Is there a real estate bubble in Israel similar to the one in the US and will we suffer a similar crash to the US?
The Israeli real estate market has outperformed every other Western market in recent years, giving rise to concerns that the bubble may burst soon, as it did in other countries such as the U.S. and Great Britain. Prices have risen 60% since 2007, and some areas have seen even more drastic rises. After the recent protests and the measures taken by the government, prices will slow down but not tumble as in the US. Let’s look at the factors that affected the US market and examine the Israeli market accordingly.
What were the factors that caused the U.S. real estate bubble and do they apply in Israel?
A number of contributing factors caused the U.S. bubble, dating back decades before the bubble burst. One of the best known factors is the sub-prime mortgage, the granting of mortgages to buyers who were unable to qualify for regular mortgages. From as early as the 1970s, various governments believed that home ownership as opposed to renting could solve many of society’s ills, especially in low-income areas.
Due to pressure from ACORN and other community activists, banks and mortgage companies – especially the behemoths of Fannie Mae and Freddie Mac – were instructed to ensure that an increasingly higher percentage of their loans be apportioned to low-income families, those who, according to normal economic principles, would not be approved for standard mortgages.
During the Reagan era, Wall Street discovered the beauty of “securitizing” mortgages, i.e. turning all types of mortgages into a bond, carved up in different ways, to later be sold to investors, who would ultimately become the mortgage holder. The rating agencies agreed to grant these various tranches of mortgages the highest ratings and investors snapped them up. Insurance coverage on these risky loans meant that the ratings remained high. Billions of dollars were sunk into the mortgage market looking for borrowers to lend to.
New borrowers with low down-payments:
The new untapped markets of borrowers with poor credit, young families, new immigrants and single parents, enticed many new mortgage companies to enter the market. Technology allowed the mortgage companies to set up their guidelines and input the borrower’s details to get instant approval from the investment firms.
Fannie Mae was dishing out low down payment loans, even as low as 3%, and every effort was made to lend to as many people as possible, including very cursory credit checks and appraisals even being done based on simply viewing the outside of the property. Some companies developed the no-money-down mortgage as the scramble for borrowers to take up the available money continued.
Adjustable rate loans:
The initial interest rates for sub-prime loans were set low as a teaser, but after a few years the borrowers ended up with high interest loans that they could not pay back, unless they successfully refinanced for another low interest loan or sold the property. Home prices continued to rise sharply, thus fuelling the demand for increased debt and supplying more equity for borrowers. A low-income borrower, who sold his property before defaulting, could start to climb higher on the ladder, but the income of these borrowers never matched the levels of debt they were incurring with the larger loans.
Despite the risk that these low-income borrowers, who took low down payment loans, would default, investors continued to pour in their money, due to the rising prices in the housing markets. Mortgage brokers tricked borrowers into taking high interest loans just to obtain the commissions for the mortgages. Borrowers were coached to lie on their income declarations. Appraisers, who worked on commissions from realtors and mortgage companies, were persuaded to appraise the property as expensively as possible. The banks kept chopping up and selling off the mortgages. Everyone profited at each stage of the process.
The Fed’s laissez faire attitude:
The chair of the Federal Reserve at the time, Alan Greenspan, known for his free market ideology, chose not to regulate the size of the mortgages granted nor the interest rates being charged. After 9/11, interest rates were lowered to spur the economy, and the mortgage-backed securities became even more attractive. Investors, who bought the riskiest loans, were making up to 9% a month return, and foreign investors bought up trillions of dollars of these securities.
Speculators and investors were buying up properties and flipping them, often to other investors. There were even examples of speculators buying back their own properties and flipping them again. Building companies were desperately buying up land and quickly putting up the cheapest houses they could get away with to capitalize on the price rises. Some whole communities were never really lived in, just flipped from one speculator to another. Just recently, the U.S. census declared that 13% of homes now stand empty, a severe blight across the landscape.
As seen above, a confluence of factors caused the almost perfect storm of a glut of money being poured in at the back end of the market, as well as a huge demand for mortgages at the front end for those unable to obtain regular loans. This increased property prices, making investment attractive, intense speculation and frenzied building. This fuelled the spiralling growth of the U.S. market before housing prices were hugely over-valued, simply could not rise any further and the whole house of cards came tumbling down.
How much of this is similar to or likely to occur in Israel?
House price increases:
House prices have risen steadily over the last few years, far beyond any increases in the average income. Many borrowers took advantage of the incredibly low interest rates during the stock market crash to invest in the tangible asset of real estate, some of which was intended for short or long term rentals.
Rentals in Israel earn anywhere between 3% and 8% but have not increased at the same pace as property prices. However, rental income has been tax free up to a ceiling of 4-4,800 NIS per month or tax can be paid at a flat rate of 10%. Furthermore, the exemption from capital gains tax, currently once every four years (although see below), enticed the casual investor in real estate to purchase another property or two, use the rental to pay off the mortgage, and then benefit from the capital gains tax upon sale, earning 5-15% a year in capital gains.
Long term increase in prices?
It’s important to remember that the property market in Israel suffered a major downturn at the beginning of the 21st century. Vastly impacted by the bursting of the dot.com bubble, as well as suffering the effects of the second intifada, real estate prices and the economy in general plummeted for a numbers of years. The below table recently published by Globes shows the long term trends in prices:
Much of the initial upturn in the last few years has been a realignment of that, in parallel with the diminishing of terrorism on Israel’s streets, the resurgence of the incredible Israeli hi-tech industry and the popularity of Israel as a tourist destination. This increased tourism included many Jewish visitors from all over the world who were tempted to purchase property in Israel, whether for Zionistic reasons or to ensure a safe-haven should anti-Semitism in their home country increase to such a degree that they would have to emigrate, such as the French demand in Ashdod, Netanya and others. Anglo-Saxon buyers purchased holiday homes for more emotional reasons. Some were visiting their children regularly and found it convenient and economical to have a local base. Other reasons included proximity to the Old City or owning an apartment with a sea view in Netanya or Hertzliya, which inflated prices in these areas and nearby.
Local tax reasons also prompted foreign buyers to invest in real estate, even though the collapse of the stock market and the strong shekel has reduced the enthusiasm of foreign buyers, especially in the high end luxury market. However, the price increases in other strata of the Israeli market show no signs of abating.
There has certainly been investment and speculation in the Israeli property market, especially in the central area of Tel Aviv and the surrounding cities. In the last few years, a number of buying groups (“Kevutzot Rechisha”) sprouted, including some speculators or investors trying to get in early on a project at a reduced price and then selling out when the project was completed. Some of these buying groups have since disbanded due to internal strife or poor management. However, the majority are comprised of purchasers who desire to live in the property, not quick flippers, like many of Jorge Perez, the “Condo King” of Miami’s, speculation-based building projects in Florida, one of which had an incredible 90% drop out rate when the market collapsed.
The Israeli banking system is a highly conservative one, especially in the realm of mortgages and loans. The banks demand full documentation and proof of earnings, and, although in the past some banks were willing to grant loans of up to 80% of the appraised value of a property, in recent years, due to the Bank of Israel’s instructions, no borrower can take more than 70%. The Bank of Israel has further attempted to influence the banks to limit the mortgage to 60% of the value, especially if the mortgage is one linked to the Prime rate. Banks, as a general rule, will not allow borrowers to take mortgages that entail repayments above one-third of their net monthly income.
Attempts to counteract price increases:
The Governor of the Bank of Israel, together with the Prime Minister and Finance Minister of Israel, have devoted much effort to diminishing the increase in house prices. One of the Prime Minister’s main reforms concerned the Minhal Mekarke’ey Yisrael, the Israel Lands Authority. This is the governmental body that owns the majority of land in Israel, agricultural and residential, and is entrusted with issuing tenders to build on the land. The Minhal is known to be a slow moving bureaucratic mess, and Netanyahu wished to shut down the entire system and reformulate it from scratch. This proposal has not yet been put into practice though progress has been made. It will take a number of years until this reform can bear fruit.
Despite constant promises emanating from the Housing Ministry of unfreezing land to build thousands of new residential units, change has yet to be seen on the ground and the effects are too minimal and take too long to trickle down to dampen the market. Furthermore, the exorbitant prices building companies pay for the land inflate the final property price, although the government is considering a reduction in initial land prices for some tenders. Many of the Housing Ministry’s reforms have been blocked by the Finance Ministry.
The government desires a higher percentage of three room apartments to be built as part of building projects, in contrast to the situation today where there is a predominance of larger 4 or 5 room apartments that bring an older and more stable class of residents and are more profitable in general for builders. There are also attempts to evict farmers who are currently squatting on land that can be used for residential construction.
Another of Netanyahu’s attempted reforms was to speed up the incredibly convoluted planning process, whereby it can take five years or more for a building company to obtain all the necessary permits and complete a project. This excessive time increases building costs, which are then passed on to the consumer. These reforms have also not yet been completely accepted. Netanyahu announced new “super-committees” to expedite the granting of planning permission.
In the past few months, a number of reforms in the taxation of the purchase and sale of residential properties in Israel have been promulgated by the government with mixed results. Purchase tax has been raised on purchasers of more than one apartment, capital gains tax has been lowered on land, and an amnesty on capital gains tax has also been put into place, in the hope of persuading investors that now is the time to bow out of the game. Furthermore the capital gains tax rules will be changed from Jan 2013 onwards.
Does the government really want to dampen the market?
There are conflicting interests in dampening the property market. The Finance Ministry gains from taxing heavily the purchase and sale of property, especially investment properties. The local authorities profit from city taxes and improvement costs paid by the building companies. All current owners prefer their homes to rise in value, and the building companies thrive off the demand. The Israeli building companies that were least involved in foreign development survived the international crises and, for the most part, are financially sound. There are many interested parties who wish housing prices would continue to rise steadily without bursting.
Young couples are finding it more and more difficult to enter the property market, especially in the center of the country where many of the jobs and their friends are situated. The government has lowered tax rates for purchasers who do not currently own property in order to assist them, and, in some areas, there are grants and other subsidies.
Are prices slowing down?
There are two main bodies in Israel that publicize the housing index, the Central Bureau of Statistics and the Finance Ministry, as well as other websites, banks and newspapers that carry out their own research. As is often the case, there have been false dawns of predictions that the market is slowing down. There are often contradictions between the figures published by the CBS and the Finance Ministry. We have yet to see a long-term decrease or even slowing down of prices across the board.
The dangers of causing the bubble to burst:
The Bank of Israel has not declared that a bubble exists. It has merely stated its concerns that one may develop. A reason the BoI is not willing to take too drastic action, such as rapidly increasing interest rates, is the possible effect of causing housing prices to plummet, with all the damage to the economy that would entail. Causing too many properties to flood the market or increasing taxation to such a degree that demand nosedives would have a knock-on effect similar to that seen in the U.S. market.
There is not yet a housing bubble in Israel. The causes of the rapid increases in prices are linked to the economy, the history of the housing market and the unique nature of Israeli real estate, taxes and bureaucracy. Should speculation increase rapidly or, alternatively, should there be a glut of properties flooding the market, then we may be subject to a bubble bursting.
The economists Akerlof and Shiller claim that the classic definitions of economic theory ignore what they term “Animal Spirits”, which are the more psychological aspects influencing the economy, such as corruption, fairness, confidence and story-telling. These also play a large role in economic theory, affecting many industries and should influence government policy.
It is my belief that this is what the government and the Bank of Israel are attempting to do. When people tell stories about rapid increases in housing prices and how others are making a fortune by flipping properties, if the concepts of fairness are overturned by the desire to get in on the property bandwagon and people have confidence that housing prices will continue to rise, then all these will act in unison to become self-fulfilling beliefs and have a knock-on effect on the economy.
The government is walking a tight-rope, on the one hand warning of the potential effects of the rapid increase in prices, and on the other hand, taking constant incremental action to change the narrative, by persuading homeowners and investors that what was isn’t necessarily what will be and they must change their mind-set. But, the government must not completely overturn the reality, thereby causing what they are attempting to prevent – a bursting of the bubble and a housing crash. That explains the constant small increases in the interest rates, the regular changes in taxation to influence the markets and the attempts to reform the planning industry and release more lands for residential purposes. Taken together, these should have the desired effect of slowing down the increase in prices without causing a significant drop in the market as seen in the US.
Further articles will discuss the changes the government has carried out as well as the effect of this summer’s protests, watch this space.