Is real estate yesterday's asset class?

This is not an original thesis. 'The Economist' magazine has been banging on for the best part of a year about the extent of overvaluation in global real estate markets.

Markets have indeed begun to cool: most notably in Australia and the UK over the past 12 months. However, the US housing market is still charging ahead, albeit with new housing starts showing some weakness in August.

'The Economist' reckons it is only a matter of time before the same forces take hold in the US as in the UK and Australia. In part this would represent a natural fall from unsustainably high prices - which means just higher than buyers can pay - and in part due to revised buyer circumstances: vis-à-vis rising interest rates, high energy prices and a less certain economic outlook particularly for jobs.

Lest we forget, global rental yields on property have fallen to record lows on the back of a long period of low interest rates. For yields to recover to normal levels either rents have to surge or property prices must fall. Given the pressures on consumer spending right now, an adjustment through real estate prices looks far more likely.

Global real estate in the past few years has acquired all the characteristics of a classic investment bubble. For a start everyone has done well, even the dimmest investor is showing a profit; and any person that you meet will tell you that you can not loose on property, especially those with zero expertise. This is surely the classic sign of an investment boom at the top of the cycle: universal optimism.

Yields must reflect prices

What people forget is that the very forces that have driven property prices to levels way beyond that justified by rental yield - which is the only true measure of value in property - also work in reverse. You get an upward spiral in property prices, and a downward spiral in property prices.

The UK property scene, for example, is in a state of denial. The fact is, pure and simple if you want to sell a property today you will need to knock 15-20% off your imagined peak price. Otherwise, you will not get a single buyer - and indeed that is why many would be sellers report waiting months without a single enquiry.

But as soon as somebody does sell at this new, lower price a benchmark is set for the next seller - or the person who just has to sell because they are moving to another area. And so prices continue on down, as the seller who took a lower price will expect the same when they buy!

From the perspective of 'The Economist' it is obvious that a long period of abnormally low interest rates has gradually puffed up a house price bubble of historic proportions. Indeed, this almost certainly is the biggest investment bubble in history.

The rational investor in oil consumer countries would sell, if possible. In the oil states the position in less clear as local liquidity is surging. Standard Chartered Bank forecasts a $75 billion current account surplus for Saudi Arabia next year, similar to this year!

Thus in the short-term at least, real estate - which is a great absorber of liquidity - should continue to rise in value.

The danger, of course, is that this is just a time-lag behind the global real estate bubble, and that once oil prices cool on lower demand from the industrialized world - due to a recession - then the real estate boom in the oil states will go bust in equally spectacular fashion.