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Capital and Property Market Bubbles and Crashes V26jan2019 PDF
Capital and Property Market Bubbles and Crashes V26jan2019 PDF
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Contents
◼ Nature of Property and Capital Market
◼ Four-Quadrant Framework
◼ Equilibrium
◼ Disequilibrium
◼ Bubbles and Crashes
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I. Property and Capital Markets
◼ Real estate is a durable capital good.
◼ How are its production and price determined in the asset/capital
market ?
◼ In this market, equilibrium is achieved when
Demand to own real estate assets = Supply.
◼ Price of houses depends on (1) how many households wish to own
units and (2) how many units are available for ownership.
◼ For instance, the value or price of shopping center space depends on how
many investors wish to own such space and how many shopping centers
there are available to investors. (Lecture 1: No. of visitors from Mainland
and the price and rent of retail space.)
◼ Everything else held constant, an increase in the demand to own these
assets will raise prices, while a greater supply of space will decrease price.
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I. Property and Capital Markets
◼ Supply of new real estate assets derives from the construction
sector and depends on the price of those assets relative to the
cost of replacing or constructing them.
◼ In the long run, the asset market should equate market prices
with replacement costs that include the cost of land.
Property Price = Cost of Construction + Land
◼ In the short run, however, the two may diverge significantly
because of the lags and delays that are inherent in the
construction process.
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I. Property and Capital Markets
◼ What are the factors that affect the demand for
ownership in real estate assets to suddenly increase or
decrease??
◼ Are there factors other than simply the price of these
assets?
◼ The answer is yes.
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What is Rent ?
◼ Need to consider the market for the use of
real estate.
◼ In the market for real estate use of space
(usu. Referred to as property market),
demand comes from the occupiers of space,
whether they be tenants, owners, firms, or
households.
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How is Rent Determined
◼ Rent is determined in the “property market” for space use, not in the
“asset market” for ownership.
◼ In the property market, the supply of space is given from the asset
market.
◼ Demand for space depends on rent and other exogenous economic
factors such as firm production levels, income levels, or the number of
households.
◼ Role of the property market is to determine a rent level at which the
demand for space use clears the supply of space.
◼ For example, when the number of households increases or firms
well.
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Contents
◼ Nature of Property and Capital Market
◼ Four-Quadrant Framework
◼ Equilibrium
◼ Disequilibrium
◼ Bubbles and Crashes
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II. Four-Quadrant Framework
◼ What is the linkage between the asset
market and the property market?
◼ William Wheaton of MIT Sloan School of Management
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Quadrant I: Property Market for Rent Determination
Rent $
II. Asset Market: I. Property Market:
Valuation Rent Determination
R*
P = R/i D(R,Economy) = S
P* S*
Price $ Stock (sq m)
S = C/d
P = f(C)
C* DS = C – d S
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Quadrant I: Property Market for Rent Determination
◼ Demand for space as a function of rents, I. Property Market
and the state of the economy.
◼ If the economy changes, then the Rent Determination
entire curve shifts. D(R, Economy) = S
$ Rent R
◼ An upward shift occurs with an
Fixed supply in short run
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demand is not observable but supply is
◼ Regression Model: 𝑆
𝑙𝑛 = 𝑙𝑛 𝛼1 + 𝛽ln(𝑅) + 𝜀
𝐸 sign is not important in regression
◼ E = Office Employment: Persons Employed in
◼ Finance and Insurance,
◼ Import/Export,
◼ Civil Servants
𝑆
𝑙𝑛 = 𝑙𝑛 𝛼1 + 𝛽ln(𝑅) + 𝜀
𝐸
◼ Estimation Results:
Ln(S/E) Coefficients Standard Error t Stat
Intercept a1 1.977 0.028 70.909
Ln(R): b -0.024 0.006 -4.297
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Quadrant II: Asset Market for Valuation
Rent $
II. Asset Market: I. Property Market:
Valuation Rent Determination
P = R/i
i = capitalization rate D(R,Economy) = S
Price $
Stock sq m
S = C/d
P = f(C)
DS = C - dS
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Quadrant II: Asset Market for Valuation
In the property market, the supply of stock is
II. Asset Market
◼
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Components of Capitalization Rate
◼ What are the components that make up the capitalization rate?
higher interest rate, higher cap rate, lower property price
◼ Long-term interest rate in the economy
◼ Expected growth in rent higher growth, lower cap rate, higher property price
higher risk, higher cap rate, lower property price
◼ Risks associated with the rental income stream
◼ Tax treatment of real estate (if any??).
higher tax, higher cap rate, lower property price
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Financial long term: 1 year
short term: 1 cycle (3 months)
Quadrant II: Asset Market for Valuation Economic long term: 20 years
R
◼ Valuation Model: P = ??
i
Private Office Price Index and 12-month HIBOR
16.00 350.0
12.00
Ln(Price) and Ln(12-M HIBOR) = -0.471
250.0
Jul 96-Jun 17
10.00
200.0
8.00
150.0
6.00
100.0
4.00
2.00 50.0
0.00 0.0
May-02
May-09
May-16
Sep-97
Apr-98
Apr-05
Sep-11
Apr-12
Jun-99
Jan-00
Sep-04
Jun-06
Jan-07
Jun-13
Jan-14
Feb-97
Nov-98
Dec-02
Oct-01
Feb-04
Nov-05
Dec-09
Oct-08
Feb-11
Nov-12
Dec-16
Oct-15
Jul-96
Aug-00
Mar-01
Jul-03
Aug-07
Mar-08
Jul-10
Aug-14
Mar-15
12-month HIBOR Overall Price Index
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Quadrant III: Asset Market for Construction
Rent $
II. Asset Market: I. Property Market:
Valuation Rent Determination
P = R/i
D(R,Economy) = S
Price $
Stock sq m
S = C/d
P = f(C)
DS = C - dS
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Quadrant III: Asset Market for Construction
Minimum dollar
◼ Let C be the level of building activity. III. Asset Market value (per unit of
◼ Given the asset price determined in space) required to
get some level of
the asset market, we can now Construction new development
determine the level of construction underway.
as follows: Price $
P = f(C)
◼ f(C) represents the replacement cost P = f(C )
of real estate.
◼ Cost of replacement through new
construction is assumed to increase
with greater building activity (C), and
so the construction curve is pointing
southwesterly. Construction Sq m
◼ If construction can be initiated at any level with almost the same costs, then the curve
will be close to vertical.
◼ On the other hand, supply is inelastic when there are construction bottlenecks, land is
scarce, and there are other impediments to development.
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Quadrant III: Asset Market for Construction
◼ Let C be the level of construction activity.
◼ Office Construction rate is given by:
𝐶
= 𝛼2 × 𝑃𝛽2
𝑆
◼ P = Asset Price per square meter
◼ [“Q”theory?]
◼ 𝛽2 = Price elasticity of supply:
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Quadrant III: Asset Market for Construction
𝐶
𝐶𝑜𝑛𝑠𝑡𝑟𝑢𝑐𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑒 = = 𝛼2 × 𝑃𝛽2
𝑆
◼ Regression 𝐶
𝑙𝑛 = 𝑙𝑛 𝛼2 + 𝛽2 ln(𝑃) + 𝜀
Model 𝑆
◼ Estimation Results (1985-2016):
Ln(S/E) Coefficients Standard Error t Stat
Intercept a2 -8.239 2.622 -3.142
Ln(R): b 0.473 0.247 1.916
𝐶
𝐶𝑜𝑛𝑠𝑡𝑟𝑢𝑐𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑒 = = 0.000264 × 𝑃0.473
𝑆
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Quadrant IV: Property Market for Stock Adjustment
Rent $
II. Asset Market: I. Property Market:
Valuation Rent Determination
P = R/i
D(R,Economy) = S
Price $
Stock sq m
S = C/d
P = f(C)
DS = C - dS
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Quadrant IV: Property Market for Stock Adjustment
◼ In the property market for stock adjustment,
the annual flow of new construction, C, is IV. Property Market
converted into a long-run stock of real estate
space. Stock Adjustment
◼ The change in the stock, DS, in a given period
Stock Sq m
is equal to new construction minus losses
from the stock measured by the depreciation
(removal) rate, d:
DS = C - d S
◼ The curve in this quadrant represents the
level of stock (on the horizontal axis) that 𝐶
requires an annual level of construction for 𝑆=
replacement just equal to that value on the 𝛿
vertical axis. ∆𝑆 = 𝐶 − 𝛿𝑆
◼ At that level of stock and the corresponding
level of construction, the stock of space will
be constant over time, since depreciation will
equal new completions. Therefore, Construction sq m
6.0%
𝛿= − 3.00%
Depreciation
𝑆 𝑆
4.0% 2.00%
1.00%
2.0%
0.00%
0.0%
-1.00%
1988
1986
1987
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
-2.0% -2.00%
C/S CHG in S/S delta
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Modeling the Property and Asset markets
𝐶
◼ Asset Market for Construction = 𝛼2 × 𝑃𝛽2
𝑆
𝐶𝑜𝑛𝑠𝑡𝑟𝑢𝑐𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑒 = 0.000264 × 𝑃0.473
∆𝑆 𝐶
◼ Stock Adjustment for Office Space = −𝛿
𝑆 𝑆
∆𝑆 = 𝐶 − 0.43% × 𝑆
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Quadrant I: Property Market for Rent Determination
Rent $
II. Asset Market: I. Property Market:
Valuation Rent Determination
R* Demand =
P = R/i
7.221 × 𝐸 × 𝑅−0.024
P* S*
Price $ Stock (sq m)
C*
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IV. Equilibrium Rent $
II. Asset Market: I. Property Market:
Valuation Rent Determination
D(R, Economy) = S
P = R/i
Price $ Stock sq m
S = C/d
P = f(C) DS = C - dS
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V. Disequilibrium
Rent $ I. Property Market:
II. Asset Market:
Rent Determination
Valuation
D(R,Economy) = S
P = R/i
Price $ Stock sq m
S = C/d
P = f(C)
DS = C - dS
Price $ Stock sq m
S = C/d
P = f(C)
DS = C - dS
◼ If the starting stock is less than the finishing stock, then rents,
prices, and construction must decrease to be in equilibrium.
◼ If the starting stock level exceeds the ending level, then rents,
prices, and construction must all rise to be in equilibrium.
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Effects of Exogenous Shocks
◼ Exogenous shocks to property market can have different impacts
on the operation of the real estate market than exogenous shocks
to the asset market.
◼ An increase in demand for space in the property market shifts
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Contents
◼ Nature of Property and Capital Market
◼ Four-Quadrant Framework
◼ Equilibrium
◼ Disequilibrium
◼ Bubbles and Crashes
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Bubbles
◼ Bubbles have violent collapses.
◼ They can lead to distortions in resource allocation.
◼ They may be associated with financial collapses.
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What is bubble
◼ A bubble is a situation where asset prices move
because they are expected to move.
◼ In a bubble the price moves away from fundamentals
based solely on expectations of further movements.
◼ Expectations become self-confirming.
◼ Examples abound….
◼ housing bubble, telecoms bubble, tulipmania,
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Example: Japan Stock Price Bubble 1985-1991
Nikkei 225
45000
40000
35000
30000
25000
20000
15000
10000
5000
0
1970 1975 1980 1985 1990 1995 2000 2005
◼ The Japanese asset price bubble was an economic bubble from 1986 to 1991 with
real estate and stock prices greatly inflated. The bubble's subsequent collapse lasted
for more than a decade with stock prices initially bottoming in 2003, although they
would descend even further amidst the global financial crisis in 2008. The Japanese
asset price bubble contributed to what some refer to as the Lost Decade. Economist
Paul Krugman has argued that Japan fell into a liquidity trap during these years.
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Example: Nasdaq Bubble 1999-2000
• Between 1999 and early 2000, the U.S. Federal Reserve
increased interest rates six times:
• The economy began to lose speed.
• The dot-com bubble burst on Friday, March 10, 2000, when
the technology heavy NASDAQ Composite index, peaked at
5,048.62 (intra-day peak 5,132.52), more than double its
value just a year before.
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Post-Crisis Property Market in Hong Kong
Price and Rental Index (All Classes): 1999 Price Level
350.0
100.0
50.0
0.0
95Q2
01Q2
07Q2
13Q2
93Q1
93Q4
94Q3
96Q1
96Q4
97Q3
98Q2
99Q1
99Q4
00Q3
02Q1
02Q4
03Q3
04Q2
05Q1
05Q4
06Q3
08Q1
08Q4
09Q3
10Q2
11Q1
11Q4
12Q3
14Q1
14Q4
15Q3
16Q2
Price Index (All) Rental Index (All)
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What is bubble
◼ Bubbles
◼ Where do they come from? What to do about
them?
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Bubbles
◼ Two broad (and polar) views:
◼ There is a shortage of store of value — bubbles
behavioral problem).
are present.
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Rational Bubble
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Rational Bubble
◼ Irrational bubbles then involve unrealistic expectations
about asset’s future prospects
◼ fad
◼ mania
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Rational Bubble—Simple Characterization
◼ Let vt be the property price; suppose fundamentals
imply that vt = v* for all t.
◼ At some time t0 the price jumps by a bubble b0 to v0
◼ suppose agents expect Dvt = 1 + r in each future
period t.
◼ i.e., bt = b0(1 + r)
t for arbitrary b . See Figure.
0
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Rational Bubble—Simple Characterization
◼ Why are agents/investors willing to pay increasing prices
for the property?
◼ expected capital gains are self-fulfilling -- this is a
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Rational Bubble—Simple Characterization
◼ A bubble in housing market
If everyone knew that at period T + j that the bubble would burst
(v -- > v* or bt -- > 0), then no one would pay the bubble price at T + j - 1.
The bubble unravels.
v bt = b0(1+r)t
V0 = v* + b0
v*
t0 T+j Time
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Rational Bubble—Simple Characterization
◼ Since prices cannot rise forever, are bubbles ruled out?
◼ No, as long as the date of price collapse is uncertain!
v bt = b0(1+r)t
V0 = v* + b0
v*
t0 T+j Time
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Stochastic Rational Bubble*
◼ Since prices cannot rise forever, are bubbles ruled out?
◼ no, as long as the date of price collapse is uncertain
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Stochastic Rational Bubble
◼ Since prices cannot rise forever, are bubbles ruled out?
◼ no, as long as the date of price collapse is uncertain
rate, and if you know v*, then you can calculate bt = vt - v*.
◼ If the bubble has not burst yet then
(1 + 𝑟)𝑏𝑡 (1 + 𝑟)𝑏𝑡
𝑏𝑡+1 = →𝑞=
𝑞 𝑏𝑡+1
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Stochastic Rational Bubble
◼ If the bubble has not burst yet, then
(1 + 𝑟)𝑏𝑡 (1 + 𝑟)𝑏𝑡
𝑏𝑡+1 = →𝑞=
𝑞 𝑏𝑡+1
◼ This probability can be then compared to the amount of time the
bubble has been growing.
◼ This notion of a rational bubble is used frequently in analysis
of asset markets.
◼ (e.g. CNN also reports the probability that the FED will raise
19872 20667
20000
15000
10000
5000
0
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
◼ What is the maximum home price the household can afford in 2012?
◼ Based on the median household income and the mortgage terms, the
maximum mortgage an average household can borrow is determined
as follows:
◼ Mortgage Loan =
−12𝑛 −12𝑛
1 − 1 + 𝑟/12 20667 1 − 1 + 2.5%/12
𝑃𝑀𝑇 =
𝑟/12 3 2.5%/12
= 1,300,042
◼ Affordable home price = HK$ 1,300,042/0.7 = HK$ 1,857,203
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Stochastic Rational Bubble
Property Price:
Class A Residential (40 square meters)
$3,500,000 3224262.8
Afforable Price
2931148
$3,000,000
Actual Price
Size of
$2,500,000
Bubble
$2,000,000 $1,857,203
$1,857,203
$1,500,000
$1,000,000
$500,000
$0
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
◼ Affordable Property Price is calculated based on 1/3 of median household
income, 20 year mortgage, 5% minus 2.5% mortgage rate, and 30% down
payment.
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Stochastic Rational Bubble
Property Price:
Class A Residential (40 square meters)
$3,500,000 3224262.8
What is the Afforable Price
2931148
$3,000,000
market Actual Price
expectation $2,500,000
that property
price will fall $2,000,000 $1,857,203
to the $1,857,203
$1,500,000
affordable
negative bubble
price level? $1,000,000
b2012 = 2931148 – 1857203 = 1073945
$500,000 b2013 = 3224262 – 1857203 = 1367060
Mortgage rate = 2.5%
$0
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
market 2931148
$3,000,000
Actual Price
expectation
that the $2,500,000
property price $1,857,203
$2,000,000
bubble will
burst within $1,500,000 $1,857,203
the next 5
years? $1,000,000
$500,000
(1 + 𝑟)𝑏2012 1.025 × 1073945
𝑞= = = 0.805
𝑏2013 1367060
$0
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
• Probability that the price bubble will NOT burst at the end of 5 years is
(0.805)5 = 0.339
• Probability it will burst within the next 5 years is 66.1%
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Stochastic Rational Bubble: Implications
◼ Fact that bubble has to grow at an expected rate of r allows
one to eliminate many potential rational bubbles.
◼ commodities with close substitutes puts limits
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End
◼ What is bubble?
◼ Are bubbles irrational?
◼ Causes and consequences of bubble
◼ Is Hong Kong Property Market a bubble?
◼ Reference:
◼ “Supply Adjustments to Demand Shocks in the
Commercial Real Estate Market”; by George Lentz
and K. S. Maurice Tse, Real Estate Economics, 1999
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