There were clear signs of an approaching crash. Were they ignored and, if so, why? Andrew Baum reflects
In his 1955 account of the Great Crash of 1929, Galbraith also said that crashes may be attributed to "men who know that things are going quite wrong [but] say that things are
fundamentally sound". Over 50 years later, he has been proved right again.
With the benefit of hindsight, most analysts would probably agree that by 2006 overpricing had become established in housing and in commercial property of all types in the UK, US and elsewhere. The causes of this are becoming increasingly well documented.
The global financial crisis of 2007-08 had its very roots in property speculation, facilitated by the packaging and repackaging of equity, debt and risk. The systemic risk that had become endemic to the market did not reduce the interest in new products. While this frenzy continued, professional responsibility appeared to take a back seat to the profit motive. The previously objective became self-interested: property researchers became fund managers, for example, and boardrooms lacked the detached yet experienced voice that advances in information and research should have made available.
But to argue that this was a failure of those engaged in objective analysis presumes that there were obvious warning signs. Is this true? Was the overpricing in 2007 evident? Was the crash predictable?
Those of us of a certain age should certainly have had an inkling that a correction was imminent. We remember 1973-74 and 1990-91, and simple extrapolation indicates a property crash in 2007-08. But this smacks of mere superstition, and no self-respecting analyst will suggest that a 17-year cycle is inevitable.
Instead, we should look at the pricing indicators. Had the dials gone into the red? Buried within the morass of statistics and opinion available to us at the time, here are three lessons that might have told us that we were heading for trouble.
Lesson 1: Too much bank lending to property is dangerous
The Thatcher boom of 1986-89, when UK consumer expenditure growth reached levels as high as 6% a year, produced huge levels of bank liquidity. The apparent security of property for lenders enabled property companies to increase their borrowings - and financial gearing - to capture the fruits of the property boom. Residential owner-occupiers geared up and many bought second homes. Bank lending to property reached all-time record levels in 1989-91. This peak in lending - a five-fold increase in 10 years - marked the end of the bull market in UK property and fuelled a crash that was fed by over-development.
The lending of 2001-2006 - by the end of which period bank lending was three times the 1991 level - makes the excesses of 1989 seem ascetic. The coincidence of geometric increases in lending commitments and a following crash is not accidental (by 2008 the drawn lending was at five times the 1991 level).
Lesson 2: Yields are mean reverting
By the late 1990s, the lessons of the Thatcher boom left the market in better shape than it had been in 10 years earlier. Minimal new development meant that stable five-year returns of 10-15% were the consensus view at the beginning of the year 2000. The total return on UK property in 2004 was 18.3%, a real return of 17.1%. In 2005, the IPD Index showed continued strong returns, with returns of 19.1%, equal to over 16% in real terms, and returns in 2006 were again in excess of 18%.
This is well over the average total return on the annual UK IPD Index Universe, first measured in 1981. Expressed as a geometric average, the average annual nominal return on the UK market over the period 1981-2004 was 11.1%. In real terms, this is 7.1%. The 2004-06 returns were close to 10% higher than the long-term average in real terms. What was driving these returns?
Over the period 1981-2006, an average property return of around 10.5% can be split into income return (around 7%); and nominal rental growth at roughly the rate of inflation (3.5%). Capitalisation rate movement can add return over short periods, but its contribution over the long term is always close to zero. In the context of the historical pattern, the return breakdowns in 2004, 2005 and 2006 appear to be something of an anomaly. In each year returns in excess of 15% were driven mainly by what became known as yield compression.
Since 1981 changes in yields from one year to the next have rarely exceeded plus or minus 0.5%. An annual fall in yields as significant as that seen from 2003-04, 2004-05 and 2005-06 had only been seen in one other year since the creation of the UK IPD Index Universe.
By the end of 2006, many market participants were keen to ask whether the fall in yields experienced in 2004, 2005 and 2006 was sustainable. Were we to expect further yield falls - or was this a bubble waiting to burst?
The figure shows UK property equivalent yields to 2009 since 1976. It is easy to conclude that there is a mean property yield of 8% or so and that when yields stood below 6%, as they did in 2006, a rise back towards 8% is predictable.
Lesson 3: Look at yields on index-linked
It is tempting to compare yields on gilts and yields on equities with property cap rates. The picture is confusing. But equivalent yields have moved in line with index-linked yields (see figure) since the recovery from the 1990-92 crash, since when the average premium of property cap rates over index-linked yields was around 4.5%.
Since 2001 in particular, equivalent yields have tracked index-linked yields down and the two series have been strongly correlated (presumably, the capital markets see property as an inflation hedge). But by the end of 2006 the difference between equivalent yields and index-linked yields had closed from a mean of 4.5% to a new level of around 2.5%. This suggests that property yields were already too low.
The timing of a correction is notoriously difficult to predict. But, as Galbraith said, the threat is there when those who know that things are going quite wrong say that things are fundamentally sound.
Myopia, the desire to be popular and a lack of economic education may all explain poor judgement, but an expert view distorted by financial incentives is much more dangerous. May the compensation structures put in place from here on more fairly reward those who remain objective.
The content is extracted from Andrew Baum's book ‘Commercial Real Estate: A Strategic Approach', Elsevier/Estates Gazette, 2009
Andrew Baum is professor of land management at the Henley Business School, University of Reading