If the real estate market declines, this happens
By David Bakkegaard Karsbøl
Several factors point to the fact that we are close to the peak of the real estate market. But what usually happens when real estate prices start to fall?
Most asset classes have benefited from the extremely expansionary monetary policy since the financial crisis, and some of them have already reacted to the expectation that central banks will tighten monetary policy again by raising interest rates (and otherwise).
One asset class that has not yet shown clear signs of having reacted is the real estate market, which is also supported by high inflation expectations and thus expectations of higher household and corporate income levels. However, the real estate market has now also run into problems, as can be seen from the following indicators:
- the futures market for real estate prices in the US is pricing in a decline of more than 10% over the next three to four years
- The job market is turning, and the number of newly created positions and companies reporting difficulties in finding employees all indicate that we are facing problems
- interest rates have risen significantly, making the financing of real estate substantially more expensive and thus reducing the expected returns for real estate investors
- Material prices and the price of raw materials related to the construction industry have fallen sharply, as have the results of surveys of companies in the construction industry.
My assessment is therefore that we can now take it for granted that real estate prices are on a downward trend (also in Denmark - partly for the same reasons). Having said that, I think it would be a serious mistake to think that we are facing a scenario comparable to the financial crisis, which was rooted in a series of much more severe financial imbalances.
Nevertheless, against this background, it is relevant to consider what normally happens when the real estate market falls. To a large extent, questions have been answered by staff associated with the US Federal Reserve, who dealt with the issue in a so-called Study Paper # 841 from 2005.
Although the paper is now a bit dated, I still consider it to have a good answer to the question, because the financial crisis' falls in the real estate market (2007-2010) were abnormally large (and thus could overstate the average estimates). In addition, the paper looks at a number of countries with data going back to 1970. If the paper and its estimates are to be believed, after a peak in the real estate market, one would normally see the following happen:
- central banks usually continue to tighten monetary policy by raising interest rates by an average of 3 percentage points in the following year. This is apparently happening now.
- The economy then weakens and gradually heads towards a recession - partly as a result of less construction activity. We are also seeing this now, as we have already seen several countries with negative quarterly growth.
- central banks then react by cutting interest rates by around 5 percentage points.
- inflation is typically high when a peak in the real estate market is observed and remains relatively high for a year afterwards. It then falls significantly.
- The stock market typically falls by 25% (adjusted for inflation) in the two years following a peak in the real estate market. We may have already seen some of this decline, but as corporate earnings estimates weaken and the labor market turns as a result of lower construction activity, equities risk being further affected.
