So many bad numbers have come out about residential real estate that they all begin to blend together. But a figure as grim as “50% decline”, applied to an entire market, even if in real rather than nominal terms, is a stunner.
This grim forecast for UK real estate comes from a futures index based on the Halifax monthly house price index. Since the monthly Halifax report released last Friday was considerably worse than expected, it’s possible that the market has overshot, particularly if it is thinly traded. But the trajectory of US housing is proving to be far worse than most had estimated initially, and UK investors are no doubt mindful of our bad example, so the price of the futures may well represent the current consensus among professionals.
From the Guardian:
The slide in house prices will continue for at least three years and crush the value of a home by almost 50% in real terms, according to a key index of property price futures. Indications from futures trading on long term property prices shows that the average UK home will recover its current value only in 2017.
By the end of this year prices will be down by 10% and by a further 10.5% in 2009, according to the index. Prices will keep dropping through 2010 and cut values by 23.5% when they hit rock bottom in 2011. House prices will then begin a slow climb back to current market values over a period of about six years.
If an average retail price inflation rate of 4% is included in the calculation and in addition the 8% drop in prices over the last eight months already registered by the Halifax index, the fall in values over almost four years will reach 47.5% in real terms.
The Liberal Democrat Treasury spokesman, Lord Oakeshott, said the figures revealed that property investors had little confidence in the market and were predicting steep and prolonged falls in prices.
“This government says this housing depression will be different from the early 1990s. Yes, that’s right. It will be worse.”
When not attacking government policy in the Lords, Oakeshott invests in property on behalf of pension funds through his investment vehicle Olim. He says he has watched the index steadily fall over recent weeks. On Friday it “fell off a cliff” after the Halifax published its latest house price survey.
Halifax said the value of a home fell by 2.4% in May, the seventh month in the past eight when prices have fallen.
The May figure spooked investors, who said prices were now falling more rapidly than at any time since the early 90s property crash. House buyers benefited from low prices until 1995 when values began to pick up….
The residential property futures market is based on the Halifax monthly house price index, published by the bank. It is an-over-the-counter market designed for banks, pension funds, insurance companies and housebuilders to trade on the future values of property. Tradition Property, a City-based property broker, operates a derivatives futures index based on the Halifax figures.
I think it is worth pointing out that property futures are the only way to take a short position in UK property. On the other hand there are many ways to take a long position, from direct investment to REITS etc.
As a result some people have argued that property futures markets have an inbuilt “technically-driven” bias towards the downside because of the predominance of people needing to open hedging (eg short) positions. Futures prices are therefore not always actually estimates of future prices but of supply-and-demand for people willing to offer “insurance” against the possibility of a slump. At the moment they will only offer this “insurance” on very cautious terms.
To put it another way, if stock futures were “too low” you could buy the future and sell the stock on margin and profit when the two converged. But how do you sell UK property on margin? I suppose you could short housebuilders or the like as an analogue, but it would not be easy or reliable.
Not that I dispute that there is going to be carnage in the UK property market. A casual glance at TV schedules over the last few years showed endless programmes such as “Property Ladder”
which suggested that any idiot can take out a 99.9% mortgage on a second home, redecorate/restore it and then flip it six months later for a £30,000 profit. I think I’ll keep renting for a bit.
Anonymous is right: the futures price should not be viewed as an estimate of future spot prices for commodities like houses. Oil futures are often misinterpreted in similar fashion as pointed out in this FT Alphaville post: http://ftalphaville.ft.com/blog/2008/05/09/12892/calling-oil-wrong/. For more background, see any textbook on futures and forwards, under “contango” and “normal backwardation”.
Given the lack of specificity in how the article is written, and my lack of access to the actual data, I cannot tell whether they are literally looking to the futures price and treating it as a forecast, or whether, as the Cleveland Fed does for Fed funds futures, they made the computations to back out the price forecast implicit in the futures price.
What anonymous said, although techinically you can take out CDS on mortgage backed securities and (maybe) covered bonds. Not many people have the capacity to do that, however, and obviously it’s not a perfect short. There’s definitely a consensus now that the housing market is in much worse shape than people thought even a month ago, but nobody I’ve spoken to thinks 50% is anything like realistic. The most pessimistic people I know (and that includes people who are short) say 25%.
But remember, the 47% is real over four years, while your 25% is nominal. And I believe the UK housing market when down over 20% nominal in the early 1990s, and (at least per what I am hearing here, but I am at quite a remove) this housing recession appears likely to be more severe.
Very briefly, because of time constraints (I’ll try to add a few lines later today): Fed funds futures differ from commodity futures in that they do allow you to infer expectations about future rates. The Cleveland Fed approach and similar methods won’t work with commodity futures. It’s therefore most likely that the Guardian article is based on simply (and incorrectly) equating the futures price and the “consensus” estimate of the future spot price.
This is not a commodities future. You don’t settle to physical. In fact, this sounds like it’s more like a prediction market (as in participants are placing bets on what the Halifax index will be) but I would assume you have the mechanics of an exchange-traded derivative,
Backwardization is a function of storage costs on a deliverable commodity. That would not seem applicable here. From “Is Managed Futures an Asset Class? The Search for the Beta of Commodity Futures” by Michael Frankfurter and Davide Accomazzo:
Accordingly, the current expectation of the future spot price (which is in actuality an unknown) is theoretically driven down because the commodity is held back from the market and kept in storage. As described by Kaldor (1939), holding back a commodity in storage is referred to as a ‘convenience yield,’ and together with congenital weakness forms the basis of the phenomenon known as ‘backwardation.’
50% in real terms doesn’t seem too far off. I think the final number in the US will be something similar.
People really need to start distinguishing the difference between real and nominal, and by people, I mean average everyday people. There should be some outrage over what is happening to paper money worldwide. Assets (stocks, bonds, homes) are losing their value at a much faster rate based on a commodity type standard.
And I understand that is beginning to happen with oil and food, but the blame is being laid on ‘speculators’ and ‘shortages’, when it is commodities across the board that are showing the worldwide debasement that is occurring. People will ‘speculate’ in commodities as long as the central banks continue to prop up bad businesses, and encourage the total misallocation of capital.
I agree that it is not useful to compare the Halifax index with a commodity, for the reasons Yves mentioned, and so concepts such as contango/backwardation are not so relevant. They apply more to derivatives where the position is (practically) hedgeable.
However I still think that there is a significant risk it is not a good prediction market because of the supply-demand factors.
People taking short positions can cancel out their risk exposure by taking the long cash position (eg by buying, or already having, a diversified portfolio of UK residential property) but people taking long positions can’t. That’s why I think there may be a risk premium in these prices because both sides of the trade aren’t almost equally hedgeable (as in commodity futures) or equally unhedgeable (as in prediction markets for politics etc).
Anyway, it’s been interesting to think about this morning. Another great post Yves, thanks.
Yves, I realise it’s over four years, but that’s kind of my point. I’m only going on the people I’ve spoken to (lenders, investors and analysts, mainly) and the research I’ve seen, but nobody among them predicts the fall to continue to 2011. I’m not saying it couldn’t happen, but it’s absolutely not a market consensus. Similarly, while there are people who see a 90s severity crash as a distinct possiblity, very few see it as “likely”. Worth hedging against, yes. Worth betting the farm on, not for most people. To cite one investor who called US subprime correctly, he sees a 30% peak to trough decline as a 1/3 to 1/5 probability. That’s up from 1/10 to 1/5 from two months ago. Now I’m probably more pessimistic than that, but not by much.