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					         Is There a Real Estate Bubble?
                                                    BY DAMIR TOKIC, P HD




INTRODUCTION                                                       BRIEF LITERATURE ON “BUBBLES” AND “BURSTS”
IS THERE A REAL ESTATE BUBBLE? IF THERE IS, what will be the       Generally, a bubble is a period of time when an asset’s
consequences on the economy as the bubble bursts? Who              price reaches irrationally high levels. The bust is an
will be affected by it, and how? These questions reflect           inevitable price correction. There have been many boom-
daily worries for a significant portion of market partici-         to-bust episodes in different financial markets, throughout
pants and general population such as: homeowners,                  the history. This paper will focus on specific studies on
potential homebuyers, homebuilders, real estate investors,         housing bubbles.
stock investors, bond investors, and policymakers.
                                                                   Studies that compare housing bubbles with equity price
Unfortunately, less informed participants are not getting          bubbles find that housing price busts were associated with
the straight answers, thereby risking losing a significant         the more severe macroeconomic downturns than equity
portion of their home equity or incurring other types of           price busts. Also, housing price booms are more likely to
financial losses. Is it questionable even if better informed       be followed by busts. In particular, five factors account for
investors or experts really know the answers to these ques-        greater severity of housing price busts:
tions?
                                                                   1. Housing price busts have larger wealth effect on con-
We would like to refer the reader to the recent dot.com            sumption than do equity price busts (Bayoumi and
bubble, when many experts and a few influential academ-            Edison, 2003).
ics argued that a dot.com bubble did not exist. Needless to
                                                                   2. Housing price busts were associated with stronger and
say, billions of dollars were lost as technology stocks
                                                                   faster adverse effects on the banking system than equity
plummeted in March 2000. Is it likely that the same will
                                                                   price busts (Eichengreen and Bordo, 2002).
happen again? Except this time, instead of tech stocks, real
estate values will drop?

This paper uses a think-tank approach to evaluate the
broad real estate market and its impact on economy. It is
an exercise that every individual can follow and logically          About the Author
arrive at answers that could save someone’s existence.              Damir Tokic, PhD, is an assistant professor of finance at the University of
First, the paper presents brief literature on “bubbles” and         Houston - Downtown. His publications have appeared in journals such as:
                                                                    the Journal of Investing, the Journal of Emerging Markets, Asia - Pacific
“bursts.” Then, it moves to specific questions regarding the
                                                                    Business Review, Journal of Corporate Finance and Accounting and others
real estate markets.                                                (tokicd@uhd.edu).



REAL ESTATE ISSUES                                             1                                                                     FAL L 2 0 0 5
                                          Is There a Real Estate Bubble?

Exhibit 1—What does the construction process involve              Exhibit 2—Effects of new home ownership on economy
and what are the effects on the economy?
                                                                  1. Consumer         Consumer borrows to buy new
   1. Real estate      Bank makes money on interest               buys residen-       furniture
   developer           Lawyers make money on fees                 tial property        - Bank makes money on interest
   borrows from        Brokers make commissions                                        - Production of furniture increas-
   a bank to buy       City makes money on permits                                       es, jobs increase
   land                issuance                                                        - Furniture retailers make money
                       Land value increases                                           Consumer decorates house
                        - Local governments make                                       - Home décor retailers make
                          money on higher property                                       money
                          taxes                                                       Consumer buys new technology
                        - Local government hires more                                 (TVs, entertainment) for the home
                          city workers with increased                                 If condo, consumer pay mainte-
                          budget                                                      nance fees. Management firm
                                                                                      makes money
   2. Real estate      Bank makes money on interest                                   If house, consumer buys lawn
   developer           Developer buys raw materials                                   equipment or hires maintenance
   borrows             - Price of commodities goes up                                 personnel
   money to            - Miner companies increase                                     Consumer pays real estate taxes.
   begin con-             production                                                   - City makes money, hires more
   struction           - Jobs are created in                                             people
                          commodity-based industries                                   - School districts have larger
                          and countries                                                  budgets hire more teachers
                       Developer buys or leases con-                                   - Police, fire departments have
                       struction equipment                                               larger budgets, hire more peo-
                       - Equipment producers increase                                    ple
                          production                                                   - Ports and other city services
                       Developer hires construction                                      have larger budgets and hire
                       workers                                                           more people
   3. Real estate      Buys new tiles
                                                                  2. As home          Consumer takes home equity loan
   developer           New air conditioners
                                                                  prices increase:     -Banks make money on interest
   completes           New alarms
                                                                                       -Consumer spending increases
   construction        New kitchens
                                                                                         with the extra cash
                       New bathrooms
                                                                                      Property taxes increase
                       Demand for items that go into
                                                                                       - City, schools, police, fire depart-
                       final product increases, increas-
                                                                                         ment, port have larger budgets
                       ing production and jobs in those
                                                                                         and hire more (or spend in
                       industries
                                                                                         other ways)
                       Inspectors make money on final
                                                                                      Investors and speculators get
                       inspections
                                                                                      attracted to real estate returns
  4. Residential       Real estate agents make com-
                                                                                       - Buy properties for quick resale
  property is          missions
                                                                                       - Buy 2nd or 3rd homes or con-
  sold                 Banks make money on interest
                                                                                         dos
                       and fees
                                                                                       - Property prices increase even
                       Lawyers make money on fees.
                                                                                         more
                       Appraisers and inspectors make
                                                                                       - Banks make even more money
                       money
                                                                                         on these loans
                       Real estate developer makes
                                                                                       - Real estate agents, lawyers
                       profit on sale
                                                                                         make money as well
                                                                  3. As interest      Consumer refinances and lowers
                                                                  rates decrease       the payments
3. Housing price busts were more likely to have been pre-
                                                                                      Consumers spending increases
ceded by a boom so that there were larger imbalances to
be unwound (Bordo and Jeanne, 2002).

4. Housing price busts were more likely associated with           5. Housing price busts were associated with tighter mone-
generalized asset price bear market than equity price busts       tary policy than equity price busts (Schwartz, 1995).
(Ito and Iwaisako, 1995).


REAL ESTATE ISSUES                                            2                                                      FAL L 2 0 0 5
                                          Is There a Real Estate Bubble?

Exhibit 3—Real estate pricing factors                         Exhibit 4—Reasons behind motivated sellers


  Real estate        Population growth                            1. Foreclosure    Lost a job, unable to make payments
  demand fac-         - Baby boom cycles                                            Divorce
  tors                - Immigration                                                 Medical expenses
                     Ability to buy                                                 Other unforeseen expenses
                      - Good credit                                                 Unable to pay property taxes
                      - Full time job                                               Home value falls below the total loan
                      - Ability to borrow                                           amount, stop making payments
                      - Savings for down-payment                                    Has to move
                                                                  2. Relocation
                     Housing assistance programs
                      - HUD, Freddie Mac, Fannie Mai              3. Defective      Previously unknown environmental
                      - Assistance with down-payment              property          hazard emerges.
                      - Guaranteed loans for sub-prime                              Neighbor problems
                         borrowers
                     Low interest rates                           4. Life           Marriage
                      - Interest payments lower                   changes           Children
                      - Consumer builds equity faster                               Larger or smaller family
                     Trend of fashion                                               Retirement
                      - Desire to upgrade
                      - Everybody is buying                       5. Speculators    Unable to sell a property bought for
                     Speculation                                                    investment purposes.
                      - Rising real estate prices.                6. Inventory      Developers’ supply exceeds the
                      - Low interest rates                        liquidation       demand, must liquidate the
                      - Zero down, interest only mort-                              inventory
                         gage products
                                                                  7. Fear that      Declining home prices may trigger
                                                                  home equity       even more selling to protect the
  Real estate         Land constraints                            will be lost      home equity
  supply factors      -Regional issues                            due to declin-    Especially for owners with 2nd or 3rd
                      Tear down old housing to build new          ing prices        mortgage
                       - Prime locations
                       - Sub-prime locations revitalization       8. Interest       Borrowers with variable rate mort-
                      Townhouses, high-rises, condos,             rates increase    gages pay higher interest
                      houses closer to each other                                   Possible default as payments increase
                      Interest rates – ability to borrow



THINK-TANK EXERCISE                                                homeowners pay property taxes, which benefits city budg-
Our exercise starts with an environment where a real               ets.
estate developer decides to build a housing project. What
                                                                   In our perfect environment a real estate developer builds
does the construction process involve and what are the
                                                                   homes and sells them to public for profits. The reality test
effects of construction on the economy (Exhibit 1)? It
                                                                   of this environment will be a function of consumer
seems like the major effect of booming construction on
                                                                   demand and the ability to satisfy that demand. Excessive
economy is job creation, not only in construction, but also
                                                                   imbalance between the demand for housing and the corre-
in services that support construction, and manufacturing
                                                                   sponding supply will greatly affect housing prices. If the
that supplies the housing industry.
                                                                   demand exceeds the supply, home prices will increase. If
Once the project is completed and sold out, what are the           the supply exceeds the demand, home prices will decrease.
effects of new home ownership on the economy (Exhibit              Our next exercise discusses the factors that affect the
2)? New home ownership requires further consumption,               demand for housing and the factors that affect the supply
including home décor, furniture, and technology.                   of housing (Exhibit 3). The major demand factor is the
Consumption of other goods also increases as consumer              ability of consumers to buy a house. Full time employ-
wealth increases due to rising home values. In addition,           ment is a necessary precondition to: save money for the
                                                                   down payment, afford the monthly payment, and to quali-

REAL ESTATE ISSUES                                            3                                                      FAL L 2 0 0 5
                                            Is There a Real Estate Bubble?

Exhibit 5—Reasons for slowing demand for housing                     Finally, our exercise ends with the question, if there is a
                                                                     housing bubble, what will be the effects on the economy
 1. Population        Baby boom cycle                                once the bubble bursts (Exhibit 2). As literature suggests,
 growth slows         Anti-immigrant laws                            the consequences of housing bust can be severe for the
 down                                                                economy. First, the jobs are lost in construction and in
                                                                     economy wide. Seconds, the wealth is lost as home prices
 2. Weak labor        Outsourcing of jobs to India, China
 market               and other                                      plummet. Both of these are translated into slower con-
                      Slow wage/salary growth rate                   sumption. Finally, financial sector suffers as lending activi-
                      Popularity of part time—temporary              ty disappears, and existing loans face defaults.
                      employment
 3. Low                                                              DISCUSSION—IS THERE A REAL ESTATE BUBBLE?
                     No money for down-payment
 savings rate        Unable to qualify to loan due to lack           Our exercise would be worthless unless we are able to
                     of savings                                      answer whether there is a bubble or not. The starting
 4. Increase in      The combination of high spending,               point of our discussion and the major assumption is: for a
 personal            low savings and sluggish job market             housing bubble to exist there has to be a significant
 bankruptcies        could increase personal bankruptcies            amount of speculation.
                     Bad credit—unable to qualify for
                     mortgage                                        Speculation, in our opinion, can take two forms. First, a
 5. Troubles at      High default rates in sub-prime mort-           real estate developer could overestimate the demand for
 housing             gage market could discourage fur-               housing and build an excessive inventory of speculative
 assistance          ther housing assistance                         homes. Second, a homebuyer can speculate by buying
 programs.
                                                                     properties for investment purposes with the hope to resell
 6. Declining        Keep away speculators
                                                                     them later for profits. These two speculators are very dif-
 home values
                                                                     ferent as homebuilders control supply while speculator
 7. Higher            More expensive to borrow money                 buyers control the demand.
 interest rates       Higher interest payments—slower
                      equity building                                The major warning sign for a real estate market is when
                      Higher monthly payments—harder to
                                                                     majority of buyers are speculators purchasing second or
                      qualify for the loan
                      Keep away speculators                          third homes for investment purposes. Why? It signals that
                                                                     consumer demand for primary residence is weak due to
                                                                     any reason discussed earlier. If the consumer demand is
fy for the mortgage. Supply factors are mostly regional, as
                                                                     weak, who is going to buy properties from speculators?
the availability of land to build differs across regions.
                                                                     Who is going to buy excess inventory from homebuilders?
However, as long as the demand is strong, homebuilders
can find a way to develop a property on limited land, such           There has to be a trigger or a tipping point that bursts the
as build townhouses or revitalize old neighborhoods.                 bubble. Most likely, that trigger will come either from a
                                                                     home builder liquidating the inventory below the market
Now that we understand the housing market pricing fac-
                                                                     value, or speculators selling their investment properties
tors, we can begin to introduce the discussion whether
                                                                     bellow the purchasing price. But what would cause such a
there is a real estate bubble or not. Our major assumption
                                                                     sell off? Speculators may be willing to hold on to their
is that for bubble to arise there has to be a high probability
                                                                     investments until the cost of holding on to a property
for a sharp decrease in the price. Otherwise, we would not
                                                                     increases. Specifically, the prospects of higher interest rates
be talking about the bubble. Next, we propose that two
                                                                     will increase the cost of holding on to investment property
conditions would essentially cause the bubble to burst: 1)
                                                                     and trigger a motivated sell. Declining home values and
there have to be motivated sellers (Exhibit 4) and 2) there
                                                                     increasing interest rates will keep away new speculators
has to be slowing demand for housing (Exhibit 5). The
                                                                     and further decrease the demand for housing. Excess
lethal combination of abundant motivated sellers, with
                                                                     inventory of new homes and the large number of motivat-
buyers nowhere to be found, is the prescription for hous-
                                                                     ed speculative sales, are likely to cause further decrease of
ing bust. Real estate speculation is definitely a worrisome
                                                                     home values.
activity that can create very motivated sellers, especially if
the labor markers are weak and interest rates are rising.


REAL ESTATE ISSUES                                               4                                                        FAL L 2 0 0 5
                                           Is There a Real Estate Bubble?

Exhibit 6—Effect of slow real estate market on economy


  1. Less             Less bank borrowing
  construction        Less transactions for lawyers and brokers
                      Loss of construction jobs
                      Slowing demand for commodities
                      Slowing demand for construction equipment
                      Slowing demand for tile, kitchen, bath, windows, and other housing products
  2. Slower           Less bank borrowing
  home sales          Less transactions for lawyers and brokers
                      Lower aggregate commissions for brokers
                      Less business for inspectors, appraisers
                      Less business for management companies and maintenance personnel.
                      Slower furniture sales.
                      Slower home décor sales
                      Slower new technology sales
                      All together, leading to loss of jobs in banks, law firms, brokerages, management companies, retail
                      stores, furniture and construction equipment producing firms

  3. Declining        Lower property taxes
  land and             - Lower budget for cities, schools, police, fire departments, ports…
  home values          - Loss of jobs and less public spending
                      Foreclosures
                       - Speculators unable to sell investment properties for profit, and unable to sell for loss—no money
                         to close the deal
                       - Loss of jobs associated with slower real estate markets
                       - Higher interest rates for variable mortgage rate borrowers increase payments
                      Loss of home equity, especially serious if home value falls bellow the loan value
                       - Consumer wealth would decrease, affecting the consumer confidence—the wealth effect
  4. Stock            Financial sector
  market down-        Construction- and housing-based sectors
  turn                Commodity-based firms and emerging markets
                      Further erosion of consumer wealth
  5. Big picture      Loss of jobs, declining property taxes, declining consumer wealth and corporate profits would make
  – the budget        it harder to lower the U.S. budget deficit
  deficit
  problems

Slowdown in housing market, as we proposed, would at                els. One only has to take a drive through any U.S. city and
first cause slowing economy, which would translate into             its suburbs to notice an abundant supply of newly built
loss of jobs. Homeowners who lose these jobs are likely to          condos and single-family homes. One can also notice so
miss their mortgage payments and file for bankruptcy. At            many “for sale” signs and “open houses” on existing
this point serious consequences would start for the econo-          homes. Isn’t this the prescription for a housing bust, as
my as numerous foreclosures further decrease home val-              described earlier? In our opinion it is.
ues and banks feel the increased number of non-perform-
                                                                    There seems to be no data to indicate who are the
ing loans.
                                                                    investors buying second or third homes. However, some
In summary, whether there is a real estate bubble or not            analysts suggest that baby boomers have been buying
depends on amount of speculation in these markets.                  homes for their retirement, which has been the primary
National Association of REALTORS shows that 23% of                  demand factor for second homes. Eventually, retired baby-
home purchases in 2004 were by investors. That means                boomers will have to sell their primary residences before
that almost 1 out of 4 homes bought in 2004 were pur-               moving to their new homes. This will only increase the
chased only to be resold at the higher price sometime in            selling pressures and contribute to the housing bust.
the future. At the same time, building permits and hous-
                                                                    Some other analysts see a high level of short-term home
ing starts continue to grow in 2005 to historically high lev-
                                                                    “flipping,” where speculators invest in a second, third, or

REAL ESTATE ISSUES                                              5                                                      FAL L 2 0 0 5
                                           Is There a Real Estate Bubble?

fourth home with the hope to resell them for profits with-         investors cause the excess demand, while the speculator
in the short period of time. Sometimes, speculators buy            homebuilders cause the excess supply. The demand-supply
homes/condos while in construction and resell them                 imbalance has to cause the price correction. The only
before the construction is completed.                              question is for how long speculators will be willing to hold
                                                                   on to their investments, before selling below the purchas-
Another theory is that, after the stock market crash in
                                                                   ing price. We conclude, as long as interest rates are low.
2000, baby boomers took money out of the stock market
                                                                   Therefore, market participants should closely follow the
and invested in real estate, hoping that real estate is less
                                                                   interest rates as the potential trigger for housing bubble
risky and more likely to appreciate than the stock market.
                                                                   bust.
In addition, a property can be rented out to supplement
their incomes in retirement.                                       REFERENCES

Whether baby boomers have been buying second homes                 Bayoumi, Tamin, and Hali Edison, 2003, “Is Wealth Increasingly Driving
                                                                   Consumption?” IMF Working Paper (Washington: International Monetary Fund).
to live in them once they retire, or to rent them out to
supplement their incomes, or whether other investors have          Bordo, Michael, and Olivier Jeanne, 2002, “Boom-Busts in Asset Prices, Economic
                                                                   Instability and Monetary Policy,” NBER Working Paper No. 8966 (Cambridge, Mass.:
been “flipping” homes for short term gain, a historically
                                                                   National Bureau of Economic Research).
high statistic that shows that 23% of homes purchased in
                                                                   Eichengreen, Barry, and Michael Bordo, 2002, “Crises Now and Then: What Lessons
2004 were second home investments is alarming because
                                                                   from the Last Era of Financial Globalization?” NBER Working Paper No. 8716
it indicates unsustainable demand that will inevitably             (Cambridge, Mass.: National Bureau of Economic Research).
result in bust.
                                                                   Ito, Takatoshi, and Tokua Iwaisako, 1995, “Explaining Asset Bubbles in Japan,”
                                                                   NBER Working Paper No. 5358 (Cambridge, Mass.: National Bureau of Economic
                                                                   Research).
SUMMARY                                                            Schwartz, Anna, 1995, “Why Financial Stability Depends on Price Stability,”
This paper discusses whether this is a housing bubble or           Economic Affairs, Vol. 15, pp. 21-25.
not, and what will be the consequences if such a bubble
exists. Using a simple exercise of what happens if, we con-
clude that there is a housing bubble because speculator




REAL ESTATE ISSUES                                             6                                                                         FAL L 2 0 0 5

				
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