As the global economy regains momentum following the great financial crisis, commercial real estate markets across the world and global sovereign bonds are once again reporting yields that are near, or even below, record levels. Also echoing trends last seen in 2007, global residential real estate markets, which are rapidly globalising, appear to be increasingly dependent on low interest rates to support valuations. Are we witnessing another bubble?
Real estate market cycles – their causes, consequences and, more controversially, possible cures – are once again in the spotlight. However, asset bubbles are a phenomenon not readily explained by purely rational choice models. To understand and navigate these bubbles, you need to take a closer look at the underlying causes.
Firstly, diagnosis must precede prescription. Economic cycles typically begin following a shock or ‘displacement’ that can occur anywhere in the economy – deregulation of the financial sector, for example, or a new invention, or a change in government policy. The typical role of real estate is then to transmit this shock more broadly across the economy.
The impact is emphasised because real estate is pervasive. In particular, household wealth is heavily exposed to residential markets, and financial institutions’ balance sheets are heavily exposed to commercial and residential markets. So, volatility in real estate markets flows directly through to retail spending, to credit availability and to jobs.
However, the real estate market is inherently cyclical and not all cycles are bad. As real estate is a long-duration asset, conventional indicators of distressed markets, such as high vacancy rates or falling rents, do not necessarily prove that bad decisions have been made. It is the financial payoff over the long term that counts. Long duration leases and complex planning processes delay market adjustments. Similarly, demand for space by tenants can shift quickly, but the supply response of developers is much slower.
What is to be done? A conundrum for regulators is that policies to limit market cycles – higher interest rates, for example – can be more destructive of wealth and economic growth than the disease itself. Every policy option involves costs as well as benefits. We need to know more about the benefits as well as the economic and social costs of market cycles if policy makers are to intervene effectively.
There are three levels of policy response to the problem of cycles:
• Macroeconomic intervention – higher interest rates and measures to limit the growth of credit which is a frequent driver of asset price spirals;
• Macro-prudential strategies – a focus on country and global financial systemic risk rather than the vulnerability of individual banks and other organisations;
• Micro-economic policies – the impact of planning and taxation regimes, policies for dealing with distressed assets, incentive structures that influence fund manager decisions and other drivers of market behaviour at the local level.
However, every policy option comes with health warnings attached.
Macroeconomic policies tend to be broad-brush – taking a hammer to crack a nut is the common metaphor. Higher interest rates may restrain an impending housing market bubble, but at the cost of a slowdown for the entire economy. What’s more, a rise in interest rates may be slow to take effect. Policies to limit real estate cycles may conflict with broader policy objectives such as stimulating economic growth, as is starkly evident in many economies currently.
Macro-prudential policies, like the macroeconomic approach, assume a capability to anticipate market cycles. When a bubble threatens, a range of lean-against-the-wind policies are recommended, including increasing the capital reserves of the banking system. Implementation of stabilisation strategies assume continuous and detailed market monitoring, which in turn imply access to timely and accurate market data.
Microeconomic policies offer a route, if not to eliminate market cycles, at least to reduce their amplitude and limit their costs. More transparent urban planning policies, quicker approval processes, work-outs rather than fire sales for distressed assets and consumer protection laws to limit home mortgage defaults are some of the items on the long check-list of policy suggestions.
It is microeconomic policies that are likely to prove key in battling bubbles. Why did some euro-zone residential markets perform so much better than others post-financial crisis, as indeed was also observed in the US? What explains the differences in behaviour between the Bangalore and Mumbai office markets? These are markets subject to the same broad macroeconomic forces, so their differences must be due to location-specific factors. Evidently, national institutional details matter.
Tempting as it may be to draw general conclusions from the specific events of 2007-08, there is some risk in doing so. We need to make sure we are not planning for the last war. It’s risky to generalise policy prescriptions from a few economies, such as the US and the UK, to all economies. There is no one-size-fits-all solution to the management of real estate market cycles and policy makers, investment bankers, market regulators, academics, as well as real estate professionals, should think about the big picture alongside the small.
David Rees is regional director of research at JLL