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GMO – Observations on the Real Estate Cycle in China and the United States (FXI)

September 15, 2011

GMO was out to day with a good read on the real estate booms and busts and specifically looks at the United States and China. I was surprised at how optimistic GMO is on housing in the USA. China is another story.

Here is their summary of the real estate cycle and the entire report linked at the bottom:

Conclusion: The Real Estate Cycle in Five Easy Stages

The real estate cycle has several stages. Hoyt described twenty of them, starting with rising rents and ending with a spate of foreclosures which clears away the wreckage of the boom (see Table 1).

This seems excessive. One of the earliest descriptions of a speculative cycle was provided by the nineteenth century banker and economist Lord Overstone, who described it as starting from "a state of quiescence, –next improvement, – growing confidence, –prosperity, –excitement, –overtrading, –convulsions, –pressure, –stagnation, –distress, –ending again in quiescence."28 This description seems equally apt for the real estate cycle (see Exhibit 7), which can be divided into the following phases:

1. Improvement. Demographic demand leads to rising rents. Vacancies fall. New housing supply is constrained.

Home prices are affordable. Credit is available, but mortgage underwriting is relatively strict and leverage

discouraged. Real estate is not the most favored asset class. Housing is seen as a necessity rather than an exciting investment.

2. Growing Confidence and Prosperity. Home prices rise above trend. New housing supply fails to keep up with demand. Rising collateral values support greater issuance of mortgages. Property is seen as a sound investment.

3. Excitement and Overtrading. Home prices rise to two standard deviations or more above trend. Rental yields approach record lows. New housing supply exceeds fundamental demand. Spurious demographic arguments justify still more construction. The macro-economy becomes increasingly dependent on the real estate market as rising home prices spur consumption and building activity provides jobs. Mortgage growth remains strong despite rising interest rates. New financial instruments improve affordability. Despite elevated valuations and excess supply, real estate is seen as the most attractive asset class. Speculators increasingly dominate the market.

4. Convulsion, Pressure, Stagnation and Distress. The higher cost of mortgages and/or the restrictions on property lending induce a downturn. Losses appear on real estate loans. Home prices fall and rental yields rise. Housing transactions dry up, vacancies increase, and new construction dips sharply. The downturn in the housing market hurts the wider economy. Household formation and the rate of homeownership experience a cyclical contraction.

Despite falling interest rates, credit conditions remain tight. Banks foreclose on delinquent mortgage loans. A rising number of homeowners experience negative equity. The general attitude toward real estate is one of panic and scapegoating.

5. Quiescence. House prices have fallen below their long-term trend. Fundamental demand for housing pushes up rents. Excess supply during the boom has been offset by insufficient construction during the downturn. Employment conditions stabilize. Mortgage credit is available, but lenders remain conservative. Leverage is eschewed. Despite improved affordability and sound demographic underpinnings, spurious arguments are made against the prospect of a recovery. Property is seen as an illiquid and unattractive asset class. As the "error of pessimism" waxes, the real estate cycle approaches its trough.

Link to entire report:


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