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The Future of Global Real
Estate Investment: Back to
Basics or Fundamentals
Professor Jarjisu Sa-Aadu
Chester A. Phillips Professor of Finance and Real
Estate &
Associate Dean of Tippie School of Management
University of Iowa
Outline of Presentation
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Brief overview of the on-going economic and financial
crises
The magnitude and duration of house price cycles
The link of house price cycle with overall business cycle
House prices and economic fundaments
The Great Moderation
Future prospects for real estate investments
China and Taiwan Free Trade Concept: The Economic Cooperation Framework Agreement (ECFA)
Current Sage: Don’t Worry be Happy;
the Sky is not Falling
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“All that said, given the fundamental factors in place that
should support the demand for housing, [we] believe the
effect of the troubles in the subprime sector on the
broader housing market will likely be limited, and [we] do
not expect significant spillovers from the subprime market
to the rest of the economy or to the financial system”
Ben Bernanke, May 17, 2007, Federal Reserve Bank of Chicago,
43rd Annual Conference on Bank Structure and Competition,
Chicago, Illinois
Some Perspectives on Global House Price
Boom-Bust and the Global Financial Crisis
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The global house price boom that started in the late 1990s
and burst in late 2006 is unique in its perspective
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It was worldwide in nature and there appears to be no prior
example of such dramatic boom occurring in so many countries
(advanced and emerging) concurrently
It was preceded by “democratization of credit” and unprecedented
borrowing by companies and households alike
Largest and most important financial institutions either declared
bankruptcy or rescued financially
It defies explanation based on rational markets and economic
fundamentals alone
Despite coordinated easing of monetary policy by governments,
trillions of dollars in intervention by central banks and governments,
and large fiscal stimulus packages, the crises appear not over
Exhibit 1: Origins of the Global Financial Crisis: The Rise and Fall of Risky Debt
3
5
4
*
*
“Global Excess
Liquidity & Yield
Chasing”
House Price
Boom
2
7
6
*
Global Financial
& Economic Crisis
House Price Bust
1997-98 Asian Financial
Crisis
1**
***
Source: Congressional Research Service
The Magnitude and Duration
of House price Cycles
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The house price boom started in the late 1990s
and ended with a bust in 2006 was global in nature
– See Exhibit 2
Started in US and other industrialized countries but
quickly spread to emerging economies
House prices started to fall in June 2006 in the US
and spread around the globe – see Exhibits 3 & 4
The boom-bust cycle is generally viewed as major
catalyst for the global financial crisis
Exhibit 2: The Global Boom and Bust in House Prices
(and deterioration and other credit markets)
Exhibit 3: The History of U.S. Housing Boom-Bust
$199,000
(2006)
$100,000
(1890)
Note: Over the long run the distinctive
feature of US house prices has been
the cycles rather than the trend
$66,000
(1920)
Exhibit 4: The Inevitable and Dramatic Decline in House Prices
“The Faster they Rise the Harder they Fall”
…… SUSTAINABLE
(12)
3
The Magnitude and Duration of House
Price Cycles: What Amplitude?
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Exhibit 5 puts the recent run-up in house prices in
perspective by comparing it with previous cycle
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The rise in house prices from 1970- mid 1990s in 18 OECD
economies lasted just over 5 years, and real house prices
increased by +40%
The subsequent downturn lasted about 4.5 years and house
prices fell about -20%
In contrast the recent rise in house price in the same 18
OECD countries lasted twice as much (10.25 years) and
house prices rose by almost three times (or 114% real terms)
– See Exhibit 5
Exhibit 5: The House Price Cycle (upturn and downturn from 18
advanced economies1)
UP-TURN
DOWN-TURN
Cycle
Duration
Price Swing2 Duration
Price swing3
1970-mid-1990s
21 quarters +40 percent 18 quarters -22 percent
Mid-1990-present 41 quarters +114
13 quarters -15 percent
1. The upturn in house prices in 18 advanced economies that started in the mid 19902 and continued
for a decade eclipsed that of earlier cycles. The downturn began three years a go and it continues. The
18 countries are: Australia, Canada, Denmark, Finland, France, Germany, Ireland, Italy, Japan,
Korea, Netherlands, New Zealand, Norway, Spain, Sweden, UK and USA
2. Real Prices from trough to peak
3. Real Prices from peak to trough
Source: Prakash Loungani 2010 Housing Prices, Finance and Development
Record decline in annual rate of return of -19.1% in 2009Q1
Exhibit 6:
Peak 2006Q4
Index value at peak 2006Q4 = 186.91
Index value at trough 2009Q1=130.46
=-56.45 points
=+106.68
January 2000 Base index = 100
Index value at start of run-up in prices 1996Q1 = 80.23
Exhibit 7: Behavior of House Prices in the Current and Previous Housing
Episodes
Panel A: Real Terms
Time window
Real House Price
Beg
Index Value
End
Real House Price Return
HPI σreturn
Episode 1
Boom
Bust
[1988:1[1990:11989:4]
1991:4]
60.74
65.20
65.20
56.43
7.34%
-13.45%
0.417%
0.587%
Episode 2
Boom
Bust
[2004:3[2006:32006:2]
2008:2]
95.00
112.08
112.08
82.97
17.98%
-25.97%
0.596%
0.948%
Panel B: Nominal Terms
Episode 1
Time window
House Price
Beg
Index Value
End
Index Change
House Price Return
HPI σreturn
rf
Sharpe Ratio
Boom
[1988:11989:4]
70.22
82.35
12.13
17.27%
0.437%
7.206%
23.030
Episode 2
Bust
[1990:11991:4]
82.35
77.99
-4.36
-5.29%
0.548%
6.410%
-21.350
Boom
[2004:32006:2]
179.45
226.29
46.84
21.07%
0.504%
2.954%
35.944
Bust
[2006:32008:2]
226.29
180.38
-45.91
-20.29%
0.833%
3.892%
-29.030
Driving Forces Behind House Price Cycles:
Why do house prices go through cycles?
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The on-going downturn in house prices is nearing the past
downturn in both duration and amplitude
It is likely the price declines will eclipse that of the past
episode, because prices rose much more and sharply
So why do house prices go through cycles?
Long-run equilibrium relationship view
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In the long run house prices, rent and income should move together
When prices and rent get outline with each other households will
switch between owning and renting – See Exhibit 8
Likewise in the long run house prices can not stray far away from
peoples’ income (affordability problems) – see Exhibit 8
Exhibit 8: Evidence of Long-run Equilibrium Relationship in house prices
With rents and income in the USA and UK
Ratio of house prices to rent reverted to
long-run average 4 times from 1970 -2000
Ratio of house prices to income hovered its long
-run average fives times between 1970-2000 in UK
The Short Run View of House Price
Cycles – drift from the fundamentals
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In short run house prices do drift from the long run
equilibrium (or the fundamentals) for various
reasons
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Strong demand momentum leads to increase in house
prices, often not fully explained by the fundamentals
The Case of Ireland
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Robust income growth between 1992-2006
Population also grew after 1992
House prices grew nearly 20% per year in the same period (10
times the previous decade)
Other factors: (1) Supply lag, (2) housing and financial
markets – feedback effect, (3) psychological and social
factors
Exhibit 9: The Rise in US House Prices and Fundamentals
DID THE FUNDAMENTALS SUPPORT THE HUGE RUN-UP IN PRICES?
Exhibit 10: US House Price Boom and GDP Growth
The Recent House price Boom Seemed Out of Step with Real Economic
Activity
So Where are We in the
House Price Cycle?
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House prices in the US fell about 30% from 2007 to 2009
They fell an average of 5% in real terms between 4th Q of 2007 and 3rd
Q of 2009 in 18 OECD countries
HOW LONG CAN PRICES GO DOWN?
 In most countries house prices are well above their levels at the
beginning of upturn in early 2000
 In many countries house price to rent and income ratios are still
above the long-run equilibrium relationship, suggested by theory
 There is evidence that the increase in house prices between 20002006 cannot be fully explained by short-run driving forces or longrun relationships (behavior of the fundamentals)
 Lastly, the current house price boom was strikingly out of step with
business cycle or output growth
The above four points suggest more price correction ahead
Exhibit 11: How Much do House Prices Need to Fall?
INCREASED
AFFORDABILITY
CHEAP
Exhibit 12: MORE PRICE CORRECTION NEEDED FOR THE FROTHEIST HOUSING
MARKETS
Are we near the bottom of the
House Price Cycles?
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At this point the correction has not thus far eliminated the
excess in house prices that occurred over 2000-2006
Exhibit 11 shows how much the ratio of house price to rent
and income in each of 18 OECD countries would have to
fall to bring it down to its long-run equilibrium
Hence the conclusion is that global housing markets have
not bottom out yet
However on both ratios the USA appears to be in much
better situation than most OECD countries
But real estate investment (housing) like politics, is always
local
The Rise of China’s Property
Markets
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The boom in property markets continues unabated (See Exhibit 13)
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1.87 billion square meters of living space under construction as of 1st
quarter 2010
Bank have expanded mortgage lending
About 10% of China’s GDP is now in real estate
House prices in 70 Chinese cities rose roughly 13% year to April 2010
Total sales value of homes (72.4m squares meters) in April 2010 was about
US$56.3 billion
Mortgage borrowing is increasing (See Exhibit 14)
Attempting to slow the party
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Restriction of housing speculation
Raising down-payment
Raising interest mortgage rates
Limitation of number of house purchase in Beijing
Exhibit 13: The Downturn in Chinese Housing Appears Over
Exhibit 14: Mortgage Utilization is Growing in China ( mortgage ratio to GDP is
still low, 15.3% compared to 79% for USA)
The Great Moderation
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One of the most remarkable features of past two decades
or so was the substantial decline in macroeconomic
volatility
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The volatility of quarterly growth in real GDP and quarterly inflation
have in most industrialized countries have declined since mid 1980s,
with the exception of Japan
This twin growth and stability has been dubbed the Great
Moderation
The global prosperity (rise in output, house prices and
wealth), have all occurred during this period
Going forward the future prospects of real estate
investment (all investments) may hinge on the repeat of
this phenomenon
What Caused the Great
Moderation?
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Three classes of explanations have been proposed
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Structural changes in the economy
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Improved performance of macroeconomic policies
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Technological innovations
Improved management of inventory (supply chain)
Financial markets innovations
Increased openness to trade & international capital flows
Monetary policy
Plain Good Luck
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Economic shocks to countries became small and infrequent
Exhibit 15: The Quarterly Variability of US Output Growth Rate 1966 to 2010
Exhibit 16: Quarterly Variability of US Inflation 1966 to 2010
Future Investment Prospects:
Some Key Factors to Consider
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1. Great Moderation: Is it due to (a) Structural
Changes, (b) Good Monetary Policy, or (c) Pure
good luck will hold
2. The level debt
3. Wealth Effect
4. Trade and oil surpluses
5. The health of banks
6. Demographic Changes
The Debt Hangover
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The rise in debt levels accompanied the Great
Moderation
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Debt increased at all levels: consumers, households,
companies, banks, whole countries (national debt)
In 10 matured economies private and public sector debt
rose from average 20% of GDP in 1995 to 300% in
2008 (see Exhibit 17)
In general the Asian countries (China, India, Korea,
Taiwan) are less indebted.
China and oil exporters built huge current-account
surplus which was lent to current-account deficit
western countries to buy more of their goods
Exhibit 17: The Debtor Nations and Creditor Nations
Exhibit 18: Significant Foreign Ownership of US Debt Obligations
Exhibit 19
: Banks with Biggest Profits and Banks with Biggest Losses
The Economic Cooperation Framework
Agreement (ECFA) between China and
Taiwan
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What is the objective of ECPA?
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Promote and normalize economic relationship between
China and Taiwan
Internationalization of Taiwan’s economic relationship
Initial steps – early harvest
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Elimination of trade tariffs on 539 export items from
Taiwan by China worth US$13.8 billion
Elimination of trade tariffs by Taiwan on 267 China
export items to Taiwan worth an estimated US$2.9
billion
Exhibit 20: Taiwan’s Trade with China
Perceived Impact of ECPA on
Real Estate Investment
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Capital flow from China into Taiwan and vice versa
 Reduction in cost of capital
Investment in tourism-related real estate
 Hotels and Motels
 Restaurants
 Retail Shops
Increased ability of Taiwanese banks to participate in
Chinese service sectors including banking
Participation infrastructure developments by Taiwanese
companies
The Investment Clock Cycle
for Real Estate
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The investment clock or the economist clock was first published in
London in 1937
It is based on well known phenomenon that major business cycles
occur roughly every decade
It depicts the movement of markets within this longer-term cycle
It is suppose to assist with timing major market moves
As shown in Exhibit 20 the progression of economic cycle through
time with 12 o’clock representing the boom down to 6 o’clock
repression the depth of recession (bust)
Real estate investment is at its most dangerous phase in terms of
liquidity when the cycle enters the credit squeeze mode
Exhibit 21: The Investment (or Business) Cycle Clock for
Real Estate – Where do you think we are on the cycle clock?