Real estate bubble
From Wikipedia, the free encyclopedia
This article is about the general phenomenon of housing bubbles. For housing bubbles in various countries, see
below.
A real estate bubble or property bubble (or housing bubble for residential markets) is a type of economic bubble that occurs periodically in local or global real estate markets. It is characterized by rapid increases in valuations of real property such as housing until they reach unsustainable levels relative to incomes and other economic elements, followed by a reduction in price levels.
Whether real estate bubbles can or should be identified or prevented, and whether they have broader macroeconomic importance or not are debated within and between different schools of economic thought, as detailed below. Some argue that the financial crisis of 2007–2010 was at least partially due to real estate bubbles, notably in the United States.
Identification and prevention
As with all types of economic bubbles, whether real estate bubbles can be identified or prevented is contentious. Bubbles are generally not contentious in hindsight, after a peak and crash.
Within mainstream economics, some argue that real estate bubbles cannot be identified as they occur and cannot or should not be prevented, with government and central bank policy rather cleaning up after the bubble bursts.
Others within mainstream economics and in heterodox economics, such as American economist Robert Shiller and British magazine The Economist, argue that housing market indicators can be used to identify real estate bubbles. Some argue further that governments and central banks can and should take action to prevent bubbles from forming, or to deflate existing bubbles.
[edit] Macroeconomic significance
Within mainstream economics, economic bubbles, and in particular real estate bubbles, are not considered major concerns. Within some schools of heterodox economics, by contrast, real estate bubbles are considered of critical importance and a fundamental cause of financial crises and ensuing economic crises.
The mainstream economic view is that economic bubbles primarily effect first a temporary boost in wealth, and secondly a redistribution of wealth. When prices go up, there is a positive wealth effect – property owners feel richer, and hence spend more, and when prices go down, there is a negative wealth effect – property owners feel poorer, and hence spend less. It is argued that these effects can be smoothed by counter-cyclical monetary and fiscal policy. Secondly, the ultimate effect on owners who bought before the bubble formed and did not sell is zero – throughout, they owned the property. Conversely, those who bought when low and sold high profited, while those who bought high and sold low or held until the price had fallen lost money, though this ultimately is simply redistribution of wealth and, it is argued, of little economic significance.
In some schools of heterodox economics, notably Austrian economics and Post-Keynesian economics, real estate bubbles are seen as an example of credit bubbles (pejoratively, speculative bubbles), because property owners generally use borrowed money to purchase property, in the form of mortgages. These are then argued to cause financial and hence economic crises. This is first argued empirically – numerous real estate bubbles have been followed by economic slumps, and it is argued that there is a cause-effect relationship between these.
Austrian business cycle theory takes a supply-side view, arguing that real estate bubbles cause misallocation of resources – too many houses and offices are built, and too many resources (materials and labor) are wasted in building unneeded buildings. Further, this distorts the industrial base, yielding an excess of homebuilders who must then retrain and retool when the bubble bursts, this transition between non-productive and productive uses of resources (and the underinvestment during the lead-up) being a proximate cause of the resulting economic slump.
Fred Foldvary, economist at Santa Clara University, has synthesized the Austrian-school theory of the cycle with the land-based theory of Henry George. His proposition is that this geo-Austrian theory fits the 18-year real estate cycle as discovered by real estate economist Homer Hoyt.
The Post-Keynesian theory of debt deflation takes a demand-side view, arguing that property owners not only feel richer, but borrow against the increased value of their property (as via a home equity line of credit), or borrow money to speculate in property, buying property with borrowed money in the expectation that it will rise in value – this last view is associated with Hyman Minsky and his Financial Instability Hypothesis. When the bubble bursts, the value of the property decreases but, crucially, the level of debt does not. The burden of repaying or defaulting on this debt is argued to depress aggregate demand and be the proximate cause of the ensuing economic slump.
[edit] Recent real estate bubbles
The crash of the Japanese asset price bubble from 1990 on has been very damaging to the Japanese economy and the lives of many Japanese who have lived through it [1], as is also true of the crash in 2005 of the real estate bubble in China's largest city, Shanghai.[2] Unlike a stock market crash following a bubble, a real-estate "crash" is usually a slower process, because the real estate market is less liquid than the stock market. Other sectors such as office, hotel and retail generally move along with the residential market, being affected by many of same variables (incomes, interest rates, etc.) and also sharing the "wealth effect" of booms. Therefore this article focuses on housing bubbles and mentions other sectors only when their situation differs from housing.
As of 2007[update], real estate bubbles had existed in the recent past or were widely believed to still exist in many parts of the world,[3] especially in the United States, Argentina[4], Britain, Netherlands, Italy, Australia, New Zealand, Ireland, Spain, Lebanon, France, Poland[5], South Africa, Israel, Greece, Bulgaria, Croatia[6], Canada, Norway, Singapore, South Korea, Sweden, Baltic states, India, Romania, Russia, Ukraine and China[7]. Then U.S. Federal Reserve Chairman Alan Greenspan said in mid-2005 that "at a minimum, there's a little 'froth' (in the U.S. housing market) … it's hard not to see that there are a lot of local bubbles."[8] The Economist magazine, writing at the same time, went further, saying "the worldwide rise in house prices is the biggest bubble in history".[9] Real estate bubbles are invariably followed by severe price decreases (also known as a house price crash) that can result in many owners holding negative equity (a mortgage debt higher than the current value of the property).[citation needed]
[edit] Housing market indicators
UK house prices between 1975 and 2006.
Robert Shiller's plot of U.S. home prices, population, building costs, and bond yields, from
Irrational Exuberance, 2d ed. Shiller shows that inflation adjusted U.S. home prices increased 0.4% per year from 1890–2004, and 0.7% per year from 1940–2004, whereas U.S. census data from 1940–2004 shows that the self-assessed value increased 2% per year.
In attempting to identify bubbles before they burst, economists have developed a number of financial ratios and economic indicators that can be used to evaluate whether homes in a given area are fairly valued. By comparing current levels to previous levels that have proven unsustainable in the past (i.e. led to or at least accompanied crashes), one can make an educated guess as to whether a given real estate market is experiencing a bubble. Indicators describe two interwoven aspects of housing bubble: a valuation component and a debt (or leverage) component. The valuation component measures how expensive houses are relative to what most people can afford, and the debt component measures how indebted households become in buying them for home or profit (and also how much exposure the banks accumulate by lending for them). A basic summary of the progress of housing indicators for U.S. cities is provided by Business Week.[10] See also: real estate economics and real estate trends.
Housing ownership and rent measures
- The ownership ratio is the proportion of households who own their homes as opposed to renting. It tends to rise steadily with incomes. Also, governments often enact measures such as tax cuts or subsidized financing to encourage and facilitate home ownership. If a rise in ownership is not supported by a rise in incomes, it can mean either that buyers are taking advantage of low interest rates (which must eventually rise again as the economy heats up) or that home loans are awarded more liberally, to borrowers with poor credit. Therefore a high ownership ratio combined with an increased rate of subprime lending may signal higher debt levels associated with bubbles.
- The price-to-earnings ratio or P/E ratio is the common metric used to assess the relative valuation of equities. To compute the P/E ratio for the case of a rented house, divide the price of the house by its potential earnings or net income, which is the market annual rent of the house minus expenses, which include maintenance and property taxes. This formula is:
-
- The house price-to-earnings ratio provides a direct comparison to P/E ratios used to analyze other uses of the money tied up in a home. Compare this ratio to the simpler but less accurate price-rent ratio below.
- The price-rent ratio is the average cost of ownership divided by the received rent income (if buying to let) or the estimated rent that would be paid if renting (if buying to reside):
-
- The latter is often measured using the "owner's equivalent rent" numbers published by the Bureau of Labor Statistics. It can be viewed as the real estate equivalent of stocks' price-earnings ratio; in other terms it measures how much the buyer is paying for each dollar of received rent income (or dollar saved from rent spending). Rents, just like corporate and personal incomes, are generally tied very closely to supply and demand fundamentals; one rarely sees an unsustainable "rent bubble" (or "income bubble" for that matter). Therefore a rapid increase of home prices combined with a flat renting market can signal the onset of a bubble. The U.S. price-rent ratio was 18% higher than its long-run average as of October 2004.[16]
- The gross rental yield, a measure used in the United Kingdom, is the total yearly gross rent divided by the house price and expressed as a percentage:
-
- This is the reciprocal of the house price-rent ratio. The net rental yield deducts the landlord's expenses (and sometimes estimated rental voids) from the gross rent before doing the above calculation; this is the reciprocal of the house P/E ratio.
- Because rents are received throughout the year rather than at its end, both the gross and net rental yields calculated by the above are somewhat less than the true rental yields obtained when taking into account the monthly nature of rental payments.
- The occupancy rate (opposite: vacancy rate) is essentially the number of occupied units divided by the total number of units in a given region (in commercial real estate, it is usually expressed in terms of area such as square meters for different grades of buildings). A low occupancy rate means that the market is in a state of oversupply brought about by speculative construction and purchase. In this context, supply-and-demand numbers can be misleading: sales demand exceeds supply, but rent demand does not.
Real estate bubbles in the 2000s
As of 2006[update], several areas of the world are thought by some to be in a bubble state, although the subject is highly controversial. This hypothesis is based on similar patterns in real estate markets of a wide variety of countries.[17] This includes similar patterns of overvaluation and excessive borrowing based on those overvaluations.
Some economists maintain that there is not enough similarity to assert a world trend. Others assert that there are enough common characteristics to call it a broad pattern; the reasons for such a pattern can be attributed to any of a number of macroeconomic trends. One such trend might be the rapid growth of developing economies such as the BRIC group. This has caused significant growth in monetary reserves and savings in those countries, which in turn has made possible extension of credit elsewhere.
The subprime mortgage crisis, with its accompanying impacts and effects on economies in various nations, has given some credence to the idea that these trends might have some common characteristics.[3]
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