a case study
The two greater challenges with forward-looking statements are guesstimating earnings and valuing assets. On this second issue, the real estate market
provides an example. The two most popular approaches with house price valu- ations are:
● Asset pricing, and
● Structural economic model.
Asset pricingcapitalizes on analogical reasoning, that is on the similitude assumed to exist between an equity investment and a house investment (see section 3). This hypothesis about an existing analogy is based on the fact that whether one buys a house or an equity, he or she receives cash flows, respectively:
● Rental, or
● Dividend payment.
As the 20-year trend curves (1984–2004) in the values characterizing UK real estate and equities markets shown in Figure 12.2 document, there is some his- torical basis for such hypothesis. With the exception of the 1995 to 2000 equities bubble, equity prices and house prices tend to move in unison – with the latter trailing the former.
In the opinion of many financial analysts, the price of a house should not be too different from its discounted cash flow, plus a factor accounting for appreciation or depreciation of the asset’s value. These variables are reflected in the following models
(12.1)
where:
Pprice of the house
Rdiscounted cash flow from rent Rggrowth rate of rent(s)
∆Vchange in value of the house Frisk-free rate of interest
Hthe house’s risk premium
Equation (12.1) is the modified version of an algorithm by the European Central Bank (ECB). In ECB’s opinion, favourable financing conditions and expected
(1⫹Rg∆V) (F⫹H⫺Rg) ᎏPR
capital gains in the 2004–5 timeframe seem to have supported strong demand for housing. On the other hand, the rapid pace of increase seen in some countries since the mid 1990s – particularly Ireland, France, and Spain – calls for close monitoring, given the potential implications for these economies and the region as a whole.4
One of the key reasons why central banks are interested in housing prices is that developments in residential property prices are an important factor in the assess- ment of underlying monetary policy decisions aimed at maintaining price sta- bility over the medium term:
● Changes in residential property prices may affect households’ consump- tion behaviour
● Wealth effects are sensitive to paper profits from residential investments.
Moreover, the housing market has a two-way relationship with credit develop- ments: it indirectly affects inflation through an increase in rents, and an avalanche in foreclosures severely tests the financial fabric. One of the nightmares of the
1984 1988 1990 1992 1994 1996 1998 2000 2002 2004 EQUITY
PRICES
HOUSE PRICES
1986
JUST NOTE DIFFERENCE
Figure 12.2 Trend curves in the values characterizing the UK real estate and equities markets
Great Depression of 1929–33 was Sheriff’s sales and home foreclosures. While gov- ernments talk up the merits of an ownership society, and brag that the number of new homeowners is the highest in history, this nightmare might return with a vengeance.
For instance, on 30 May 2005, the Washington Postwrote that there are fears of
‘Depression-era’ numbers of foreclosures in Pennsylvania. A report by the Pennsylvania Banking Department, released in March of that same year, pointed to such fears. This has been a study prompted by the concern that Pennsylvania was ninth among states in the number of foreclosures in 2003, and fourth in the category of subprime loans. The latter are the high-interest, high-risk loans addressed to lower-income borrowers with no good credit standing.
Therefore, given the polyvalence of objectives to be met by marking to model housing prices, prior to discussing how the variables entering into the construct can be estimated, it is important to notice an important limitation of the asset pricing method. Note that this limitation also prevails in many other cases of thinking by analogy.
While both the equity market, as a proxy of asset prices, and the housing market have historical boom–bust cycles, these are not necessarily an image of one another. A recent IMF survey analysed periods of bust in housing and equity mar- kets, reaching the following conclusions:5
● Housing price busts appear less frequently than equity price busts. (This can easily be seen in Figure 12.2).
Housing price peak to trough periods last, on average, longer than equity price busts: 4 years vs 2ẵ years, respectively. Price declines during housing price busts are in the order of around 30% vs 45% for equities. Both statistics are positive for housing. The negative is that, again on average, some 40% of housing price booms are followed by busts; for equities this stands at 25%.
● During housing price busts, bank-based financial systems incur larger losses than market-based financial systems; the opposite is true for equity price busts.
During the post-World War II period, nearly all major banking crises in industrial countries coincided with housing price busts. Moreover, output losses associated with asset price busts have been substantial. The loss incurred during a typical
housing price bust is near to 8% of GDP. The loss associated to equity price busts is roughly 4% of GDP.
Financial analysts are aware of this broader impact and its likely aftermath on the economy. Therefore, they take a close look when confronted with house pric- ing booms, and bubbles likely to lead to subsequent busts. Spikes and/or a steady upward trend in house prices prompt them to look into just where the froth and the risks in the housing market are located.
For instance, a mid-2005 study by Merrill Lynch found that more than half of the top 50 US cities are showing signs of overheating, with housing prices far out- stripping personal income gains. At the top of the list were Miami, New York, Los Angeles, and Denver. Furthermore, as this study indicated:
● The overheated local markets represent such a big slice of economic activ- ity that the growth of the US economy, as a whole, could suffer if the hous- ing market were to falter, and
● It was estimated that GDP growth would be trimmed by one-half of a per- centage point in 2005, and more than a full percentage point in 2006, if house prices were to simply level off.6
The analysts concerns were well-grounded because both in the United States and in the UK increases in real estate wealth have been an important driver of eco- nomic growth in recent years. In America, average house prices have soared by more than 40% since the Fed started cutting interest rates in early 2001; and mid-2004 to mid-2005 home prices have been looking even frothier as yearly growth has accelerated in pace.
● Rising real-estate net worth accounted for 70% of the rise in overall house- hold wealth in the past five years, and
● An increase of 1 dollar in housing wealth boosts consumer spending by 6 cents, an impressive 6% increase.
The Merrill Lynch study concluded that housing wealth has accounted for about
$50 billion a year in US consumer spending over five years, adding about one- half of a percentage point to real GDP each year, on average, since 2000. The bro- kerage firm has developed a housing model using the house price index (HPI), real mortgage rates, real disposable income, and a proxy for the housing stock.
The model shows that, by a wide margin, interest rates are the key factor driving house prices and they have six times more influence on home prices than does income growth.