A bubble about to burst? The Spanish Real Estate Market

Contents

1. Introduction

2. Real Estate Markets & Price Bubbles

3. Demand and Price Evolution for Spanish Real Estate

4. Conclusion

A. Figures & Tables

1. Introduction

When real estate prices in Spain rose roughly around 160 per cent in the period of 1998 until 2004 [GVM05, S. 9] the country ultimately joined the group of economies currently perceived to be threatened by a real estate bubble. Comparing the increases of home prices from 1997 until 2005 places Spain third behind Ireland and Britain which experienced a similar surge in house prices¹. [Eco05] Curently property bubbles receive a good deal of attention since major economies like the USA and UK all appear to be threatened by this process.

This paper discusses the phenomenon of asset bubbles with an application to the Spanish real estate market. It is organized as follows: The rst section provides a brief introduction into the subject. It rstly discusses some mechanism of property markets and determinants of asset bubbles. For further clari cation it secondly refers to some countries which experienced similar processes and respective causes for their bubbles. To wind up the introductory part section 1 brie y also mentions potential threats of price bubbles.

Section 2 carries out an analysis of the Spanish real estate market in order to identify possible drivers of demand. It also illustrates some similarities with countries which have in fact experi- enced a (bursting) price bubble in the past. The section concludes with an evaluation whether or not Spain's real estate market is indeed su ering from a bubble. Theoretical ndings will be supported by data supplied by the Spanish Housing Ministry.²

2. Real Estate Markets & Price Bubbles

This chapter will re ect on theories about the catalysts and mechanisms of real estate markets and asset bubbles. To clarify the introduced concepts additional examples from past bubbles in di erent countries will be provided.

Characteristics of property markets

Rampant house prices are a result of growing demand. In many cases they are commonly also associated with housing bubbles. However when is it accurate to describe a commodity like o ce space or ats as overpriced and therefore its market in ated? Since price levels depend on supply and demand a concise search of price bubbles in the housing market should embark on two aspects: 1. What is causing an adjustment in demand and therefore price uctuations? and 2. Is the reaction of prices reasonable? i.e. their upward tendency is solely caused by present or future scarcity of supply. Any residual increment left unexplained might suggest the existence of a bubble. Prices (and overpricing) on the housing market are however notoriously hard to assess: This is mainly due to the great heterogeneity of the goods traded and the mass of additional price determinants such as neighbourhood, bay view etc.

Another particularity which distinguishes the housing market from just any other commodity market is the existence of a time lag between demand and supply. In case of a surge in property demand supply tends to respond with a certain amount of sluggishness. [TZ04, p. 68] Since the search for suitable land and construction requires time the moment in which all demand for property will be met is usually delayed. In the meantime residual demand generates upward pressure on property prices causing them to "over-react". [dM04, p. 4] The next paragraph analysis some causes of demand.

Given the nancial constrains individuals tend to face when nancing a house, external funding plays an important role.¹ Thus the potential costs of taking out a mortage can in uence the decision to carry out a real estate purchase. Demand (and thus prices) of property are therefore directly correlated to interest rates. [TZ04, p. 68]

As [Ren97, p. 16 .] highlights, in 1985 the costs of credit in Japan dropped considerable when the Central Bank lowered rates to as low as 2.5 per cent.² Cheap credit triggered real estate investments: The share of capital destined for property investments hiked from 7 to 17 per cent of total credit. "Inelastic urban land supply" in the presence of a soaring real estate sector boosted land prices. Consequently companies with land holdings (gaining in value) were able to borrow yet greater amounts of capital for further property investments. Thus an asset bubble was fuelled in parallel to land price in ation. Easier access to credit also triggered additional capital out ows into the real estate markets overseas. [Ren97, p. 18]

Nordic countries made similar experiences upon transforming their banking system from be- ing one of the most "tightly regulated" in the 1980s [Ren97, p. 22] to a more liberal design. In addition [San04, p. 81] writes that the Scandinavian tax system even encouraged borrowing by making interest payments deductible from taxable income. (see also [DP95, p. 28].) Addition- ally thanks to in ation the real cost of borrowing was very low or even negative. All Nordic countries experienced a drastic expansion of loans in relation to GDP.³ As observed in the case of Japan property prices in the Nordic countries skyrocketed as a consequence⁴. In ation might also provide additional motivation to engage in real estate purchases. As [TZ04, p. 75] write individuals can invest their money into property to avoid erosion of their wealth by in ation.

The mechanisms of property bubbles

A price bubble occurs when unrealistic expectations about future demand (i.e. its determinants) start to pose considerable in uence on present prices. According to [AG99, p. 13 .] speculation about the future adds supplemental momentum to the actual costs of buying property. As an illustration the authors exemplify that overly con dent speculation about both future credit and demand expansion⁵ and consequently higher future property prices can send present on an unreasonable skyward drift. A bubble is consequently the result of unrealistic expectations.

Concerning the assessment of overvaluation [Eco05] suggests a growing divergence between house prices and rents as an indicator for overvalued real estate prices. Buying a house can be understood as an investment project. House prices should therefore re ect the discounted future earnings of the prospective owner in form of rental income or saved rent payments. Rising house prices in relation to rents or better said price-earnings-ratios -as those calculated by The Economist therefore indicate that expectations about future asset prices might have lost touch with reality. Countries home to asset speculation will often also feature an increasing stock of vacant property waiting for the next alleged surge in demand.

Aside from the fact that property bubbles pose nancial hardship on anyone trying to buy a house, they imply additional problems at the macroeconomic level. In ated house prices are after all a bet about future price increases. If prospects for such an event suddenly turn dim house prices will drop. Causes for such a change in perception can be manifold: As [AG99, p. 13] explains bubbles are generally burst by a shock in icted upon the economy.

In the case of Japan the shock was of nancial nature when the Central Bank sought to cut back liquidity in an attempt to correct the price bubble.⁶ As a consequence the Japanese economy experienced the "dual burden of the decline in consumption linked to asset de ation and the credit crunch linked to a weakened banking system's inability to lend." Norway on the other hand experienced a real shock when oil prices collapsed in 1986 sending economy and demand for property downwards. Its neighbours Sweden and Finland made similar experiences when monetary conditions tightened up as central banks began to ght in ation. [HO98, p. 112 .]

As seen in the case of Japan and Scandinavia a sudden drop of asset value tends to cause repercussions for the entire economy: Soaring house prices also work their way into the de- mand function of households through a so-called wealth e ect. In some cases owners of value- increasing property are able to borrow against the appreciation of their house price. [Mon03, p. 40] In economies where this is very habitual (like the US) falling property value is likely to curtail demand and foster loan default.

In many countries the construction sector also su ers hard when property bubbles burst after several years of seemingly endless expansion.

Housing bubbles are therefore no direct indicator of an upcoming economic crisis. They are however proof that an important market in the economy is overheating which most certainly will aggravate conditions in the presence of economic slowdown.

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¹ For additional comparison refer to gure A.1 on page 14.

² Ministerio de Vivienda, www.mviv.es/es/

¹ As [MMS98, p. 56] illustrate real estate also constitutes an important factor for the economy as a whole,since "Residential investments usually comprises around a fth of gross domestic capital formation", the construction sector provides about 5 10% of European employment and "housing expenditure, except in the Mediterranean area, typically compromise 5 10% of total public expenditure. (or 1 4% of GDP)"

² The drop in the interest rate was induced by the 1985 Plaza Accord, among other measures such as Dollar Yen exchange rate stabilization.

³ Norway: from 40% in 1984 to 68% in 1988, Finland: from 55% in 1984 to 90% in 1990

⁴ According to [HO98, p. 113] real house prices increased roughly 50% in Finland, 44.4% in Norway and 37.2% in Sweden. After their peak prices declined 50.1%, 36.6% and 26.7% respectively.

⁵ Taking into account the above introduced relation between credit availability and real estate demand, expected future credit growth for real estate traders logically implies a boost of future demand for property. This will push up expected future prices and discounted present value.

⁶ These de ationary policies especially included reducing credit for the real estate sector and raising the discount rate from 2.5% to 6.0% by the end of 1990.