Sunday, September 5, 2010
Why does a tiny Tel Aviv flat cost more than a US house?
Since there are good arguments to be made for both sides, the truth is probably somewhere in the middle, with both speculative and genuine economic factors contributing to push up prices. A typical Tel Aviv apartment block. The price of income-generating properties rises as long-term interest rates drop.
The following example, based on a real apartment, supports the economic explanation, not the speculative one. For the sake of convenience I have rounded out the numbers.
Five years ago, in the summer of 2005, an investor bought an apartment for rental purposes: a small studio apartment in a new building but in an unattractive, congested area of south Tel Aviv. He paid NIS 430,000, using his own savings rather than taking a mortgage. At the time he could expect to rent it out for from NIS 2,400 to NIS 2,500 a month. Rental income of NIS 30,000 rent a year on an investment of NIS 430,000 translates into returns of about 6.5% a year. Israeli government fixed-income Shahar bonds would have yielded roughly the same return, in nominal terms.
Investing in property isn't like investing in government bonds. Like every instrument of investment, it has both benefits and drawbacks. On the minus side are the headaches of being a landlord, the risk of getting stuck with a bad tenant and occasional expenses. Unlike nominal bonds, however, rents and home prices tend to keep pace with inflation, and up to a certain threshold rental income is not taxable. Capital gains from bonds are taxed. In any event our man went for the property, not the bonds.
Five years later, where are we? The monthly rent rose to NIS 3,000 a month, representing an annual increase of around 4.5%, or between 20% and 25% over the five-year period. That wasn't a meteoric pace, it was roughly the same as inflation. But the purchase price is another story altogether. Similar apartments sell for NIS 800,000 today, meaning it rose by by 80% in five years, far outstripping the increase in rent.
In 2005 the return on investment was the same as nominal government bonds. Now the equation is NIS 800,000 (apartment value ) divided by NIS 36,000 a year (rental income ), which works out to 4.5% - the same as the return on Shahar bonds. In other words, that didn't change in the five years. That, dear reader, obeys the laws of economics and financing. When long-term interest rates drop, the price of income-generating properties rises. The longer the lifetime of the assets, the more their prices increase. Those are the laws of mathematics. Since property has a long lifetime, its price rises significantly when long-term interest rates drop.
Tel Aviv up, Florida down
But that isn't the end of our story. Let us travel abroad. That modest apartment in Tel Aviv cost $100,000 in dollar terms back in 2005. Back then, a single-family home in a good neighborhood in Florida cost around $400,000. Since then the dollar has weakened against the shekel and U.S. property prices have spiraled down. The dollar price of the Tel Aviv apartment more than doubled, to $210,000, while the price of the Florida house shrank by 50%, to $200,000. And that means that for the money you could get for that tiny studio apartment in an undesirable south Tel Aviv neighborhood, you could buy a pretty house in a Florida suburb, lawn and plastic flamingos included.
Does that make sense? At first glance it seems absurd, but it isn't. That Tel Aviv apartment can be easily rented out for an annual return of 4.5%, while that Florida house could well stand empty for a long time, racking up maintenance costs and creating a negative cash flow. That's because thousands of unneeded homes that stand empty today were built during Florida's extreme housing bubble, while nothing of that sort happened in Tel Aviv.
Strange as it may sound, the main reason for the sharp increase in the price of housing in Tel Aviv is the implosion of the real-estate bubble in the United States. Why? Simple. That implosion caused a financial crisis that led to interest rates falling through the floor. After the U.S. Federal Reserve in the bond market, yields on U.S. Treasury bills also fell hard. In 2005, yields on 10-year T-bills were running at 4.5%. Yields on Israeli government bonds were at around 6.5%. Today, the U.S. bills are trading at yields of 2.7% and Israeli bonds at 4.5%. The gap has held steady, but it is the drop in yields from 6.5% to 4.5% in Israel that caused housing prices here to mushroom, as described.
Claim that there is a real estate bubble in Israel is thus tantamount to saying that there is a bubble in T-bills, as they are what underlie housing prices in Israel.
The cost of protecting the financial system
Thus the U.S. Federal Reserve, which has done everything in its power to protect the financial system by shoring up financial asset prices (not very well, it must be said ), has been inflating housing prices in Israel. In cases like this, where asset prices mushroom - with all the problems that implies - people usually attack the central bank, asking what it means to do about it. The answer can only be to raise interest rates, to dampen the speculative urge and lower asset prices.
Say that tomorrow yields on 10-year T-bills were to be in the range of 4%-4.5%, placing yields on Shahars at 6%. Then the price of our studio apartment would drop significantly. At a yield of 6%, its price should be around NIS 600,000, 25% less than today. But the Bank of Israel's hands are tied. It can't raise interest rates as it pleases just to tame housing prices. Since U.S. interest rates are so low, a substantial hike to interest rates in Israel, causing long-term bond yields to jump to 6%, would cause the shekel to strengthen more and more. The implications for industry and exports would be horrendous and the upshot could be serious recession.
Thus the decision-makers face a dilemma: Should they raise interest rates and prevent a real estate bubble, despite all the other problems it could create such as savaging Israeli exports and jobs? Or should they keep interest rates low, stimulating the economy and risking the creation of a property bubble? It is a tough one, and there are no elegant solutions. In the United States, by the way, five years ago and today too the answer was clear: Avert a slowdown at any cost. That is why interest rates are kept low and Washington is building up tremendous budget deficits, despite the risks.
This story of one south Tel Aviv apartment is just that - one story, insignificant on its own. But it demonstrates beautifully just how distorted economies worldwide have become while also highlighting the dilemmas faced by policy makers everywhere, as a result of developments in the United States rather than in their own countries. It also demonstrates beautifully just how little room for maneuver our leaders have.