It is now more than ten years since the global financial crisis, a key trigger of which was a downturn in the US property market. Indeed, property has been associated with financial crises and recessions many times throughout history.
Why then does the property market have the potential to have such an important bearing on the global economy?
Firstly, it is, quite simply, a very big market. At more than $200 trillion, the total value of global residential and commercial property is almost double the size of government and corporate debt securities, around 2.5 times the size of the global equity market and 1.5 times global gross domestic product. The sheer size of the market is obviously part of the reason why property is so important to the health of both the financial sector and the broader economy.
Property affects the economy via the construction of buildings and through related supply chains. It also affects consumer confidence as rising prices boost the feel-good factor of property owners. The value of property also affects the amount of collateral households and companies can borrow to fund investment and spending. And, crucially, it affects the health of the overall banking sector because property purchases are funded by debt.
Property also tends to be a major influence on the economy due to its cyclical nature, with a propensity to experience periods of boom and bust. It is common for global house prices to fall in real terms during an economic downturn but rise on average by over 5 per cent per annum during an upturn. This tends to magnify the effects property can have on an economy on both the way up and the way down.
The cyclical nature of the property market did not just begin in recent times when mortgage finance became more prevalent but goes back centuries. The big swings in prices are partly because the supply of property tends to adjust more slowly than the demand for property. The resulting periods of mismatch between supply and demand explain why the sector seems to be especially vulnerable to swings in sentiment and speculation which can accentuate price cycles. Borrowing that finances much of property demand means leverage can magnify underlying property market cycles.
PROPERTY HAS BEEN THE CAUSE OF MANY RECESSIONS.
The combination of property’s tendency towards booms and busts, and its multiple links to the economy, explains why it has been the cause of many recessions in the past. For example, there have been twelve burst housing bubbles in the G7 economies since 1960 and eleven of those have been followed by a recession within three years.
In addition, burst housing bubbles have been more likely to result in a recession than burst equity bubbles. This is because of the greater value of property and because households are more heavily invested in property than in stocks and shares. Mortgages also make up a large proportion of bank assets. What’s more, the cumulative loss of output from a residential property related recession is about three times greater than a typical recession.
Leverage is a big factor in why property downturns often result in a banking crises and recessions. Research by the International Monetary Fund shows that of nearly 50 systemic banking crises in recent decades, more than two thirds were preceded by boom-bust patterns in house prices. One of the most dramatic examples of property being the root cause of a crisis is the recent global financial crisis of 2007/8. Because of the way that American mortgage debt had been sliced and diced, securitized and sold throughout the world, the downturn in the United States property market led to the global credit crunch.
Given that purchases of commercial property are typically bank financed, it clearly has as much scope as residential property to cause serious downturns. However, it is rare to see a downturn in the commercial property market without one in the residential market. Accordingly, commercial property tends to magnify downturns rather than cause them. Commercial and residential property prices tend to move closely together, given that they share common drivers such as lending standards and interest rates.
CAN PROPERTY MARKETS TRIGGER A GLOBAL FINANCIAL CRISIS?
Despite the importance of property to the global economy and its tendency to precipitate national and regional crises, it is highly unusual for property to spark a global crisis as it did in 2008/9. Part of the reason is because there is not a “global” property market.
For most of the time, national property markets tend to move in different directions and at different speeds and do not appear to be synchronized. This is because country specific factors are most important in driving property markets, including demographics, taxes, income growth, lending practices and property supply. For instance, even during the global financial crisis, while house prices in advanced economies fell meaningfully, in emerging markets the boom in prices halted but did not reverse.
However, a property downturn that starts off in just one country can still prompt a global crisis if that property market’s connections with other countries are big enough to bring them down too. This is what happened in the global financial crisis; the United States’ property market imploded and the impact on credit conditions around the world prompted the collapse of many other property markets. Nevertheless, only a country like the United States, or perhaps China, is big and systematically important enough for a property slowdown to have a significant spill over elsewhere.
Not every housing downturn in a large economy will have global ramifications though. The American downturn in 2007/8 sparked a global crisis because the international financial system was exposed to United States mortgage debt.
In summary the circumstances that bring about a property induced global financial crisis are rare.
PROPERTY AND THE CLARION INVESTMENT PROCESS
Clarion do not hold property related investments in any of the Clarion Portfolio Funds or Model Portfolios.
We believe that property can add diversification benefits to a portfolio in normal market conditions but during times of market turmoil, such as the 2008/9 financial crisis, there are likely to be more sellers than buyers of property. Property transactions are typically long processes which means that excess supply is likely to exacerbate price falls. The effect of this is to increase the correlation between property and other falling asset classes which diminishes the diversification of the property allocation.
Property is of course much less liquid than other assets classes and liquidity is a core part of our process. Furthermore, at times of market stress, values over-react, and prices can often fall indiscriminately. Sometimes, as in the 2007/8 financial crisis, and more recently when the M&G Property Fund refused to allow cash withdrawals, investment funds holding property are “gated” meaning there can be a delay of up to 6 months or more for encashment which can result in lost opportunity.
In addition to this, at Clarion we are mindful that many investors are likely to be homeowners which means that a substantial portion of their net assets are already invested in property. Therefore, holding property assets on behalf of our investors could involuntarily increase their exposure to this asset class.
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