The Property Bull is Dead – What Happens Now?

The Property Bull is Dead – What Happens Now?

“The Trend is your Friend, until it Ends!”

The trend in the property market has been up for so many years now, that for a sizable part of the population it is all they have ever experienced. Starting in the early 1980’s from a point where property was seriously undervalued by historical standards, global real estate began a multi decade climb that has seen valuations go from undervalued to reach stratospheric heights in some parts of the world.

When the trend changed in favour of property, the recovery was initially driven by investors lured by high yields and the added benefit of falling interest rates - a virtuous combination. However as the years have progressed and debt has become easier to obtain, cheaper to borrow, and easier to leverage, the property market has morphed into a speculative frenzy driving valuations to excesses never seen before.

However, before we look at how the bull market will end, its worth taking a look at how it develops in the first place.

The Three Phases of the Property Bull Market

THE Stealth PHASE

The first stage of a property bull market we can think of as the stealth phase, which is the start of the upward trend. The stealth phase typically comes at the end of a downtrend, when everything is seemingly at its worst. But this is also the time when the price of property is at its most attractive level because by this point most of the bad news is priced into the market, thereby limiting downside risk and offering attractive valuations.

This is therefore also the point at which informed investors start to enter the market, looking for property investments offering fantastic yields and growth opportunities.

The majority of this phase will be characterized by persistent market pessimism, with most people thinking things will only get worse.

It is only towards the mid-to-latter stages of the stealth phase that we see the price of the market start to move higher.

The awareness PHASE

When informed investors entered the market during the stealth phase, they did so with the assumption that the worst was over and a recovery lay ahead. As this starts to materialize, the new trend moves into what is known as the awareness phase.

During this phase, negative sentiment starts to dissipate as lending becomes cheaper and more affordable. As the good news starts to permeate the market, home owners start to trade up and first time buyers come to the party. Attracted by the now steadily rising prices, this is also the time when the number of speculators increases, creating more demand and sending prices higher.

 THE MANIA PHASE
As the market inexorably moves higher and the move starts to age, we begin to head into the mania phase. At this point, property is the ‘go to’ investment. Credit is cheap to get and banks are falling over themselves to lend it. Increasing numbers of property owners, seduced by the seemingly never ending gains, join the ranks of property investors, thereby competing with the desperate and hugely leveraged first time buyers.

With valuations now reaching ludicrous levels, this last stage in the upward trend is the one in which the smart money starts to scale back its positions, selling property off to those now entering the market. The perception is that everything is running great, that only good things lie ahead and that the market will keep on climbing higher.

This is also usually the time when the last of the buyers start to enter the market - after large gains have been achieved. Like lambs to the slaughter, the late entrants hope that recent returns will continue. However, with valuations incredibly over stretched and the interest rate cycle about to turn against them, they are buying near the top.

The Tipping Point

There are a number of factors that can affect the price of property. The level of interest rates and inflation, the outlook for the economy, the availability of credit, and changes in the population numbers to name a few. All these factors can help accelerate, or slowdown a trend for a period of time, but none of them are capable of changing or reversing the dominant trend in motion. Property, like all assets, move in long term repeating cycles from under-valued to over-valued and back again, in a process we have observed for millennia. And although certain measures may delay the inevitable (usually with more painful consequences later on), once the peak of overvaluation is reached, the market will start its long, painful journey to once again reach undervalued levels, where finally a new bull market will spring forth.

In many parts of the world we have witnessed a change in the property market dynamic since the global financial crisis of 2007. Up till that point we saw a broad based bull market with massive participation and prices rising across the board. But since the price falls triggered by the GFC a change has occurred. Once the dust settled, prices once again started to rise, but this time the rise was driven by big money looking for safe havens in the large centres of the world, not by broad based buying. We witnessed new highs in many of the worlds biggest cities, but the breadth of the market was slowly falling away, and in many countries the gains in the wider property market has seriously lagged behind. This 'two-tier' market, and distillation of the gains into an ever decreasing pool of investments is classic sign of the late stage of a bull market. And in the last year or so we are seeing price falls in those large centres as the cycle rolls over. As the process moves on, we will start to see these falls ripple out until the entire global property market is in retreat.

What we have witnessed since those far off days of the 1980’s is a global property market moving from extreme undervaluation to extreme overvaluation, and the current combination of sky high valuations and enormous levels of property debt leave us awaiting the catalyst that will propel the market lower. 

Which brings us to interest rates.

The Power of Interest Rates

Contrary to popular belief, Central Banks around the world do not control the interest rate market. They do have the power to set the official cash rate (called various things around the globe), but unless they intervene directly into the bond market by buying or selling (as we have seen with quantitative easing), all other rates, be it 3 month, 1 yr, 5 yr or 10 yr etc are set by how those bonds are trading in the market. It is therefore the supply and demand for bonds that is the critical factor in establishing the interest rates that matter to you and I, not the rates that the central banks control. So just because the central bank changes its rates, does not mean it will be mirrored in your mortgage rate, credit card rate or deposit rate. 

But it gets worse.

The US dollar is the world’s reserve currency, meaning that the US Bond Market is seen as the safest investment in the world, and therefore bond markets around the world are all referenced to what happens in US bonds. In simple terms this means that if investors start to sell US bonds, thereby driving interest rates up, this will also be reflected in interest rate movements around the globe – when US interest rates go up, so do ours!

We can now see that the domestic factors that affect interest rates in our own countries can be overwhelmed by the movements of US interest rates. So bearing in mind the importance of interest rates on property prices, it is critical that we pay attention to the outlook for US interest rates, and it is not a pretty picture.

Here we can see a chart of the US 10 yr bond yield from 1960 to the present day. It illustrates the rise in rates from the 60's, through the inflationary period of the 70's and finally peaking in the early 80's. Since then, rates have ground inexorably lower until finally reaching a bottom in 2016. This snapshot only shows the cycle from the 1960's to the present day, however if I were able to obtain the data you would be able to see this pattern repeated time and time again. Unfortunately for us, the lows we have experienced through this particular cycle have carried interest rates to levels never experienced before, and as high interest rates follow low interest rates as sure as night follows day, we have much higher rates in our future. 

To get a better timeline on that, we need to look at a shorter term chart.

In this chart we get to see more detail of the US  10 yr bond yield over the last 10 year year period. It is apparent that we have experienced a huge basing pattern as rates have moved between the 1.3 to 3% zone ( the rates in the charts are expressed as 10x the rate ie 13.36 rather than an actual rate of 1.336). Basing patterns are important to pay attention to, as the rule is that the longer the pattern lasts, the greater the move will be when it finally breaks out. And although only by a small margin, prices have broken out and exceeded the previous highs established back in 2014.

Overhead resistance will still be offered by the falling 200 day moving average (green line on chart) so it may take a little while to work through this. However once that is overcome, much higher rates await.

This picture is corroborated when we look at a point and figure chart.

Here we can see the big move up from the lows of 2016, giving us a projected target of 4.967% (49.67 on the chart) resulting in a 70% increase in borrowing costs from the current level. But this will only be the start. Having fallen so far for so long, history tells us that we should expect a protracted rise in interest rates, and as we now know, once the trend is in motion there is no stopping it.

This rising interest rate environment, allied to stratospheric property valuations and huge leverage is the recipe for a housing price disaster. It has been an incredible ride, but contrary to popular thinking, interest rates do not stay low indefinitely and housing bull markets don't last forever.

What Happens Now?

As the combined factors of over leverage, over valuation and rising interest rates start to take affect we will see the property market change:

1. The volume of sales starts to fall as the cash buyers at the top end of the market dry up.
2. There is a growing disconnect between sellers expectations and what buyers will pay, decreasing the level of sales still further.
3. As the market stagnates buyer perception of potential gains changes and bidding prices start to drop.
4. Sellers start to become aware that the market has changed, and that they need to lower prices if they wish to sell.
5. Usual real estate bullshit around it being a good time to buy.
6. As interest rates start to rise, banks start to reduce their exposure to mortgage debt and make it harder to obtain a mortgage.
7. Speculators leave the market, reducing the demand for property still further.
8. The first whiff of fear takes hold. Property owners that are forced to sell have to accept much lower prices.
9. Some over leveraged property owners, squeezed by falling prices and rising mortgage costs , hand back the keys.
10. The constantly rising interest rates and falling prices creates a vicious cycle. Sellers keep reducing prices but buyers are squeezed by reducing access to credit and rising debt service costs, reducing the amount they can pay.
11. Usual real estate bullshit around it being a good time to buy.
12. The volume of property for sale, and the length of time it takes to sell both increase. This overhang of property is an added deterrent to buyers. Why buy now when they will be cheaper next month.
13. Over leveraged property speculators start to sell down property to avoid going bankrupt.
14. Banks balance sheets are affected by the volume of failed mortgages they have, and the number of properties they now own as a result of owners giving back the keys. As a consequence, mortgagee sales increase and drive the market still lower.
15. Finally the market reaches a point of equilibrium as all the forced sellers have sold. Prices stabilize. 
16. Activity is very low. Buyers, now conditioned to falling prices, sit with bids below the market price. There are only cash buyers as credit is extremely hard to access. Sellers, wanting but not needing to sell, sit with asking prices above the market price, waiting for an uptick. Time drags by.
17. Real estate agents go bust due to low volumes. Number of agents is radically reduced.
18. Driven by a combination of falling prices, inflation and the passage of time, property is once again finally undervalued.
19. Buyers, unable to obtain property with low-ball offers finally have to pay market rate.
20. The stable prices encourage value investors to once again enter the market.
21. The overhang of property is slowly eaten into and prices start to rise.
22. The process is ready to start all over again. 
23. The usual real estate bullshit around it being a good time to buy.........finally they are right.

Dependent on where in the world you are, you will likely face some if not most the outcomes listed above. There will always be variations, for example in the US property loans are non-recourse, meaning that you can hand back the keys without the debt hanging over your head. This pushes the risk back to the banking sector which is where it should lie, and speeds up the process of falling prices and the correction to undervaluation. However, in places like the UK and New Zealand, mortgage debt stays with you, so defaulting on a mortgage is a last resort. This slows down the correction and can force the economy into a slow, grinding retreat. Whatever the local variables, the big picture is clear.

When it comes to property, the trend has indeed been our friend, but nothing lasts forever.

Good luck.