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How much will property prices drop in a recession?


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Rob & Rob touched on the difference between property prices and a recession during an Ask episode last week (https://propertyhub.net/podcast/ask337-recession-house-prices/)

I thought it was a really interesting point and decided to expand on what they said and explore it further in an article:
https://propertyhub.net/recession-will-property-prices-drop/

We'd love to hear what you think is in store for property prices if there's a recession.

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@haf1963 the 90s was 20% drop but over a five year period. The difference this time is we don't (yet) have the conditions for forced sales to drive down prices. The recession in 2008 was intwined with property but a recession this year would be caused by inflation and pandemic recovery, which may or may not impact house prices. The article attempts to tackle the automatic assumption that recession = house price fall. I may not have succeeded though!

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Hi @russellshire,

Thanks for the article. I think this is an important point to consider for anyone wanting to manage risk in their investments. In order to put some numbers to risk, it is helpful to be able to put a number to a maximum anticipated drop in prices.

I would quickly caution though that the best number to arrive at might not be the average price drop from a previous recession, because there was a large range between different properties in terms of how much their value dropped.

Now turning to what might happen next, I think we are in uncharted waters! As a country and as a world, current debt levels are historically high and interest rates historically low. So the economic theory goes, a government can sustain as much debt as they want as long as the economy is growing at a higher rate than they are paying interest. For the last 14 years that has been easy because we've had negative real interest rates, so the economy doesn't even need to grow in real terms to exceed the interest rate. Meanwhile, the 30 years we've had of falling real interest rates have pumped up all asset prices including property, in both real terms and nominal terms. 

Line chart of policy rate minus inflation, showing real interest rates have fallen in developed economies since the 1980s

 

The situation seems stable then, as long as these real rates stay low. And on top of that, today we have better mortgage health as well (no silly 100% LTV mortgages like in 2007). 

Of course though, nothing is ever that easy and unfortunately we have a pandemic and major regional war causing inflation higher than we have seen in many of our lifetimes. What's interesting is I think a lot of people alive today don't appreciate the potential for high inflation to cause instability and major market disruptions.I include myself in that, I'm living through this for the first time like many others. 

I don't think inflation in itself is necessarily going to cause a crash, in theory rents and prices will rise. Interest rates will of course rise, but as long as real interest rates remain where they are today, rents and prices will simply keep up over the long run*. This would mean no concern for unencumbered property owners as everything will balance out and good news for leveraged investors who's mortgages get smaller in real terms.

So I think an important question to grapple with is whether these negative real interest rates can be sustained. To shine some light on this I found data for the last time there was an inflation spike. Here I plot data from the worldbank.org showing that the inflation spike in the 1970s was followed by a rise in real interest rates and these high real rates were sustained around 5% for the next two decades while inflation was brought under control. That's 7% higher than the real interest rates of -2% we had last year!!

 image.png.6e1d3cdb4f64f55e9e26b71c470bc2bd.png

An important differences between then and now is that real asset prices are much higher, so they have a long way to potentially fall. A common argument is that central banks cannot raise interest rates very much at the moment because governments are carrying a lot of debt. That makes sense but I'm not sure I am convinced. Sure they don't want to raise rates if they don't have to, but their job is literally to control inflation and raising real rates above zero the only tool they have to do this. What would be worse, governments getting crippled by debt repayments or inflation spiraling out of control?

My point is that interest rates might have to rise a lot more than people are expecting. This is the opposite to what happened during the 2008 financial crisis and the opposite environment to which everyone is used to operating in. This is almost certainly going to mean real price decreases, I can envisage real prices reducing more than in 2008. But for the leveraged investor, that might not be a problem as long as nominal prices hold up (which is what people normally think of when thinking of the property market). 

I'm concerned about this but my prediction is not for a big crash, because central banks seem to be reacting slowly. And that leaves me worried about inflation... Things could get messy!

 

Q: What do you think, is it bizarrely real interest rate changes that is going to control nominal prices?

 

* I like to think of this relationship between interest rates and inflation like running on a treadmill. The speed of the treadmill is inflation and the speed you walk at is the nominal interest rate. Whether you are moving forward or backward on the treadmill is the real interest rate.

A tread mill speed of 1mph (eg. 1%) is quite easy to keep up with, you just stroll along and all is fine. If you are going a bit too slow you have plenty of space to react before you fall off, by adjusting your speed (AKA the real interest rate). In real terms, life is stable. Up the speed a bit to 4mph (4%) and you have less time to react, but it's still pretty stable. Now up the speed a lot to 12mph (12%). You can still keep up with inflation here by running at 12% nominal interest rates, but it's a lot less stable, you don't have much time to react to mistakes. Up the interest rates too much and you'll crash into the front (recession), go too slowly and you'll fall off the back (spiraling inflation).

The treadmill in my gym doesn't go above 12mph, but there's no reason inflation couldn't go higher and higher if it sets in and real rates don't tick up.

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