Why A Tightening Monetary Policy Will Have The Exact Opposite Effect On Real Estate Prices Than You’d Expect
TL;DR
Inflation is pernicious and harmful, but the remedies at hand could have more insidious side-effects. As the first post of a series exploring the forces at play in affecting the real estate prices in Tel Aviv, we explore the two conflicting edges of inflation. Inflation (both CPI and building costs) alone cannot explain the meteoric rise in real estate prices. Other factors are at play, and tackling inflation through Quantitative Tightening and/or Interest Rate hikes won’t solve the problem. We think that monetary activism will in fact exacerbate the endemic shortage of homes.
Traditional economic theory tells us that the best remedy to rising inflation is a tightening monetary policy i.e. raising interest rates and quantitative tightening through central banks reversing of the bond purchase programs. Usually, with higher benchmark interest rates, higher mortgage rates and more expensive corporate loans, you ‘ d expect the housing prices to ease off. We already saw a cooling off of the new homes starts and sales in the US. Our opinion is that in Israel and more particularly in the very hot Tel Aviv residential market, those liquidity measures will have a transient negative effect on home prices, new ones especially, but over the not-so -long-term, a positive impact on prices. Here’s why :
Inflation Headaches
The situation in Israel was somewhat different in that the average leverage of home owners is relatively low and banks have always been prudent when lending to first time buyers. In the recent past however, the banks have been more forthcoming and loosened their wallets. Still, we are way below US levels. Nonetheless, it is safe to assume that interest rate hikes as a response to higher inflation will have a negative effect on prices of real estate. And that already has been happening in the US, where properties have been exchanged 30% lower than pre-reopening.
However, the largely anticipated reaction of all central banks (except for Turkey …) will react to inflation with both a quantitative tightening and rate hikes. That is exactly what is happening in the US and around the world. More than the actual hikes, central banks have to prove their credibility because this entire game is based on expectations rather than actual steps taken by them. In any case, the direct effect of an interest rate hike is the increase in your monthly mortgage payments, and the tightening of the lending terms for new construction projects (more on that later). So it is safe to assume that money becoming more expensive, fewer people will buy apartments and some may even have to sell as they can’t stand by their mortgage payments.
We’ve all been very worried about inflation in the past few months. If you are old enough, you might even suffer from cold sweats at the prospect of reliving the oil shock and the ensuing skyrocketing of prices, all prices: from food to stamps and of course petrol. But all inflations are not born equal. The main distinction is whether it is cost pushed, or demand pulled. Cost-push inflation theorizes that as costs to producers increase from things like rising wages, these higher costs are passed on to consumers. Demand-pull inflation takes the position that prices rise when aggregate demand exceeds the supply of available goods for sustained periods of time.
Developers have caught onto the demand for new homes and have rushed to raise prices. The New Dwellings Price Index has risen by almost 6.5% in the past two months, which compares with a 7.7% annual rise in prices of all homes. Another important statistic in this context is the Building Inputs Price Index, which is rising at an annual rate of 6-7.
The inflation we are experiencing at the moment is cost-pushed. The disruptions to the supply chains caused by the pandemic, the war in Ukraine and the embargo on Russia definitely have a significant impact on prices. There is however a monetary cause the steep rise in prices. The quantitative easing programs, in particular in the US set in motion as a response to the pandemic for fear of a sudden drop of economic activity definitely accounts to a large portion of the inflation today.
Still bruising from the financial system meltdown of 2008, the US government preemptively flushed the world economy with cash. Some may argue that the response, specifically the magnitude of the program overestimated the severity of the economic slowdown of the pandemic. Conventionally, the expansion of the money supply (such as the one generated by the QE programs) will generate inflation as more money is chasing after the same amount of goods available. Same principle applies to the government cash payments to workers forced to stay home. In other words, inflation is akin to a hangover headache.
So how does all this affect the price of real estate in home market. So the effects are two ways and are conflicting with each other. On the one hand, real estate, which is not included in the calculation of the CPI, tends to be viewed as a refuge in high inflation environment. Historical data seems to support this thesis. In particular, when the stock market and the bond market disintegrate the way that it has in the last few months, the last viable asset class is indeed real estate. So institutional and private investors will try and get their hands on apartments and office spaces, pushing prices up and yields down.
Those who will bear the brunt of the increase in interest rates costs are the real estate promoters. The highly leveraged operators won’t be able to absorb the hike and the costs will be reflected in the final price of the new apartments. Additionally , and not trivially, a lot of projects won’t come to market and the economic reality will not support them. This will affect the supply of new units, in a market already starving for residential.
The problem facing israelis and anyone looking to buy an apartment in Tel Aviv, is very much a real problem. And by real we mean, a supply and demand imbalance driven by population growth, immigration and economic growth. The tools the Israel central bank, and all other central banks for that matter, can only affect the latter (thankfully!)
Interestingly, you’ll notice in the graph above, that inflation (both CPI and building costs) alone cannot explain the meteoric rise in real estate prices. Other factors are at play, and tackling inflation through Quantitative Tightening and/or Interest Rate hikes won’t solve the problem. We think that monetary activism will in fact exacerbate the endemic shortage of homes.
