Jeremey Grantham: “A Storm Is Brewing” in the Global Real Estate Market

Real estate is a global bubble. It has driven house prices provably to multiples of family income all over the world. No one can afford to buy a house now. No young kids coming out can buy a house. House prices will come down everywhere.

Jeremy Grantham is a billionaire investor and one of the most closely followed voices in all of Wall Street. He is the co-founder and chief investment strategist of GMO, an investment firm with well over $100 billion in assets. Grantham has never been afraid to speak his mind when it comes to calling a bubble, having successfully called the tech bubble of the early 2000s and the great financial crisis in '07 and '08.

Now Grantham is warning that these prior bubbles pale in comparison to what's happening currently in real estate markets across the world. Here's what he had to say: "So to put a bone in this as a bubble historian who is eager to see them, are you guilty of being too eager to see one now?"

"I don't think so. I think everybody else is guilty of the usual crime of expecting a soft landing when it never comes, but it's always claimed believing the FED who has never gotten one of these bubbles right, regardless of the fact they have involved several different Feds. They help create them; they don't see them, underestimating the time that it takes for some of these things to work through, particularly real estate. And I'm sympathetic on that one because real estate is a global bubble. It has driven house prices provably to multiples of family income all over the world: China, you know, Beijing, Shanghai, you tell me, 15 times, 20 times family income; Sydney, Adelaide, yeah, etc. Canada, the UK, London... there used to be multiples of three and a half times family income. London is now 10; Toronto is worse, etc. etc. No one can afford to buy a house now. No young kids coming out can buy a house. This is not a stable equilibrium."

Furthermore, the mortgages have gone from three, which explains everything, to seven, which explains nothing. Eventually, the seven will start to explain quite a bit, but how long does it take? I mean, just think. The first reflex is, I can't move for God's sake; I can't afford to go from three to seven; sure, so I am going to stay, which means no houses are on the market, which means for the handful of people who have to move, they're actually in a bidding war and prices stay up.

Yeah, but real estate has never been about three-month predictions. It works slowly but surely. In the end, you pay more because you could afford to; in the end, you will pay less because you can't afford to. House prices will come down everywhere.

From Australia, mentioned that in Australia it's World War III instantly. They are more optimistic than Americans, and they hate any idea that they're really jaded. By how much? Because I agree housing prices—it's an awful issue for people that are looking to get into a home. Are they going to come down? Down by 10%? Down by 30%? Or 30% would be a pretty good guess.

One simple way to gauge home affordability is to compare the annual income of a typical household with that of the average price of a home. Let's use Jack and Jill here as an example. Let's say that Jack and Jill combined make $60,000 a year. That also just happens to be the median household income in the city that they live. At the same time, the average house in the area costs $240,000. That means in this example the average home costs four times the median household income, calculated by simply taking the average home price and dividing it by the median household income.

Think of this metric as similar to a PE ratio for a stock. The higher the PE ratio, the greater the likelihood that the stock is overvalued, all else being equal. Well, that same basic logic applies when comparing the median household income to that of the average house in that area. The higher the ratio, the more likely the housing market is overvalued.

Let's say a few years pass, and Jack and Jill's income rises from $60,000 a year to $70,000 due to inflation and wages increasing in their city. This $70,000 number is also the median household income now. However, during that same time period, the price of the average house in the area skyrockets from $240,000 all the way to $422,000.

Doing the same math as earlier, we can now see that the average house in the city is now six times that of the median household income. The reason why this metric is so important is because it is a measure of how easy or difficult it is for a first-time home buyer to buy a house. Unlike families that already own a house and are looking to upgrade, first-time home buyers don't have an existing home to sell when looking to buy a new one.

As a result, first-time home buyers don't have the ability to benefit from home appreciation and roll that equity into their next house. This means that unless these first-time home buyers get financial help from family members, their only source of generating the funds required to purchase a house is through their income. The bigger the difference between the median household income and the average house, the more the typical family has to stretch their finances in order to buy a home.

As we can see in this chart here, the home price to income ratio has never been higher in the US. The most recent data point has this ratio at a staggering nearly 7.5. During the run-up in home prices prior to the great financial crisis, this metric didn't even break into the sevens. This chart goes all the way back to the end of World War II.

As we can see here, the home price to income ratio was above six in the decade immediately following the end of the Second World War. However, as the men returning from the war re-entered the civilian workforce, many found work in the construction industry. The US went through a construction boom. These newly built houses added supply to the market, thereby making affordable starter homes plentiful throughout the country.

Additionally, during the 1970s, 80s, and '90s, more and more women entered the workforce. While home prices rose throughout these decades, housing remained generally affordable to the typical household. Increased home prices were offset by families having larger incomes from more women earning money outside of the house.

However, things really started to change around the year 2000. Wage growth simply hasn't been able to keep up with the rising price to buy a home. As Grantham alluded to, this is far from just a US problem. In fact, in some respects, the US actually has it easy compared to other countries.

In the UK, the home price to income ratio recently peaked at over 9. In Australia, things are even worse; the home price to income ratio is over 10.5 in the most recent reading. However, that only tells part of the story. Certain major cities in Australia have seen housing affordability completely collapse.

Use the city of Sydney, Australia, as an example. Sydney is one of the largest cities in the country. The price to income ratio in the city is currently astronomically high at 16.8. Home prices are so expensive in Sydney that it is estimated that it would take the average person over 14 years to be able to save up enough money to not buy a house outright in cash, but just have enough money to be able to afford the down payment.

And then there's Canada. The Canadian real estate market makes purchasing a house in the United States look easy by comparison. The price to income ratio in Canada is over 10. Affordability is even worse in the major cities. The price to income ratio in Victoria is over 16, Vancouver is 15, and Toronto is over 12.

Throughout history, it wasn't uncommon for individual countries to see their real estate markets experience a bubble. For example, in the late 1980s, home prices in Japan increased dramatically. As we can see in this table, the home price to income ratio hit 7.4 in 1989. That same year, the United States home price to income ratio was just 3.2. Eventually, home prices in Japan came back down to reality. This is just one example, but there are plenty to pick from.

Over the generations, throughout history, it has been common for real estate bubbles to form in certain countries and cities. What makes the time we are living in now so unique is that seemingly for the first time in history, it appears that this potential real estate bubble is truly global in nature.

It's not just the sky-high home prices that are causing home buyers to be squeezed; the final nail in the coffin for global home affordability has been the dramatic rise in interest rates over the last 12 to 18 months. Using the United States as an example, a whopping 78% of home buyers used a loan to finance their purchase in 2022. In the year 2021, that number was 87%. While it fluctuates a little depending on the year, roughly eight out of 10 buyers need a mortgage in order to be able to purchase a house.

Because the vast majority of buyers use debt, housing affordability is extremely dependent on interest rates. As some background for our non-US viewers, the typical mortgage used in the United States is the 30-year fixed-rate mortgage. With this type of mortgage, the interest rate is fixed, aka it remains the same for the entirety of the 30-year period.

As we can see here, the average interest rate on a 30-year mortgage was 2.65% in January 2021. Since then, mortgage interest rates have been on a steady climb to nearly 8%. Logically, one would think that given these higher rates, home prices would have had to come down substantially.

Well, let's just say that has been far from the truth. As of now, at the start of 2021, the average home price in the US was $439,900. At this price, with a 2.65% interest rate on a 30-year mortgage with 20% down, a home buyer would have a monthly mortgage payment of $1,132. Currently, based on the most recent data, that same average house would cost $495,000.

That is roughly a 20% increase. However, what makes things really nasty is when you factor in the much higher interest rate. If we use the higher home price, a 20% down payment, and an interest rate of 8%, we can see the monthly mortgage payment skyrockets to $2,996. Higher home prices and higher interest rates have made the monthly mortgage payment on the typical US home more than double over the course of just a couple of years.

Grantham makes the argument that this is simply unsustainable, and something is going to have to give. The key question, though, according to Grantham, is when the bubble will finally burst.

You see, compared to the stock market, the real estate market is much more slow-moving. Here's what I mean by that: the stock market is just that; it is a market. In the US, the stock market is open from 9:30 a.m. to 4:00 p.m. Eastern Time, Monday through Friday. During those times, there is an active price that is quoted for every single publicly traded stock.

There are literally millions of shares of stock being traded every single day. The stock market is extremely liquid—liquid being a fancy way of saying that it is very easy to buy and sell shares on the stock market. This ease of transaction is why there are wild fluctuations in stock prices. If a company has a bad news event or the economy starts to weaken, that information can be reflected in changing stock prices almost instantly.

Compare this dynamic in the stock market to that of real estate. Real estate is very much an illiquid asset. Meaning, compared to the stock market, it is very difficult to transact in real estate. Anyone who has ever bought or sold a piece of real estate knows this firsthand.

With a stock, someone can open up a brokerage account directly on their phone and buy and sell stocks within minutes, all without incurring virtually any transaction costs. With real estate, it can take weeks or even months for a price to be agreed upon between the buyer and seller. On top of that, there are costs associated with having brokers, agents, lawyers, and inspectors involved in the transaction. These fees can add up to tens of thousands of dollars and cause a transaction to take several months to finally close.

All of these factors result in it taking longer for real estate prices to adjust to the new economic reality. Here's a hypothetical example to demonstrate. Think of the neighborhood you live in currently. Let's say one of your neighbors gets a new job and has to relocate for work. They list their home on the market for $500,000. They think to themselves that this is what similar homes sold for nearby last year, so it only seems like a fair price.

However, what this fails to take into consideration is that interest rates have risen significantly over the past year, making it much more expensive to use a loan to purchase a house. Because of this, your neighbor's home sits on the market for a few weeks without getting much attention from buyers. Your neighbor thinks to themselves that it's only a matter of time until a buyer comes along. Your neighbor decides to just ride it out and keep the price the same.

Meanwhile, buyers are thinking to themselves, "No way can we afford these high prices with where interest rates are." In our example here, there's a mismatch between sellers and buyers: sellers want the high price from years prior, while buyers simply can't afford those prices anymore.

This is where we are at currently in the real estate market. Buyers and sellers are in disagreement over price. As a result, the number of real estate transactions taking place has fallen to a nearly two-decade low. But eventually, something has to give.

Let's revisit the story of your hypothetical neighbor. Once he switched jobs and, while waiting for his old house to sell, he decided to buy a house closer to his new job. Now he's making two mortgage payments each month while he waits for his old house to sell. Eventually, he is going to become what is called in the real estate world a forced seller. Not being able to afford both payments, he lowers the listing price of his old house. It goes under contract at this new lower price and finally sells.

While this is, of course, a hypothetical example, hopefully, it helps explain why it takes time for real estate prices to adjust lower. Whenever there is some sort of shock to the real estate market, whether it is a slower economy or higher interest rates, buyers try to hold out as long as possible.

However, whether it is life events or perhaps something like financial distress, eventually, some portion of homeowners become forced sellers. Real estate prices start to decline as these forced sellers add inventory to the market. For reference, home prices in the US peaked in the first quarter of 2007; however, home prices didn't fully bottom until the end of 2011. That means it took nearly five years for the US real estate bubble to fully deflate.

Last time, only time will tell how things will play out this time, but one thing is for certain: either prices or interest rates need to come down in order for home affordability globally to return to more normalized levels. If that doesn't happen, we may be entering a period where home ownership will be out of reach for many people throughout the world.

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