Asset valuation is a tricky business. It is, however, a skill that accountants are often commissioned to use. It’s also a useful one to have when making personal decisions, such as whether to buy a home or not.
Some people would argue that a major driver of the current economic slump in many countries is the collapse of house prices.
In a number of countries, house price bubbles were enormous. There are lots of motivations for buying a home; principally as a place to live, a store of value for the future; certainty come retirement (when the mortgage is paid off so housing costs drop only to be maintenance).
Another motive has been speculation. In my opinion, speculation in house prices is a bad thing, since it drives up house prices. This means that new houses are not affordable for the young. The more that house prices go up, the greater the transfer of wealth from the economically active young to the less economically active old.
Unsustainably high house prices cause uncertainty in an economy and when a crash eventually happens, it can cause people to be locked into homes with loans greater than the value of the asset (negative equity). As well as a source of human misery, negative equity reduces labour mobility, which is bad for the economy as whole.
The Economist newspaper tracks house prices in different countries, using a method based on rental yields. The assumption here is that rental markets react more readily to underlying supply and demand conditions. If one had $500,000 to invest, would one use it to buy a house which could then be rented out, or buy other investments such as bonds? If the rental yield (rent / initial value x 100) is less than the yield on bonds, then the house price is overvalued. It’s a simple enough methodology that can give some revealing results.
A couple of years ago, this analysis suggested that UK property prices were 35% overvalued. A crash followed. There have been property crashes and recession in many countries where speculation is a big motive to buy property. The alarming thing is that a recent analysis (Economist 10 July, page 75) revealed that properties are under and overvalued in certain countries:
UK: 33.8% overvalued (following a hard-to-explain recovery in house prices)
USA: 6.5% undervalued
Spain: 50.4% overvalued
Australia: 61.1% overvalued
Germany: 14.5% undervalued
Ireland: 15.7% overvalued.
This may be poor news indeed for the economy of countries with very overvalued property. With these sorts of valuations, mortgages may become unaffordable the moment that interest rates rise to above the rock bottom levels we have at the moment. This could release very big downward forces in the economy and dampen out any economic recovery.
On the plus side, the USA looks to have reacted quickly, albeit brutally, to the changed economic circumstances and it might be a good time to sell your home in Australia (cash out your investment while it’s arguably overvalued) and buy somewhere in America. If you can get a visa. Oh, and a mortgage!
