Asset Price Dynamics

Real Estate Rules of the Game: How and Why it’s different
by Dr Megan Walters and Dr David Rees
Asset pricing dynamics in real estate have come under scrutiny since QE was implemented following the global financial crisis. A recent
paper prepared under the auspices of the World Economic Forum by Dr David Rees at JLL provide an in-depth survey and a suite of case
studies examining specific examples of real estate boom/bust cycles across a range of sectors and markets.
One of the features of the case studies and report is that ‘no one size fits all’ in terms of why, where and when real estate bubbles occur.
However, common patterns do emerge from the case studies which we have depicted in the illustrated model.

How does the illustrated model work?

The academic background for identifying the patterns in the case studies
is grounded in the work of Nobel prize-winning economists Ronald Coase,
Douglass North, Robert Shiller and George Akerloff. This body of work,
often described as “Institutional Economics”, emphasizes social interaction
in markets and firms, and identifies the “rules of the game”, both formal
and informal, as key determinants of the performance of markets and the
behavior of market participants.
The theories behind asset price bubbles are complex, with Alan Greenspan
famously claiming it is impossible to spot them. However, Professor
Robert Shiller, author (with George Akerloff) of Animal Spirits and Irrational
Exuberance, suggests there are signals we can look for to anticipate
emerging bubbles: high levels of liquidity, rising numbers of transactions
and rapid turnover of ownership.
Price bubbles can be created by lack of market transparency, both from
‘money illusion’ – whereby the face (nominal) value of money is mistaken
for its purchasing power (real value) – from inflation and investors trading
‘stories’ of beliefs that markets will go higher, along with a high rate of deal
turnover and high liquidity. A common, but dangerous, observation about
emerging bubbles is the common belief that “this time it’s different”.
Why is real estate different?
Real estate markets differ from stock markets because real estate has a
physical component that influences participants’ behavior. Work on common
property resources by Eleanor Ostrom (another Nobel prize winner)
and Ronald Oakerson is helpful in identifying the impact of the physical
constraints of property on market activity.
Our illustrated model work, adapted from Oakerson’s model, shows how
commercial real estate markets operate to illustrate the findings from the
JLL/ WEF paper.
Here we provide a snapshot to explain key points of our adapted model.
Land Supply
Starting on the left hand side, real estate markets have physical
characteristics that affect the availability of land supply – and can influence
the speed with which supply can meet investor demand for real estate. In
Hong Kong land is limited due to topography. In the so-called sand states
of the United States - Arizona, California, Nevada and Florida - additional
land for housing is readily available, providing for a highly elastic supply
response when house prices rise. Where land is restricted a “bubble” can
build where excess demand cannot be met by additional supply – Hong
Kong, for example. Conversely- where there is unlimited land a “bust” can
occur as over supply can arise relatively quickly. Either way, the physical
characteristics of land have a fundamental effect on the ultimate outcome of
real estate pricing.
Market rules and social customs
The middle part of the graphic shows the operation of the property market -
a combination of formal rules, statutes and regulations and informal custom
and social practice. There rules operate at three broad levels: government,
organizations and individuals. In the JLL/WEF asset pricing paper examples
of formal rules might be the legislation to limit new office development in
the United Kingdom in 1965, and the repeal of these policies in the early
1970s. Informal custom and practice might be decisions by Japanese
banks to provide loans in anticipation of future price growth in the late
1980s. In Mumbai, for example, office development is often speculative
whereas in Bangalore “developers usually commit to commercial buildings
in consultation with occupiers…” The rules in the real estate market,
whether formal or informal, arise from an inter play between the physical
characteristics of a location and economic conditions. For example planning
rules and restrictions arise and are enforced to different degrees, depending
on the capacity and resources of the government or regulator to provide the
rules and enforce them. In Johannesburg, South Africa, for example, the
case study record how failing attempts to regulate population movements
led to the “hijacking” of residential and commercial buildings which were
then abandoned by the legal owners.
The extent to which a real estate market operates a landlord and tenant
system as oppose to an owner occupier system has a material effect
when a market is transitioning from predominantly owner occupied to one
where private landlord and tenant rights can occur (as in the Shanghai
case study).
Macro-economic environments
The real estate market operates within an economic framework – shown
on the right hand side of the picture. Decisions on interest rates, easier
availability of debt, lower cost of debt, relative returns in other asset classes
and foreign exchange rates were all found to have played a role in at
different times in most of the real estate bubblesanalysed. Typically a shift
in one of the factors in the macro environment provides a displacement in
the real estate cycle that triggers the start of a boom, following the classic
Minsky-Kindleberger cycle (see page 11 in WEF/JLL report).
To quote Reinhart and Rogoff after Rees ‘While real estate figures in many
market crises, debt is widely identified as a critical ingredient: “If there is one
common theme to the vast range of crises we consider… it is that excessive
debt accumulation… often poses greater systemic risks than it seems
during a boom.”’
 It would be alright if it weren’t for other people Contacts

The patterns of interaction between the economic framework and real estate markets take place via market participants – organizations and people. Shiller
and Akerloff identified five forces that drive markets. Along with ‘confidence’ they identified: fairness, corruption, money illusion and “stories”.
Stories are the anecdotes we hear about- the expat who made millions buying a flat in Hong Kong at the bottom and selling at the top and retiring to Dorset
on the proceeds. The reinforcing nature of stories is amplified by TV programmes on buying and renovating property, and seminars on buying in foreign
cities with guaranteed income returns. We believe these stories and conveniently forget those who bought at the height of the market and saw their flat fall
Dr Megan Walters Dr David Rees
by half in value. People usually do not discuss their losses – only their gains, giving a one sided view of market dynamics- that markets only go up.
Head of Research, Asia Pacific Head of Research, Australia
In real estate pricing dynamics, money illusion (the inability to assess the time value of consumer price inflation) and “stories” are two of the most important. Capital Markets david.rees@ap.jll.com
What starts as a natural response to increased pricing due to a supply demand mismatch can escalate into large fluctuations in pricing. megan.walters@ap.jll.com

And back to physical characteristics

The final part of the graphic shows how rules and market practice in the real estate market interact with economic conditions and pass through the filter of
human psychology. The overlay to this and the part from Oakerson’s model that is particularly pertinent is the fact that real estate has a physical component.
Acres of empty housing that have been foreclosed exert negative externalities on the urban environment. Empty commercial buildings or, worse, half-
completed development projects may have negative land value – far more costly than if no development had taken place.
The JLL/ WEF report and case studies show how complex and multi-faceted the issue of real estate bubbles is. The graphical diagram highlights some of
the dimensions: the physical landscape; the local real estate market rules and customs; the economic conditions and psychology of human action.
The complex machinery of asset price cycles is itself a warning that simple solutions are unlikely to be effective. Macro-economic policies and regulatory
strategies have important roles to play. But the human dimension also points to research and education as worthwhile investments as well. Finally, the
multi-dimensional feature of the typical boom/bust cycle is itself cause for optimism – there are many avenues by which cycles can be interdicted and even
defused even if there is no “one-size-fits-all” panacea.

Click here to view the Emerging Horizons in Real Estate, An Industry Initiative on Asset Price Dynamics Report
Click here to view Emerging Horizons in Real Estate, An Industry Initiative on Asset Price Dynamics Executive Case Studies
FOOTNOTE: Oakerson, Ronald J. 1992. “Analyzing the Commons: A Framework.” Making the Commons Work: Theory,
Practice, and Policy, ed. Daniel W. Bromley. San Francisco, CA: Institute for Contemporary Studies.
www.jll.com/investor
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