When the slump finally comes, home prices could fall by half

Putting a fair value on housing is no easy task but there are some worrying property numbers in terms of average real interest rates

PUBLISHED : Monday, 21 January, 2013, 12:00am
UPDATED : Monday, 21 January, 2013, 5:38am

I know this column has banged on ad nauseam about Hong Kong property prices recently.

But there's a couple of big topics we haven't tackled: how much Hong Kong homes are overvalued and how far prices can fall, and the major structural changes the government needs to make to ensure the market's long-term health.

The structural changes can wait for another day. But given the government's pledge to ramp up housing supply, it's worth asking now how overpriced Hong Kong homes really are, and how deep any eventual correction is likely to be.

Unfortunately, putting a fair value on housing is tricky. On the face of it, property looks eye-wateringly expensive. The average Hong Kong family would have to put aside every penny it earned for almost 13 years to save enough to buy a typical flat in the city. That's four times as long as the average American family would have to save.

But high prices alone don't mean the market is overvalued. Other measures indicate that Hong Kong's property prices are more or less in line with what you would expect.

Certainly there is no credit-fuelled housing bubble. The levels of both residential mortgages and overall property loans are slightly below their 10-year average relative to total Hong Kong dollar loans, and both are falling as a proportion of overall bank lending.

And if you attempt to value property purely as an asset, then current prices look about right.

In its latest Article IV consultation with the Hong Kong government, the International Monetary Fund tried to do just that.

The fund's researchers worked from the basis that in an efficient market the cost of owning a home should be the same as renting one over the same period. If the cost of owning is higher, then property prices are overvalued.

Factoring in mortgage rates, taxes, maintenance charges and a clutch of other costs, they found that smaller flats are currently priced about 7 per cent above fair value, while big flats are a touch below.

Overall, they concluded, "prices are broadly consistent with fundamentals".

Not satisfied with that result, the IMF's boffins also tried valuing Hong Kong's property market using a range of macroeconomic factors, including land supply, construction costs, per capita income, credit availability and interest rates.

This time they found that as of June last year Hong Kong homes were just 10 per cent overpriced relative to their fundamental value.

But as the researchers pointed out, the trouble with their assessment is that although prices may currently appear more or less in line with economic fundamentals, right now the economic fundamentals themselves are abnormal. The main driver of home prices is interest rates, and at the moment interest rates are exceptionally low.

To correct for this, the fund's researchers ran their model again, this time using Hong Kong's average real interest rate between 2003 and 2007.

The results were sobering. In the middle of last year housing prices in Hong Kong were almost 30 per cent higher than they would have been if the city's real interest rates had been in line with their pre-crisis average. Since then, home prices have climbed by another 10 per cent. That implies prices will have even further to fall - roughly 40 per cent - in two or three years when interest rates finally begin to rise again.

Except that price swings generally overshoot. And then there is the prospect of ramped-up supply, with some 25,000 extra new flats a year reaching the market just as rates go up.

The results will not be pretty. The fall won't be as severe as the property crash that followed the 1997 bubble. But even so, when the slump finally comes, Hong Kong properties could end up losing almost half their value.