Home prices are rising in most major cities around the world, but in some they are rising too far, too fast.
When prices reach the so-called bubble territory, that is, overvalued in relation to fundamentals like income and employment, they are at a far greater risk of correction. While it is hard to pinpoint exactly when that correction will occur, identifying the bubbles early can offer insight and protect investors.
In the last five years, bubble risk has grown significantly in several cities, according to a new report from UBS. Toronto, Stockholm, Munich, Vancouver, British Columbia, Sydney, London, Hong Kong and Amsterdam are at "bubble risk," according to its Global Real Estate Bubble Index.
Real house prices in these cities have risen nearly 50 percent since 2011. This is far higher than local economic growth and inflation rates, and incomes and rents have risen less than 10 percent in these cities during the same period.
While no U.S. cities make that highest "bubble risk" category in the index, San Francisco and Los Angeles are considered "overvalued." Prices in San Francisco are up almost 65 percent since 2011, but has "limited bubble risk, given its strong economic fundamentals amid the astonishing boom of tech companies," according to the report.
The reasons for strong price appreciation are varied. In Canadian and European markets, prices have been able to rise swiftly due to historically low mortgage rates. In European cities, while prices are higher, homeowners' annual payments are below their 10-year average. In the U.S., low mortgage rates are also helping buyers afford more homes, but the real driver of prices is very low supply of homes for sale.
U.S. homebuilders still have not recovered from the housing crisis that began in the late 2000s, and are not back to producing even the historical average of new homes, never mind all the pent-up demand. The U.S. market also lost about a million homes to investors, who turned them into lucrative rentals, removing them from the potential for-sale stock.
Of course a bubble can't be proven until it bursts, but history proves the risk to these markets when home prices are decoupled from economic fundamentals of a local market.
"A change in macroeconomic momentum, a shift in investor sentiment or a major supply increase could trigger a decline in house prices," according to UBS researchers.
And then there is the "Superstar" scenario. This theory suggests that even when prices are out of whack with fundamentals, there are certain superstars, that will dominate. This holds true for movie stars and major metropolitan cities alike. UBS researchers suggest that Hong Kong, London and San Francisco are "Superstars." High net worth investors will always flock to these cities, and as long as supply doesn't exceed demand, prices are at less risk of weakening.
The one variable in all this is a big one: interest rates. Should rates begin to rise, slowly or swiftly, investors could pull back. "Also, the current affordability crisis may trigger policy responses that could end the housing party rather abruptly," according to the report.
Housing policy in Vancouver, specifically a tax on foreign investors in real estate, was designed to cool the overheating home prices there. As a result, more investors set their sights south, to Seattle, which now leads all U.S. markets for home price appreciation.