Bloomberg

Uh-oh. Is the biggest bubble in the western world about to pop?

I’ve learned from long experience that one can never tell for certain. But the signs are ominous.

I’m in London, where real estate is just entering the sixth year of a mania that seems to be putting all others in the shade. London’s property market today makes Las Vegas in 2005 look like penny ante poker in an old people’s home. It makes you think of Tokyo in the late ‘80s.

This mania is massive. Everyone here is rich — on paper. Every piece of real estate is worth gazillions. My old one-bedroom, fourth-floor walk-up would apparently now sell for nearly $1 million. It measured 450 square feet. Did I mention there was no elevator?

Everyone is talking about how much money they have made on their home in the last year and how much more they are going to make in the next. Prices are up every month. Values are way, way past the levels seen even in 2007.

Conversations here go like this: “Did you hear? A flat just like mine over on Thingummy Avenue just sold for $2.2 million. I think it was about the same size as mine, but it didn’t have a third bathroom, and the view wasn’t as good. I think my place is now worth $2.5 million.”

“Well, the flat two floors below us sold for $3 million. They’d only been there a year. It needs a new bathroom. And it’s on the other side of the building, so the view isn’t so good…”

But there’s just one problem.

While the nominal value of property is still going up, the cost of renting one of those properties isn’t keeping pace.

In fact, it’s going down. No, really.

The key numbers here come from the London real-estate firm of Knight Frank, which tracks rents and purchase prices in the valuable inner core of London, which it calls “Prime Central London.”

 

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London is a gigantic city. Much of it is suburb. Much of that suburb is pretty uninteresting. What matters for the property boom is the London of the inner core — the areas along the Thames River, up around the Hyde and Regent’s parks, and then east to the City and surrounding, trendy areas like Islington.

Prices in these areas are in orbit. Rich Russians and rich Chinese and rich Middle Easterners are fighting each other to snap up the best properties. They are buying all the flats in the same building and then turning them into a single home — as they were back in the Victorian days.

Overall, prices for Prime Central London property are up by about two-thirds in the past five years, and have more than doubled in 10, says Knight Frank. They are up nearly 8% in the past year and are currently rising by about 1% a month.

Yet the average cost of renting these places is going down. It’s fallen about 2% in the past year, and 4% since peaking in 2011.

Yes, it’s modest. But it’s in the wrong direction. If homes really are becoming more valuable to own, shouldn’t they also become more valuable to rent?

In Fulham, where I am currently writing this, prices have risen 12% in the last year, but rents are down 6%. Just north of Hyde Park prices have risen 10%, but rents have fallen 8%. In tony Mayfair, once the home of the aristocracy and now better known for its diplomats, prices are up 5% — but rents are down 8%. And along the south bank of the Thames directly across from the City, in the area known as Riverside, prices have risen 13% in the past year, but rents have fallen 2%.

Nobody ever seems to know when a boom will end or how. I’ve been skeptical of London property valuations for years, but they have just gone up and up and up. Maybe, like Monets, they will just keep rising and rising forever. A local hedge fund manager explained to me a while back that central London property should really be understood as a luxury asset. London is where the international rich launder their gains, he said. Vladimir Putin’s cronies are probably glad they have a lot of London property right now — the money is out of Russia, and probably safe from any likely sanctions. A corollary of this, he said, is that prime central London property needs to be valued in U.S. dollars — like gold, or diamonds, or Monets — rather than British pounds.

Nonetheless, this is a huge city with a lot of inventory (planning restrictions notwithstanding). And the math is very interesting.

A friend talked me through the math on her home. She lives in a luxury flat on the river. In the current market, it would sell for $2 million. Instead she rents it for $65,000 a year. Meanwhile the owner has to pay about $17,000 in condo fees (the place has a gym and a pool and a parking garage and a porter and so on).

In other words, if she decided to buy it instead of continuing to rent, she would have to fork over $2 million, but after accounting for condo fees, would only save about $48,000, net, a year. That’s a yield of about 2.4%.

According to the Bank of England, the inflation rate is forecast to hit about 3% by next year. So the “yield” on purchasing a property is below likely inflation.

She is not alone. This is what happens when prices go up and rents don’t. According to Knight Frank, the gross rental yield on prime central London property has now collapsed to the lowest levels since they began keeping records in 1995. The gross yield, 4% as recently as March 2009, is now down to 2.8%. Ten years ago it was north of 5% and in the mid-1990s it was up toward 10%.

A 2.8% yield may be fine so long as short-term interest rates are on the floor and flexible-rate mortgages are cheap. You can do all sorts of funny stuff if you artificially halve the cost of capital for a while. The problems arise when the cost of capital goes back to where it is supposed to be, which is usually several percentage points above inflation.

I don’t know what the future holds. I just know math. In 2008, shortly before the financial crisis, I visited the housing bust in Florida and concluded that “the smart money rents in Miami,” where it was cheaper to rent than to own . The math may not be quite so upside down in old London town, but if I lived here right now I’d probably rent too.

www.marketwatch.com/