You do not have to run into payment difficulties yourself for the housing market to turn. It is enough that the family who is to buy your home after you can no longer borrow more than you did.
For several decades, the Norwegian housing market has been driven by a mechanism so self-evident that we have almost ceased to notice it: The next buyer has been able to borrow more than the previous one.
It sounds banal. But this is the very key to understanding how house prices can rise far faster than wages, consumer prices and construction costs over long periods.
A home does not become worth six million NOK (about USD 750,000) because it cost six million to build. Nor does it become worth six million because the seller wants six million. It becomes worth six million if there is a buyer who is both willing and able to finance six million.
The price of a home is therefore ultimately determined by the purchasing capacity of the marginal buyer – the one who submits the highest bid.
And that purchasing capacity has been able to expand for several decades.
Interest rates fell. Two incomes became the norm. Debt ratios rose. Loan terms became long. Housing wealth grew. Parents could provide equity or security for their children. Higher house prices created greater collateral values, which in turn made it possible to take on more credit.
We acquired a self-reinforcing mechanism:
More credit produced higher house prices. Higher house prices produced better collateral. Better collateral provided the basis for more credit.
As long as this circle could be expanded, house prices could also continue to rise.
The question is what happens when it can no longer be expanded.
Credit has a limit
In reality, a household does not buy a home solely with money it already has. Most people buy a home with future earnings that the bank advances in the form of debt.
The housing market is therefore not merely a market for homes. It is also a market for credit.
This is what distinguishes housing from most ordinary consumer goods. If the price of milk doubles, the household can buy less milk or choose another product. If the price of a home doubles, the purchase normally takes place by increasing the debt correspondingly.
House prices can therefore diverge from wage growth for long periods, provided that the financial system simultaneously makes it possible to borrow against an ever greater share of future income.
But this cannot continue indefinitely.
At some point, the interest burden begins to come up against households’ actual cash flow. Food, electricity, municipal charges, insurance, transport and tax still have to be paid. The bank can calculate collateral and debt ratios, but the family has to make the monthly payment every month.
And it is precisely here that the difference arises between a high property value on paper and actual financial capacity to pay.
A loan of five million kroner is one economic proposition at an interest rate of 2 per cent and quite another at a mortgage rate of 6 per cent.
At 2 per cent, the interest amounts to 100,000 kroner a year before deductions. At 6 per cent, the same interest expense is 300,000 kroner.
The home is the same. The family is the same. The salary may be roughly the same.
But the price of credit has tripled.
This means that the same household cannot necessarily finance the same house price.
It is the next buyer who determines the price
This is perhaps the most underestimated point in the entire housing debate.
It is not only when today’s homeowner can no longer service his loan that house prices come under pressure. Prices can begin to fall long before defaults and forced sales become a major problem.
It is enough that the next buyer can borrow less.
Imagine that a home was bought for six million kroner because the strongest buyer in the market had financing for six million. A few years later, it is to be sold again.
The seller wants seven million.
But the new interest rate means that the group of buyers to whom the bank would previously have lent six or seven million can now finance only 5.5 million.
It then matters little that the seller believes the home is “really” worth seven million.
The price can only be realised if someone can pay it.
This is why the financial carrying capacity of the housing market is more important than the notion that homes always rise in value because “people have to live somewhere”.
People have to eat as well. That does not mean that every food product can be priced without limit.
Need is not the same as effective demand.
The Bank of Mum and Dad is also part of the credit system
The Bank of Mum and Dad has served as an important shock absorber in the Norwegian housing market.
When young buyers have not had sufficient equity, parents have been able to contribute money, additional security or guarantees. The housing wealth of one generation has thus been used to finance the home purchase of the next.
But there is a limit here too.
The Bank of Mum and Dad does not create money out of nothing. It is largely based on wealth that has already been created through previous house-price growth, saving and repayment of debt.
An interesting circle thus emerges.
The parents’ home rose sharply in value. This increase in value made it possible to provide security for their children’s loans. The children’s increased financing capacity in turn helped to sustain high house prices.
Yesterday’s house-price growth was thus used as security for tomorrow’s house-price growth.
But neither can this mechanism be scaled indefinitely.
Parents cannot mortgage the same home ever more heavily without the debt eventually beginning to compete with their own pensions, consumption and financial security. And ever more parents themselves have large loans well into adulthood.
The Bank of Mum and Dad is unlikely to disappear. But its ability to serve as an ever larger marginal source of financing may be diminishing.
The property industry feels it first
This is why developments in the property industry are interesting.
The figures now emerging show sharp growth in both bankruptcies and compulsory dissolutions in the property sector. It is tempting to regard this as an isolated industry problem.
That may be wrong.
Property developers are ahead of homebuyers in the economic value chain. They buy land, finance the project, design, build and take risks several years before the finished product is sold.
They therefore feel changes in the credit market early.
A project can, in very simplified terms, be expressed as follows:
Expected sale value minus land cost, construction cost, financing and other costs equals the developer’s margin.
When interest rates rise, two things happen simultaneously.
The developer’s own financing costs increase.
At the same time, the end customer’s ability to finance the home the developer is to sell is weakened.
The developer is thus squeezed from both sides.
If the buyer can pay a maximum of six million for a new home, it matters little that the cost of the land, construction, public requirements, financing and the necessary margin mean that the project has to sell for seven million.
The result is not necessarily that the home is built and sold more cheaply.
The result may simply be that it is not built.
This is an important reason why we can simultaneously have a housing shortage, population growth and very low levels of housebuilding.
There can be an enormous physical need for housing without there being sufficient effective demand at the price for which new homes have to be sold.
The need may be enormous.
The market nevertheless asks only: Who can pay?
Before prices fall, the market may grind to a halt
If the credit constraint really begins to bind, it is not certain that the first consequence will be a dramatic fall in house prices.
Property markets move slowly.
Sellers remember the highest price their neighbour received the year before and tend to regard this as the “value” of their home. They are not readily willing to accept that the market value has fallen.
The buyer, on the other hand, has a more prosaic problem: The bank will not lend him the money.
The initial result is therefore a gap between the buyer’s financing capacity and the seller’s price expectations.
Transaction volumes then fall.
Homes remain on the market for longer. There are fewer bidding rounds. Developers postpone projects. Land becomes harder to sell. Refinancing becomes more difficult. Investors demand a higher risk premium. Weak companies begin to fall by the wayside.
Only later are price expectations forced down.
This is a classic characteristic of illiquid markets: Volume reacts before price.
A housing market can therefore appear stable even while the fundamentals are already beginning to change.
Bank of Norway is in a difficult position
The problem becomes particularly interesting because Bank of Norway still believes that monetary policy must remain restrictive.
The policy rate is 4.25 per cent. At the same time, the Bank has made clear that it may still be necessary to raise the interest rate if inflation does not fall sufficiently. Norges Bank has also itself pointed out that prices for existing homes fell markedly in July and that construction activity remains low.
On 24 August, Governor Ida Wolden Bache also emphasised a point borrowers should take note of: Even when interest rates can eventually be lowered, the Bank does not envisage that they will necessarily return to the extremely low levels to which households became accustomed.
This may prove far more important for the housing market than the question of whether the next interest-rate meeting produces an increase of 0 or 0.25 percentage points.
For if the era of virtually free credit is indeed over, the housing market must adjust to a new normal.
And then one of the most powerful engines behind the price growth of recent decades disappears.
There are only a few ways out
When house prices have grown faster than households’ underlying ability to pay, the relationship between prices and incomes must sooner or later be restored.
This can happen in several ways:
Wages can grow faster than house prices for many years.
Interest rates can fall sharply and thereby increase borrowing capacity again.
Or house prices can fall.
The most politically palatable solution is the first: House prices remain roughly unchanged in nominal terms, while wages and general price growth gradually catch up with them.
Such a development does not look dramatic in the statistics.
If a home still costs six million kroner five years later, people will tend to say that the price “has not fallen”.
But if wages and the general price level have meanwhile risen by 20 per cent, the home has fallen significantly in real value.
It is a silent correction.
And for a highly leveraged society, it is far less painful than a nominal housing crash.
But higher interest rates also make this way out more difficult, because the interest rate simultaneously puts pressure on current ability to pay.
The price tree does not grow to the sky
For many years, the Norwegian housing market has taught us to regard rising house prices almost as a law of nature.
But there is no such law of nature.
House prices cannot permanently grow faster than the income and credit that must finance them.
For a time, the difference can be covered by a higher debt ratio. Falling interest rates can then increase debt capacity further. Parents’ housing wealth can then be drawn upon. Loan terms can be extended. Two incomes can be leveraged more heavily.
But each of these mechanisms has a limit.
In the end, one returns to the simple question that the economy can never escape:
How much of its future income can a household actually use to service its home?
If we are now approaching the point where the next buyer can no longer borrow significantly more than the previous one, the housing market faces a regime shift.
That does not necessarily mean a collapse.
It means something more fundamental.
The housing market can no longer assume that ever more credit will validate ever higher prices.
Prices must then once again adjust to incomes.
The problems in the property industry may therefore be more than a story about a few overleveraged companies that have taken too much risk. They may be the first visible sign that the credit cycle is beginning to reach its economic limit.
And if Norges Bank raises the interest rate once more, we may get the answer to the question that has long underlain the entire Norwegian housing model:
What happens when the next buyer can no longer borrow more?
