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October 13, 2015

By Dr.Megan Walters, Head of Capital Markets Research at JLL

Asset pricing dynamics in real estate have come under scrutiny since Quantitative Easing (QE) was implemented following the global financial crisis. A recent paper prepared under the auspices of the World Economic Forum by Dr David Rees at JLL provides an in-depth survey and a suite of case studies examining specific examples of real estate boom/bust cycles across a range of sectors and markets.

One of the features of the case studies and report is that ‘no one size fits all’ in terms of why, where and when real estate bubbles occur. However, common patterns do emerge from the case studies which we have depicted in the illustrated model.


How does the illustrated model work?

The academic background for identifying the patterns in the case studies is grounded in the work of Nobel prize-winning economists Ronald Coase, Douglass North, Robert Shiller and George Akerloff. This body of work, often described as “Institutional Economics”, emphasizes social interaction in markets and firms, and identifies the “rules of the game”, both formal and informal, as key determinants of the performance of markets and the behavior of market participants.

The theories behind asset price bubbles are complex, with Alan Greenspan famously claiming it is impossible to spot them. However, Professor Robert Shiller, author (with George Akerloff) of Animal Spirits and Irrational Exuberance, suggests there are signals we can look for to anticipate emerging bubbles: high levels of liquidity, rising numbers of transactions and rapid turnover of ownership.

Price bubbles can be created by lack of market transparency, both from ‘money illusion’ – whereby the face (nominal) value of money is mistaken or its purchasing power (real value) – from inflation and investors trading ‘stories’ of beliefs that markets will go higher, along with a high rate of deal turnover and high liquidity. A common, but dangerous, observation about emerging bubbles is the common belief that “this time it’s different”.

Why is real estate different?

Real estate markets differ from stock markets because real estate has a physical component that influences participants’ behavior. Work on common property resources by Eleanor Ostrom (another Nobel prize winner) and Ronald Oakerson is helpful in identifying the impact of the physical constraints of property on market activity.

Our illustrated model work, adapted from Oakerson’s model, shows how commercial real estate markets operate to illustrate the findings from the JLL/ WEF paper.

Here we provide a snapshot to explain key points of our adapted model.

Land Supply
Starting on the left hand side, real estate markets have physical characteristics that affect the availability of land supply – and can influence the speed with which supply can meet investor demand for real estate. In Hong Kong land is limited due to topography. In the so-called sand states of the United States – Arizona, California, Nevada and Florida – additional land for housing is readily available, providing for a highly elastic supply response when house prices rise. Where land is restricted a “bubble” can build where excess demand cannot be met by additional supply – Hong Kong, for example. Conversely- where there is unlimited land a “bust” can occur as over supply can arise relatively quickly. Either way, the physical characteristics of land have a fundamental effect on the ultimate outcome of real estate pricing.

Market rules and social customs
The middle part of the graphic shows the operation of the property market – a combination of formal rules, statutes and regulations and informal custom and social practice. There, rules operate at three broad levels: government, organizations and individuals. In the JLL/WEF asset pricing paper examples of formal rules might be the legislation to limit new office development in the United Kingdom in 1965, and the repeal of these policies in the early 1970s. Informal custom and practice might be decisions by Japanese banks to provide loans in anticipation of future price growth in the late 1980s. In Mumbai, for example, office development is often speculative whereas in Bangalore “developers usually commit to commercial buildings in consultation with occupiers…” The rules in the real estate market, whether formal or informal, arise from an inter play between the physical characteristics of a location and economic conditions. For example planning rules and restrictions arise and are enforced to different degrees, depending on the capacity and resources of the government or regulator to provide the rules and enforce them. In Johannesburg, South Africa, for example, the case study record how failing attempts to regulate population movements led to the “hijacking” of residential and commercial buildings which were then abandoned by the legal owners.
The extent to which a real estate market operates a landlord and tenant system as oppose to an owner occupier system has a material effect when a market is transitioning from predominantly owner occupied to one where private landlord and tenant rights can occur (as in the Shanghai case study).

Macro-economic environments
The real estate market operates within an economic framework – shown on the right hand side of the picture. Decisions on interest rates, easier availability of debt, lower cost of debt, relative returns in other asset classes and foreign exchange rates were all found to have played a role in at different times in most of the real estate bubbles analysed. Typically a shift in one of the factors in the macro environment provides a displacement in the real estate cycle that triggers the start of a boom, following the classic Minsky-Kindleberger cycle (see page 11 in WEF/JLL report).

To quote Reinhart and Rogoff after Rees ‘While real estate figures in many market crises, debt is widely identified as a critical ingredient: “If there is one common theme to the vast range of crises we consider… it is that excessive debt accumulation… often poses greater systemic risks than it seems during a boom.”’

It would be alright if it weren’t for other people
The patterns of interaction between the economic framework and real estate markets take place via market participants – organizations and people. Shiller and Akerloff identified five forces that drive markets. Along with ‘confidence’ they identified: fairness, corruption, money illusion and “stories”.

Stories are the anecdotes we hear about- the expat who made millions buying a flat in Hong Kong at the bottom and selling at the top and retiring to Dorset on the proceeds. The reinforcing nature of stories is amplified by TV programmes on buying and renovating property, and seminars on buying in foreign cities with guaranteed income returns. We believe these stories and conveniently forget those who bought at the height of the market and saw their flat fall by half in value. People usually do not discuss their losses – only their gains, giving a one sided view of market dynamics- that markets only go up.

In real estate pricing dynamics, money illusion (the inability to assess the time value of consumer price inflation) and “stories” are two of the most important. What starts as a natural response to increased pricing due to a supply demand mismatch can escalate into large fluctuations in pricing.

And back to physical characteristics
The final part of the graphic shows how rules and market practice in the real estate market interact with economic conditions and pass through the filter of human psychology. The overlay to this and the part from Oakerson’s model that is particularly pertinent is the fact that real estate has a physical component.

Acres of empty housing that have been foreclosed exert negative externalities on the urban environment. Empty commercial buildings or, worse, half completed development projects may have negative land value – far more costly than if no development had taken place.

The JLL/ WEF report and case studies show how complex and multi-faceted the issue of real estate bubbles is. The graphical diagram highlights some of the dimensions: the physical landscape; the local real estate market rules and customs; the economic conditions and psychology of human action.

The complex machinery of asset price cycles is itself a warning that simple solutions are unlikely to be effective. Macro-economic policies and regulatory strategies have important roles to play. But the human dimension also points to research and education as worthwhile investments as well. Finally, the multi-dimensional feature of the typical boom/bust cycle is itself cause for optimism – there are many avenues by which cycles can be interdicted and even defused even if there is no “one-size-fits-all” panacea.

Click here to view the Emerging Horizons in Real Estate, An Industry Initiative on Asset Price Dynamics Report 

Click here to view Emerging Horizons in Real Estate, An Industry Initiative on Asset Price Dynamics Executive Case Studies 

**Oakerson, Ronald J. 1992. “Analyzing the Commons: A Framework.” Making the Commons Work: Theory, Practice, and Policy, ed. Daniel W. Bromley. San Francisco, CA: Institute for Contemporary Studies.

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