Wednesday, April 17, 2013

The Real Question

If someone says that arguing whether it's a bubble or not is most of the time retarded, I have to agree. But when the discussion really turns into nonsense is when the arguments for it not being a bubble are just arguments for prices being high at the moment. The usual stuff about continuing high demand and "them building not enough houses", you know. You can argue for hours about the future demand and supply, and the best you can arrive at is some kind of understanding of if there is a "bubble" in demand, i.e. the current demand is not sustainable in the future, or if there is shorter-term supply issue that will be solved (by building more houses in the coming years). But in no way does this address the real issue: the bubble in the prices.

Having seen how one-sided the public discourse on house prices in Norway is, I think it's best to explain a bit further. A financial bubble (in house prices, in stock prices, in tulips - you name it), or what I'd like to call simply too high prices, is always a result of high demand against a supply that doesn't fully meet the demand (supply that fails to keep the prices stable). If bubbles are a result of high demand vs. low supply, how can you tell a bubble or non-bubble by focusing on how demand exceeds supply?

The real question you need to answer to detect if it's a bubble or not is this:
What is a fair, reasonable price to pay for a house, and where does the market price stand in relation to this fair price?
It is a hard -if not impossible- one to answer. So, as Daniel Kahneman has taught me, we might substitute this hard question with an easier one focusing on the demand and supply, and by answering that question we think we have answered the ultimate question about if it's a bubble or not. But we haven't.

Try to ask someone what is a reasonable price for a house in Oslo. I don't have any accurate answer to it. But I can tell it's not
  • what the market asks for,
  • whatever amount the bank (including government & parental subsidies) is willing to give you,
  • "any price" because real estate is always a safe investment in the long-term, or
  • "any price" because Statistics Norway says house prices will go up until at least 2016 and I'll sell in 2016.
If you have no idea of a reasonable price, and instead rely on the bullet points above when deciding to buy a house, you risk paying way too much. Let's say during 25 years out of 30 it's fairly safe to buy. That might help you sleep at night, but it's still a big gamble to take when we talk about the biggest financial decision in many people's lives.

I have to admit that I don't try myself to answer the real question in any detail. I think you just can't know the answer. Instead I rely more on the "second-level thinking" I introduced earlier, trying basically to understand to what extent the buyers are being blind to the price (= follow the bullet point criteria above). Understanding this and the price of, and access to, credit is crucial in my opinion.


  1. I'll try to explain why I recently bought a place....
    First I DON'T want prices to go up, this is because I am buying a flat and will want to upgrade to a more expensive house in the future.
    We buy and sell in the same market, so for example my flat is 3 million, but my ideal house is on the market for 6 million. So say houses doubled in 7 years then yes my flat will be worth 6 million but my ideal house has doubled to 12 million, so I would need to find an additional 6 million Kroner. If (as I hope) prices stagnate for 7 years then although my flat is still worth 3 million my ideal house is also still 6 million, thus would need an additional 3 million to buy rather than 6 million, so in effect I am 3 million better off, if my end gaol is to buy a bigger house.
    So the question then becomes is it cheaper to buy rather than rent. At these low interest rates and with tax deductions for mortgages then my calculated interest each year is significantly less then the cost of renting the same appartment (this takes into account the opportunity cost of having my deposit savings in a bank earning ineterst). It works out to be around 70000 NOK a year less in interest as opposed to the rental cost. Also you have the intangible value/pleasure/security of owning your own place. The risks of course are increases in the interest rates, however increases in the reserve bank rate imply higher inflation and an overheating economy, thus increasing rents and wages. My mortgage interest could still go up 2% and still be slightly cheaper to buy vs rent. I think in a macro perspective the mortgage interest deduction has translated into higher prices for houses than would be otherwise, so in principle I disagree with this. Of course everything could go horribly wrong in the world economy, but you can't wait around waiting for this to happen (may never happen!).

  2. Thanks for sharing your thoughts!

    A lot of it makes sense. You are in a situation that Warren Buffett has referred to when he said "You should buy your second house first" :-) This of course assumes rising prices, and like you say, it would be best for you if the prices stayed flat.

    Like bubble-spotting in general, this might be mainly a "gut feeling" (although, IMHO, proven in bubbles time after time), but I would argue that it is just practically VERY unlikely, if not possible, that prices, after rising fast for more or less 20 years, would flatten out for the next 7 years. I hear your calculations and thoughts on interest rates, but I think that even the most able "experts" are unable to calculate and forecast these things called bubbles. So I don't give you much hope outside these two options:

    1) Prices keep on rising still (although at a lower pace) for many years due to "goldilocks" scenario for Norway, with continuing high immigration, low interest rates and -underlying the whole economy- high oil price. Though, like mentioned before, stable oil price is no insurance either due to economic cycles that always prevail.

    2) Prices stop rising, which takes the momentum (the expectations of rising prices keep the prices rising, up to a point) out of the market, and leads to falling prices. With flat price expectations, people don't need to rush to buy, they can afford to wait - and start asking themselves: Perhaps it's cheaper next year?... Second house investors don't feel anymore that they are losing an opportunity to get rich, but start rather worrying about losing money. The same momentum turns against the housing market.

    With stable earnings and some buffer savings you will of course most likely navigate through this in one piece, so I don't want to frighten you too much :) But I think that people gravely underestimate the risk connected to buying. Perhaps it's because "you just can't know what happens and the rule of thumb is that you should always buy"?

    By the way, did you add the monhtly running costs ("felleskostnader") to your calculations? Paid interest is of course less than the rent, but in some areas "interest + running costs" comes close to the rent price. These costs can be as high as 2000-4000 NOK?

  3. AnonymousMay 02, 2013

    Yes in regards to point 2), we can see this happening in the UK, where there is no longer the rush to buy and transaction volumes plummet, though prices hold up. This is because houses have a 'sticky' tendancy, due to being a lot less liquid than shares for example, and pyschological loss aversion. So people will hold on unwilling to sell at a lower price while those wishing to buy are unwilling to pay that price. This can continue for a long time! To change this standoff and have rapidly falling prices you need an external trigger like very high unemployment or a more liberal housing market as in the US where people can walk away from their houses leaving the banks having to sell (foreclosures). The Norwegian government has a vast array of weaponary at its disposal to fight unemployment, as public finances are in good shape and can tap into it's sovereign wealth fund, plus also having it's own currency!! A weak housing market will maintain low interest rates. So this is why I think prices will stabilise rather than plummet and transaction volumes will fall - so might not be the best time to start as a real estate agent!
    People look at nominal prices not real prices so for example in 7 years inflation/wages will rise around 25-30%, so in effect the house has gone down 25-30% in real terms. The reserve bank has, if not publically, acknowledged the risks in the housing market, hence requiring a minimum 15% deposit, and are increasing reserve requirements for domestic banks.
    I fully agree that people underestimate the risks of buying, leverage works in both ways, amplifies your gains and also amplifies your losses, lots of leverage in the housing market! So investors should be beware at the moment. But if you are secure in your job and have some additional savings to fall back on and know that you will be living in the house for 5+ years then it can make more sense to buy rather than rent even if prices dont go up and fall a little.
    Also your mortgage remains the same each year (ceterius paribus), and interest portion of your loan decreases each month, whereas rent may increase each year.
    Also one more point for those wanting to buy just now - beware the new build flats that all look the same, they can always increase the supply of them, but if you find a unique (hard to find) place in a good location then there is always limited supply of such properties, so they will likely hold value more.