Is the housing bubble really just a lot of babble?

The existence of a real-estate bubble is a matter of opinion, at least before the fact. The question of whether one has developed in Israel's real estate market is a heated topic indeed.

A bubble is typified by prices rising beyond reasonable levels in a relatively short period of time. That is not what has happened here.

During the last 10 years, from 1997 to 2007, Israel was one of the few emerging markets where property prices did not develop into bubble proportions. The price of an average home in Israel rose by 40% during those 10 years while inflation ran at 34%. After adjustment for inflation, that is not a big increase considering the length of time.

Yet when we present the data, nobody believes us. People living in central Israel figure we're simply wrong - prices rose 40% just in the last two or three years, they say.

Meanwhile, the people living in "outlying areas" which simply means anywhere outside central Israel, including Haifa, figure we got the direction wrong - the change is minus 40%, not plus, they say.

But we didn't. The data is from the Central Bureau of Statistics and the 40% represents the change in the price of the average apartment in Israel.

What would Confucius say?

Israel was spared the grim fate of most of the industrialized world, in respect to real-estate bubbles and their inevitable implosion, for an utterly prosaic reason. Housing prices in Israel had doubled in real terms during the previous decade, because of the inundation of immigrants from Russia, and that sharp increase in prices had nothing bubbly about it.

The surge in housing prices triggered a spike in building starts. The result was a glut of housing, and prices steadied for roughly 10 years.

In fact, an average apartment (costing NIS 849,000) is only 3.8% more expensive than it was in 1999. Even the fresh fruit and vegetables component of the consumer price index has increased by more. One might conclude that bananas would have been a better investment, though one can't get much rental income from them.

Okay, people say, so you proved that housing prices were asleep for a few years. But the bubble is growing now. The price of the average apartment in Israel increased by 11% in the first half of 2009.

The chart herein shows the inflation-adjusted price of the average apartment in Israel, and shows that quarterly swings can be big. And let us keep in mind the ancient Chinese proverb - "Every tiger bubble starts with a price increase of 0.1%."

If in the years to come, the price of the average apartment in Israel doubles (as happened in the United States), or triples (as happened in Britain), we can look back and see the starting point of the bubble a few quarters ago. But we certainly can't look at the data today and say, this is the picture of a bubble.

The source of the bubble claim lies in the hearts of potential home buyers. But in contrast to prevailing impressions, they can actually buy a home today for not much more than it would have cost a decade ago, in real terms. In terms of purchasing power, based on the average wage, the price of the average apartment hasn't changed in the last 15 years. Then as now, it's about 100 times the gross average wage.

Then there's the mortgage

Another claim making the rounds these days is that the increase in housing prices is all the Bank of Israel's fault.

The Bank of Israel would love to take credit for such a thing, at the same time as stressing its contribution to the increase in stock and corporate bond prices. That is the very purpose of expansionary monetary policy: to lower the price of money, making it more attractive to invest in.

The Bank of Israel can take pride in the contribution of low interest rates to the increase in housing prices. But it has to be concerned about the harm that future interest rate hikes could cause to mortgage borrowers, who undertake variable-interest mortgages without realizing what they're committing to.

The knowledge that an interest rate hike will sharply increase their monthly repayments, coupled with the assumption that these borrowers haven't realized it, led the supervisor of banks to issue a warning about such loans.

So low interest rates may boost housing prices. But we have to think that prices would have risen sooner or later even without the low interest rates.

In recent years the pace of building starts has consistently been less than the pace of population growth. However, when comparing the annual increase in demand for housing (additional number of households) with the annual increase in the supply of homes (new building starts), we have to consider additional elements.

For instance, buildings deteriorate. Some of the building starts are replacing existing homes. Then on the flip side, conversion of office space to residential doesn't appear in these figures, so the actual supply of housing is bigger than one might have thought. Nor do all building starts make it into the official figures, most notably building starts in Arab towns.

No effect on the CPI

The claim that increases in housing prices will create inflation sounds sensible. But it isn't. Housing prices are not in fact a component of the consumer price index in Israel.

What the housing index in Israel's consumer price index looks at is the change in rental prices, not the price of property.

However, you may intuitively argue, it doesn't matter, because rental prices are correlated with property prices, so changes in housing prices do affect the CPI after all.

Thing is, it isn't true. During the last six years, the price of the average apartment in Israel has risen by about 30%. But the average price of rent increased by less than 6%.

When you consider the increase in demand for property for investment, one might think that the relationship should be the reverse - the more apartments are bought for investment, the more the supply of rental apartments increases, the lower rent becomes.

The bottom line is that housing prices have barely budged in real terms over the last 10 years, although it is true that fluctuation from quarter to quarter is high.

For years, the population grew by more than the supply of housing. Prices were bound to increase. But at least at this point in time, this is not a bubble.

The author is the chief economist at Psagot.