Saturday, December 23, 2006

Attention: Real Estate Speculators in India

Here's a Lesson from Hong Kong's Housing Bubble. This article was written by Grace Wong, Professor of real estate in Wharton University. It was originally published on May 18, 2005. It is more relevant to current market conditions in Indian Real Estate.

Whenever housing prices soar -- in Shanghai, San Francisco or Santiago -- experts wonder whether the cause is a speculative bubble that could eventually burst, causing widespread distress. Such frenzied swings are not confined to real estate alone, of course, as any investor who lost his shirt during the dot-com mania of the 1990s knows. What causes such bubbles? Is there a way of spotting them while the bubble is actually being formed -- rather than after the fact? A new research paper that examines volatility in Hong Kong's residential market between 1992 and 1997 offers interesting insights into these questions.

In "The Anatomy of a Housing Bubble" Grace Wong offers ways to spot future real estate bubbles in time to introduce corrective measures before the damage takes its toll. Wong's research explores the Hong Kong housing market, which saw a "real increase" in prices of 50% from 1995 to 1997, followed by a "real decrease" of 57% from 1997 to 2002. (Real increases and decreases refer to changes adjusted for inflation.) Transaction volumes, too, rose dramatically from 68,000 in 1995 to more than 172,000 in 1997, but fell to 85,000 the following year.

Wong says the movements in the underlying market and macro-economic fundamentals in Hong Kong during the period studied do not fully justify the dramatic price upswing or the changes in the volume of trading in homes. She says her study offers "a potentially powerful tool" to define, track and look for evidence of speculative activity in the housing markets. "My paper can be used as a diagnostic tool and not after the fact. We can track these movements when a price upswing is actually happening." That ability, she says, will arm policy makers, developers and others in the housing market to reassess their plans much before a bubble bursts. Central banks also could use such real-time market analysis to check for any wanton speculation in the housing market, and intervene with monetary policies like interest rate changes.

So how exactly does the diagnostic tool work? "When there are speculative activities in the asset market, we should see an increase in transaction volume as well," explains Wong. "This positive relationship between turnover and price should be on the top of any positive relationship implied by other theories such as liquidity premium (which states that as assets are traded more liquidly, prices go up.) What I did was make use of a unique data structure that allowed me to separate these stories apart and provide evidence on whether there is speculation." Wong cautions, though, that like other diagnostic tools, this one is probably not perfect.

"The interesting thing is, the bubble grows as speculative activities build up," Wong notes. "There is likely to be some speculative demand in the market at all times, but bubbles form only when there is substantial speculation. What we can do is to keep track of changes in turnover volume, separate increases in turnover due to speculation and those due to other factors, and therefore get a sense of how much speculation there is. When there is a frenzy of trading, a red flag should be raised and we should take a careful look at the fundamentals (which are difficult to measure) and housing prices."

Hong Kong is a suitable setting to draw lessons for markets elsewhere in the world, Wong says, for several reasons. It is a metropolitan city much like other major world cities, and its 1,102 square kilometers is about six times the size of Washington, D.C. It has home ownership rates of about 50% and well developed capital markets. The city's large-scale housing complexes allow researchers to work with an empirical framework; that would be more difficult in other situations with low transaction volumes and housing units that are not comparable.

For all the different components of her study, Wong uses a sample size of at least 200 large-scale housing complexes, called estates in Hong Kong. That sample increases to cover data representing up to 320 complexes in select cases. About half the roughly 2.3 million housing units in Hong Kong are provided by the public sector, and most are rental units. Wong's focus is primarily on the other half that are privately owned. The average Hong Kong estate has these characteristics: It is 18 years old and has 291 apartment sizes averaging 590 sq. ft. each. Wong's study reveals that average home prices rose from U.S. $767 a sq. ft., adjusted for inflation, in the pre-upswing period (July 1993-June 1995) to $992 in the post-upswing period (October 1995 October to September 1997).

Wong's choice of the data sample and methodology helped her overcome some challenges that have typically dogged similar studies. She notes that from the Tulip Craze in the Netherlands in the 17th century to the technology stock bubble of the late 1990s, asset pricing models have been questioned. Also, there has been limited literature on speculation in markets because of the difficulties in measuring the fundamental value of assets. Wong was also confronted with the peculiarities of her target markets: housing stock is heterogeneous; transaction frequency is typically low; and location and local institutions play a significant role -- such as in specifying zoning laws -- in determining values.

Wong was able to overcome those obstacles by conducting a "within-city" analysis, using data sets covering 200-plus Hong Kong estates. But before arriving at that sample, Wong started out with raw transaction data for all real estate transactions in Hong Kong between 1994 and 1998. She excluded transactions involving non-residential sectors and non-livable space such as car parks to get to her next research stage. That meant going over nearly 350,000 property-level observations such as the settlement prices, gross square footage, building names and street addresses.

Wong provides evidence to underscore her theory of "overconfidence-generated speculation" in Hong Kong, supported by a model used in a February 2003 study by Jose Scheinkman and Wei Xiong of Princeton University in their paper, "Overconfidence and Speculative Bubbles." To test alternative theories on the relationship between speculation and turnover, she uses a model put out by Jainping Mei of the Stern School of Business at New York University, and Princeton University's Scheinkman and Xiong in their February 2004 paper, "Speculative Trading and Stock Prices: An Analysis of China's A-B Share Premia."

With that armory of data and methodology, Wong was able to establish that the price increases in Hong Kong were not caused by "a simple supply-side story, in which a sudden decrease in housing supply or rational expectations of future supply decreases" were the main culprits. Wong also discovered that so-called fundamental factors -- such as population growth and migration, wage trends, real interest rates and tax structures - did not spark the demand frenzy.

Wong also discounted the possible explanation of a "flight to quality" by investors after studying returns on equity stocks, bonds and foreign exchange. Here, Wong looked at Hong Kong's Hang Seng stock index, where she found the returns to the non-real estate components were at least as high as that to holding residential housing stock. She extended this part of the investigation to track Hong Kong housing prices alongside indices in stock markets in Singapore and Japan. Her finding: While all three experienced a downturn between 1996 and 1998, the "foreign stock market indices (Singapore and Japan) fell much earlier than Hong Kong housing prices, and they did not show the sharp upward movement before the fall." What this told her was that while the housing market crash may have been caused or aggravated by the regional economic downturn, the upswing before 1997 was rooted in factors specific to Hong Kong.

Wong also explored interest rate movements as a possible explanation to rising home prices. Here, she found little evidence to support an argument that cheaper finance may have fueled the boom. The Hong Kong dollar is pegged to the U.S. dollar, and so the prime rate is often a reflection of the economic conditions in the U.S. rather than in Hong Kong.

The report is a "work-in-progress," says Wong, who wants to continue with her research and refine her findings. "I want to dig deeper into this story," she notes. Without the benefit of adequate data and analysis, Wong won't allow herself to be drawn into speculation on where the next bubble might be, although she does see some evidence in U.S. coastal city markets including San Francisco and Boston that warrant "suspicion." She adds, however, that she cannot say "whether it is time to be alarmed, because I haven't studied the data."

(One year after her study, it’s evident that it was time to get alarmed. Prices in Bay area and Boston came down, it’s still going down. Economists expect the price decline will continue into 2007)

Wong, who has and will continue to present her findings at conferences in Asia and the U.S., hasn't yet sent her work to government policy makers and regulators in Hong Kong, but she plans to distribute copies among peers and other academicians. Her next research project aims at exploring "the linkage between the extent of speculation in different parts of Hong Kong and land supply". Wong also plans to study the evolution of land use restriction variation across time and space in Hong Kong. "This is a very complex subject and it helps to have more minds focus on it," she says.

Indian real estate speculators need to learn the lesson from this article. Many parts of the world including India, South Korea and China are experiencing real estate boom fueled by speculation and flipping. History shows how this would end.


Anonymous said...

Hi Nidhi,

I have read your article regarding the buble in india.

If you take the major citi like bangalore the house ownership is very poor like 30% and if you consider that another 30% would be ready to buy in any part of the year.

Also there is a demand for the second investment home from established techies.

Also the immigration into the citi is manifold if you consider the new graduates.

So Real estate market which is growing at 30% will manintain the growth for another 5 years min.

Bharathi said...

I don't really believe that.

1. In bangalore, why the house ownership is (if that is true) only 30%? Because people just can't afford those obscene prices.

2. Demand for investment home? That's what I call speculation. All bubbles are created by this kind of speculation.

3. When the new graduates migrate to Bangalore, would they be able to buy the homes? At the current rate, they can't even rent a house. They need to share with 5 other guys to afford the rent.

Current real estate situation, especially for residential properties, is nothing but a bubble. RBI is also aware of it, that's why it is increasing interest rate to stop this. They are already too late, let us see how this would end.

Anonymous said...

Hi bharathi,
Please read my comments below:

I don't really believe that.

1. In bangalore, why the house ownership is (if that is true) only 30%? Because people just can't afford those obscene prices.

>> See the good 2 bedroom apt is 30L in any nice part of the city. If 3 year techie is able to save 5 lakhs in those years and gets another 5 lakh from his family property in town then the down payment becomes 10L and remaining in 16K in monthly EMI. I think it is manageable for the techie whose take home would be 35K and thinks that he would go oniste and earn another 12 L in 12 months straight and gets a salary hile of 15% {till his salary reaches the US counterpart of 3L}every year and he is very bullish until somethis on the terror front happens. That is why the Apt are selling like hot cakes in 40-60L range-- If you consider the techie is married and has the wife's salary at the disposal.

2. Demand for investment home? That's what I call speculation. All bubbles are created by this kind of speculation.

>> See you have agreed that the guys and gals are staying in a single apt 5 in inumbers rt. Think about the time each one of them getting married-- Then each family needs to have a seperate house and it is in the top of agenda in every one's mind who has migrated there. Also the established techie who has a house and car and land and top of that money earned from US assignment would like to invest in second home. He is not going to sell that in the event of real estate collapse unlike his partners in USA. This is the difference you need to know. He buys that property for long term invertment. COme real estate collapse of bull run he won't sell because in india the family which takes the decision even though the earning adult member purchases it and he has a little say in the property matters. So the speculation does not affect him. So established people with lots of money can't be expected to drain them in arabian sea or write a will for community.

3. When the new graduates migrate to Bangalore, would they be able to buy the homes? At the current rate, they can't even rent a house. They need to share with 5 other guys to afford the rent.

>> Yes because there is so much of influx and little property available for rent and this shows that the property will boom in near time for a long term.

Current real estate situation, especially for residential properties, is nothing but a bubble. RBI is also aware of it, that's why it is increasing interest rate to stop this. They are already too late, let us see how this would end.

>> See india has seen the housing rates of 21% EVEN 5 Years back. Nothing will freighten the techies unless govt puts legislation which bars foreign earned money flow into the real estates.

Bharathi said...

Hi, you made some interesting points and triggered a good conversation. I agree with you about traditional values, etc.,

I am not sure whether you have actually seen the bubble explosion. I personally witnessed those situations. This is a typical scenario:

1. Home prices shoot up. People are happy with their homes, if it is longterm investment they are very happy.

2. Lot of investors (speculators) buy lot of lands and homes to flip, they push up prices artificially so that they get profit when they sell after few months.

3. When the bubble burst, these speculators try to unload their properties. They can't, because there will be no demand. So, they reduce the prices and unload it. This will affect the entire housing market, pulling down prices in all areas and in all price levels.

Effect of this will be much severe, if there are many speculators in the market.

This will have domino effect, when the prices are coming down every month, many people will get panicked and try to sell their homes. This will lead to more price pressure.

If everyone is holding the house for long-term, what you said is absolutely correct. That is not happening.

I appreciate and respect your comments. We don't know how this would end. If there is a housing bust, it would affect entire economy, so I will be happy if there is no bubble. Let us hope for the best.

Thanks for writing!

Anonymous said...

Hi Bharathi,

I read something like this
Though this article encourages people to take home loan, we should be very carefull especially if you are planning to buy a flat in Bangalore, Pune, Hyderabad & Chennai. The flat sq ft rates existing in this cities are fake and it is priced atleast 35% more than the actual value. Since the Banks are ready to give home loans excess in of 20 lakhs to software engineers, and software people are somehow finding a way to save income tax, the real estate people fix the rate at very higher prices.

for example a 2 BHK (900 sq ft) semi deluxe flat in Middle Class living Bangalore/Chennai Area should not cost above 16 lakhs. But it is sold at 28 lakhs!!!!. You will be repaying for 5-7 years only for the *fake* amount. Remember, you are not losing 12 lakhs here but 24 lakhs (for 20 year loan with intrest).

Now software people like me have become very cautious and we are not going blindly for home loan. We Understood the IT industry in india has already reached the stagnation phase and we can expect saturation in another 3 -5 years. After that it is going to be diminishing phase. Jobs have already started moving to countries like Brazil, China, Costa Rica, Philipiness, Russia , Romania & Bangladesh because of high wages paid here. Recruitment currently is happening in very slow phase even in Bangalore & chennai. Out of 5 people resigning the company recruits only 3 in India and goes for other 2 in low cost countries as above. It is Ok if we live in a rented house for next 5 years and pay Income tax. The "flat" prices will fall in another 3 years and room rent will also come down drastically. It is time to save money in intelligent way!! for future use (say 2012).


>>>>> So we need to have a balanced approach and need to buy based on need.

Anyway thank for writing replies.

Bharathi said...


As you said, IT industry is moving jobs to China and other countries, many Indian companies already set up offices in major cities of China. Even SSI training set up an office there.

If you write a reply, let me know your name.