see the bricks and mortar) is a popular choice - one in which non-investment professionals can largely manage their own wealth. 

At the same time, property markets rarely ever decrease in value.  Even when the market corrects quite sharply, price appreciation slows significantly as a consequence, but very seldom turns negative unless the acquisition and disposal time is less than 24 months.

With the above variables in mind, namely the US housing market already having corrected significantly and the Federal Reserve being preoccupied with inflation concerns, interest rates in the US are set to increase further making the possibility of a US housing market crash very remote.

Increases in US interest rates will cause increases in South African interest rates in order to prevent investment funds leaving the country and this should allay concern regarding a SA housing market crash.

The evident cooling of the SA market over the past year which has concerned many investors can be put down to housing becoming more expensive, taking into account the increase in the ratio of house prices to remuneration in recent years.

Despite the soaring prices of recent years, however, the affordability of local housing -as measured by the ratio of house prices to income--remains well below 1980 levels, whereas in the US it has risen quite steadily.

SARB data also shows that household debt as a percentage of disposable income has risen to just over 60% recently, high by historic standards but far lower than levels in the US and many other countries. This demonstrates that SA is less risk-tolerant in using debt to finance investments in real estate outside of primary residences, and so there is less of an artificial boom effect on the property market.

Another shielding factor for SA is that when you compare it internationally, we still offer some of the most affordable prime property in the world, with the top end areas in SA trading at a discount of being up to ten times cheaper than areas with similar lifestyles like the South of France, Monaco and Malibu in California, showing that local property prices are not artificially inflated. SA’s historic economic risk is also being eradicated as we prove through our sound policies over time that it is unjustified risk.

One need look no further than the good news story Trevor Manuel shared with us in February this year. Our economy continues to grow strongly and socio political changes and BEE has brought many new players into the market who were previously excluded from the mainstream economy and so- called white areas.

As SA’s international profile continues to grow, we will attract more economy boosting foreign investment - unless government decides otherwise or there are unpredictable external shocks to the market. The 2010 World Soccer Cup will also provide important support to the property market.

SA’s inflation and interest rate environment is also favourable, making the property market less sensitive to a US housing downturn. The Reserve Bank is widely expected to leave interest rates unchanged in 2006, unless the Federal Reserve in the US hikes rates further.

However, for the sake of being comprehensive in our research, one needs to consider the remote possibility of a US house market crash.  This would spark a depreciation in the US dollar, causing the Reserve Bank to lower interest rates to counter the impact of a decrease in competitiveness in exports, one of our main drivers of GDP.

This easier monetary policy would stimulate domestic demand, helping to offset the negative effects of too strong an exchange rate which could cause a second positive run for the interest rate sensitive SA housing market.

Ultimately, however, although the SA housing market would benefit from a weaker US economy initially, over time, as the US market recovers and the dollar strengthens significantly against the Rand, the Reserve Bank will be under pressure to raise interest rates to curb an inflationary environment due to an excessively buoyant SA export market. At this stage, there could be a significant correction in the SA housing market which may be considered a crash. 

The SA property market would also not escape the contagion effect from a global deterioration in property’s attraction as an asset class following a US led housing market crash.

With the recovery in the US, the dollar would resume its upward trajectory and the rand would weaken, bringing with it continued inflation and even higher interest rates. As the property market in SA is super-sensitive to interest rates as the fundamental driver, this worst-case scenario in turn would induce correction upon correction in the SA property market until such time as interest rates in the US stabilize or come down.

Still, the chances of a substantial rise in interest rates—returning to the 15-16% levels seen in the past—are small—which should bode well for the local property market over the next five years.

For this year, Absa is expecting the current declining trend in nominal and real house price growth to continue, with nominal growth in house prices of between 10% and 12% projected.

Thank you all for all you support and for sharing some great insights and ideas over the past few years and please feel free to call on me personally or any of my team should you need a “glocal” (global local) view on anything to do with real estate.