Property Booms and Busts: Cycles or Bubbles

1. Property Booms and Busts: Cycles or Bubbles Neil Dunse, Colin Jones and Michael White

2. Introduction • Downturn following credit crunch saw investment funds dramatically dry up. • Impact saw first yields rise then fall in development as it became unviable and unfundable, then rents fell • Aftermath credit crunch highlights role of external influences • Increase attention in the concept of asset bubbles • Paper = contribution to role of bubbles by an analysis of urban office yields over time.

3. Bubbles or Cycles • Term ‘bubble’ is inconsistent with the concept of efficient markets • Notion of a bubble creates another debate about its relationship with the cyclical behaviour of real estate markets • Can speculative bubbles occur independently of property cycles or do they amplify cycles? • Potential for bubbles in market given inefficiencies

4. Existing Research • Extended period of house price inflation across the world in the 1980s and especially from the mid 1990s stimulated academic studies • Tested whether these trends can be justified by reference to fundamentals • Only one by Hendershott (2000) of Sydney, Australia, has examined commercial property • 11 years study period over one cycle • Approach = deviations of a fundamental value to replacement cost ratio and requiring an independent forecast of vacancy rates. • Conclusions suggest the existence of a bubble

5. Property and Business Cycle • Capital investment as the key cyclical driver of economic growth • New development = key influence on the business cycle • Occupation demand is linked to business cycle • Property market is inevitably cyclical • But there is a further factor - development time lags

6. Stylised Commercial Cycles • Development lags amplify economic cycle • Studies conceptualised the property cycle by reference to the 'cobweb model' and the role of development lags • Different types of real estate have different cycles reflecting different development lags

7. Barras Model

8. Internal Dynamics of Cycles • Cycles amplified by internal mechanics • Valuers or surveyors tend to over-price in booms (under-price in downturns) • Pressures by developers to support their decisions based on current values or expected values derived from extrapolating the past • Investment demand/ development via adaptive expectations –> prices beyond fundamentals • Supporting element in this process is akin to a Ponzi scheme in that new investors/developers are attracted by the profits made by first investors

9. continued • Processes can operate in reverse direction • Simplification • Banks financing development also support these processes and display lack of caution in upturns • Arguably a collective under-pricing of risk • Consequences are that construction /development activity at peak of the cycle becomes too “high” and unsustainable • Downturn or slump is also greater

10. Bubble Processes • Mechanisms overshoot price fundamentals -> a bubble • Parallels with bubble processes identified in financial asset markets • Shiller -> bubbles driven by feedback loop theory -> exogenous shocks instigate price increases encouraging further investment demand through adaptive expectations. • Property studies centre on housing - bubble as abnormal • Shiller in the latter sees the bubble as a normal phenomenon/cycle - an exaggerated cycle

11. Argument • Unlike asset bubbles instigated by exogenous shocks property cycles driven by internal lags • Shiller’s model of a bubble incorporating endogenous feedback driven by adaptive expectations = generic ‘cyclical’ model • ‘Barras’ cycle is special case that adds time lags • ‘Bublical’ model is assymetrical • Bubbles are not one off occurrences but are a natural part of property cycles but that the adaptive expectations processes of amplification are greater in the upturn than the downturn

12. Empirical Research • Continuous dynamic price system can be decomposed into a fundamental and bubble component with former present value of future income • Himmelberg et al (2005) approach - examine housing bubbles via a ‘user cost’ approach • Assess whether property is over or under valued • Essentially user cost if a function of the risk free rate of borrowing, expected capital value change (and income growth for commercial property) plus a risk premium • Property taxes etc assumed zero

13. Some detail • Within this framework in long run equilibrium capital value to income ratio should equal the inverse of the user cost, ie initial yield • Dunse et al (2007) model extended - link to real property market via inclusion of key demand variable, finance and business services output • Property markets are taken to be essentially urban with different rent cycles and have different associated risk. • Based on the office markets of British cities over the period 1981- 2006. • City level property data provided by IPD

14. Model • Overall yield model can therefore be rewritten as • IY = f (ΔRRVI, GY, LEP, FBO) • GY = return on long dated gilts and LEP = average yield on the FTSE 100 index, ΔRRVI =current real rental growth • Equation models Barras model although development lags are not explicit, implicit in expected rental growth • Model is extended to include market fundamentals capturing the user market by value of finance and business services output (FBO) • Estimated by panel time series multiple regression in logarithmic form. • Long run adjustment models for the cities

15. Logic of Results • Fundamentals and expectations for yields are captured from the model • Remaining mispricing may be attributed to a ‘bubble’ • Following estimation of this model, fitted values were calculated for each city • Proportionate difference between actual yields in each city and those estimated from model • Greater difference then larger over- or under- pricing of office real estate

16. Percentage Differences between Actual and Estimated Yields for Individual Cities 1981-2006

18. Commentary • Late ‘80s London more susceptible to bubble effects • In latest upturn on par with some of provincial cities and scores substantially lower than Leeds • Clear individual patterns over time presumably reflecting localised demand and supply expectations • Asymmetry in these effects is perhaps less straightforward • Depths of under-pricing generally less than over-pricing for each city • Under-pricing can still be severe, eg 1998

19. Conclusions • Empirical analysis shows substantial and systematic cyclical bubble effects • Prices will always by ‘over-priced’ in a boom and ‘underpriced’ in a bust • Traditional exposition of the property cycle with its time lags needs to be augmented to encompass such effects • Barras property cycle as a special case that adds time lags to a more generic model of cycles centring on adaptive expectation stimulated by external shocks