Is a real estate bubble developing in Israel? Treasury officials are increasingly saying yes.
Figures show that despite the substantial rise in new construction starts around the country — already above 45,000 this year — prices aren’t leveling off because demand is growing even faster.
Much of this demand comes from investors who already own more than one apartment (26% of apartment purchases have been by investors), or from people posing as investors, namely parents rushing to buy their children apartments. The apartments are registered in the children’s names (the money clearly comes from the parents), even though they won’t be moving in for many years.
This trend of second-hand investment is concerning treasury officials. It was revealed in all its glory in the large Carmei Gat housing project in Kiryat Gat, where apartments cost 840,000 shekels ($210,000). About a quarter of the people registered as the owners earn less than 3,000 shekels a month.
The concern stems not only from the fact that this is a way to evade taxes. It also reflects a middle-class attitude by which you better buy your children an apartment today and beat a spike in prices. This is precisely what characterizes a bubble — the feeling that prices can only go up.
You don’t have to go to Kiryat Gat to get a sense of this. When conversations in the living rooms of people in mid-to-high income brackets focus on real estate investments, it’s clear that speculation is steering the market. The dismal situation of our stock markets, which have been abandoned to a certain extent, is another indicator that the rich are choosing housing at the expense of stocks.
In light of the expanding bubble, the treasury is considering draconian measures to dampen demand, such as increasing sales tax for investors to as high as 15%, taxing rental revenues from the first shekel and even imposing a capital gains tax on residential apartments. These harsh measures are being considered because more mild ones have failed.
Sales tax on investors was already raised in 2014, along with the precedent-setting step of a capital gains tax on apartments purchased as investments. Neither move cooled investors’ ardor.
The main question, therefore, is whether these investors, as well as parents hurrying to buy apartments for their underage children, are right in their choice, and that Israeli apartments are really a profitable investment.
Last summer, the treasury’s chief economist published a graph that seems to refute this. The chart compared the increase in the value of bonds, stocks and housing between January 2009 and July 2014, showing that the stock market’s TA-100 index beat the housing index handily.
The bottom of the crisis
But this graph is problematic for two reasons. First, it ignores the ongoing returns on investments in housing, namely revenue from rent. An accepted figure for real-value returns from rentals in Israel is 3% a year.
A second more important point is the graph’s starting point. January 2009 was the financial markets’ lowest point after the global crisis. We can safely say that anyone bold enough to buy stocks at that point almost certainly outperformed any other investment made at the same time. We can also venture to say that the number of such investors can probably be counted on one hand.
A final comment reveals one of the many problems in trying to compare investing in housing and in financial markets. This relates to timing. Both these markets fluctuate a lot, so selecting starting and end points can easily tilt the result one way or another.
Thus choosing almost any other point over the past decade will unequivocally favor the housing market. After a decade in which housing prices rose by almost 90%, it’s not surprising that investing in housing at this peak point seems very attractive to many.
To overcome the timing issue, we compared financial and housing markets from 1995 to 2015. Such a long duration tends to dampen the effects of timing, even though in this case, where the end point of 2015 reflects a peak, there is a built-in bias in favor of investing in the housing market.
The comparison was done for us by Ofer Klein, head of the economics and research division at Harel Insurance. To compensate for inherent difficulties in such comparisons, only simple returns were considered, ignoring taxes, costs for buying, selling, maintenance and amortization, and even revenues from rent. Some of these omissions will be corrected for in future comparisons.
The comparison shows, even at its most basic level, that even at the peak of the current surge, investing in financial markets is more profitable than investing in housing. Investing in different markets yielded a gross annual profit of 5.4% to 7.4% on average, compared with only 2.9% in the housing market.
Adding rental revenues (assuming 3% a year) and subtracting annual amortization of 1%, housing investments yielded 4.9%, on average, compared with an average return of 6.4% in financial markets. These numbers apply to the highest peak of the housing market, which apparently causes an upward bias when calculating multiyear returns.
A few reservations
Thus, cold calculations show that investing in housing is less lucrative over the long run when compared to investing in stocks. This conclusion is bolstered when housing prices peak — we can’t expect them to continue rising for another 20 years at the same pace. But now for a few reservations.
First is taxes. We don’t know how far the treasury will go in taxing real-estate investors. The custom is to equalize taxation on various investment streams so that investors won’t see big differences based on where they invest.
But things are different when buying a first home, which is exempt from taxes — this is likely to remain the case. Thus net returns on a housing investment should be 4.9%, compared with 4.8% (after deducting a 25% capital gains tax) on an investment in stocks. Taxation therefore makes investing in housing just as attractive (or even slightly better) than investing in stocks.
The second reservation relates to the fact that the average return doesn’t necessarily reflect specific cases in different regions. Klein’s comparison showed that in some areas investing in housing outperformed financial markets, even when disregarding taxation.
Note that small Tel Aviv apartments yielded gross returns of 4% over the last two decades. When rental revenue is added (which applies even to apartments one lives in, since this saves alternate expenses) it turns out that small Tel Aviv apartments did better than stock markets.
The third reservation relates to risk. Financial markets fluctuate more than the housing market — the average standard deviation in the former is 6.7% to 9.9%, compared with only 3.8% in the housing market, rendering financial markets riskier.
Klein calculated risk-free returns (using the Sharpe index) and found that in many areas of Israel the risk-free returns on housing were better than for stock markets. In addition to Tel Aviv, three-room apartments in the greater Tel Aviv area belonged in this category.
It’s hard to assess which type of investment is riskier. Investments in financial markets are diversified, whereas an apartment constitutes a single investment.
In addition, investing in an apartment is almost always financed by a cheap and accessible mortgage, in contrast to other investments. Mortgages are what makes investing in housing so popular, making returns appear to be even larger when calculating the own funds invested. But a mortgage can become a double-edged sword if there’s a housing crisis, when investors can lose their entire investment and even get stuck with debts.
The fourth qualification relates to the psychology of an investment. The average long-term 4.9% return over two decades is likely to be the highest yield investors will reap. This investment is viewed as an investment in one’s pension or something the children will inherit.
In contrast, an average return of 6.4% in the stock market will only be enjoyed by a minority of investors, since very few investors keep at it for two decades. One need only look at January 2009 and consider how many investors didn’t rush to ditch their holdings. One mistake like that can wipe out returns made over decades.
The conclusion from such comparisons is complex. Theoretically, investing in financial markets is preferable.
This may not be true for those buying a first apartment due to tax benefits. This also isn’t true if you consider only your own capital investment (minus the mortgage), but then you have to take into account the high risk.
This is true for investors who can act rationally, investing systematically and continuously over decades, ignoring wild fluctuations. Such investors can almost certainly obtain better yields in stock markets compared to housing markets. But which investor in this country is truly rational?
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