You are here:

Real Estate Speculation and the Efficient Market Hypothesis

efficient market hipothesys

The concept of Price to Rent Ratio immediately leads us to discuss another particular phenomenon that is influenced, and at the same time influences, the real estate market.

We are talking about speculation.
Everyone has heard about the concept of speculation, mainly in the financial, insurance and currency markets, and many have also put into practice speculation strategies in these markets, with short, medium and long-term objectives (as in real estate) but with very different techniques and assumptions.

The real estate market, as already mentioned, has rigidity and non-reactivity as innate characteristics, as it is a market in which the adjustments of the supply or demand curves need a certain period of time to materialize. Nonetheless, and albeit with other characteristics, even in the real estate market we can observe marked phenomena of
speculation.

The goal of speculation players is to obtain profitability from the investment, for example with rent; a capital gain from resale; or both of them.

Rigidity in the supply side is a factor that can foster these goals.
In the short term, a large increase in demand will cause prices to rise (due to the inability of supply to react quickly) and this can easily trigger expectations for further increases. The increase in prices will trigger expectations of high returns in builders and market operators who will start new buildings which will nevertheless be on the market after a few years. In a scenario like this, investors can also decide to move capitals from alternative investments: real estate becomes the object of the
attention of investors both as a safe haven asset and as an opportunity of speculative maneuvers, this leads to a growth in demand.

So the pressure depends on the forecasts and expectations of investors, which can in turn influence or determine speculative dynamics. In other words, it can trigger a speculative spiral in which the price increase causes further increases.

To better understand the speculation, we have to start with some mention to the efficient market hypothesis.

In financial economics, the efficient-market hypothesis (EMH) states by principle that asset prices reflect all available information. In other words, according to this theory, a market can be defined as such when all investors have the same knowledge and therefore the prices of listed products perfectly reflect the available information.

In an efficient market, where there isn’t any asymmetric information, the price of a product is a fair and “real” value, a value that can be defined as “fundamental value” (FV).
But the real market is characterized by asymmetric information, external factors, psychological beliefs “If I don’t buy now I won’t buy anymore, house prices are always rising, these are safe investments”, etc..

So we can say that the price is always the sum of the FV and an additional variable value (ΔP), which can be positive or negative and whose amplitude is determined by buying or selling behavior.
The starting data therefore tells us that

P (Price) = FV (Fundamental Value) + ΔP (Variable Value).

In order to understand if we are in a highly speculative phase, we must try to understand how wide the ΔP value is, and to do this, the best method is to determine the FV and measure the difference with current prices.

To estimate the FV value, a reliable criterion is the historical price trend. We assume that, in the absence of speculation, prices vary continuously: at first, real estate revalues in line with the rate of inflation; if, on the other hand, salaries increase more rapidly than inflation, we can assume that the price of real estate reflects this growth rate; If, then, growth is accompanied by low interest rates, the increase in real estate prices will also be greater than the increase in incomes. Interest rates are in fact
among the exogenous variables that influence the market (we will see this later).

This method of estimation, which is rather basic, does not take into account external variables but can help in evaluating the FV factor.
To give a concrete and very basic example, let’s assume that in the last ten years there has been an average price increase of approximately 3% per year; a specific property was purchased 5 years ago for 200,000; applying an annual increase of 3%, today this property should have a value of approximately 225,000. If we find it on the market at the price of 280,000, we can assume that the ΔP is high, and probably the property is the object of a speculative maneuver.

If we apply the same concept in general and consider market averages, we can get an idea of the level of speculation, and understand if we are in a bubble phase.

In a phase of intense speculation, the ΔP value can be very large, and this distorts the true price, or value, of an asset. The speculative phase is also, by definition, a temporary and unreliable phase, so it is important to understand if the prices of a given period are distorted by speculative variables, and for this analysis, the market comes to us with some solutions.

One of these is the Price to Rent Ratio, already analyzed in the previous chapter.
We have already seen that dividing the average value of purchase prices by the average annual value of rents, we obtain a coefficient that mathematically evaluates the ratio between the price and the rent of a real estate. In general, we can say that if this coefficient is very high, the purchase prices of houses are in a phase of overvaluation, so much so that it is much more convenient to rent than to buy. When, on the other hand, the coefficient is low, there is an underestimation of the value of
real estate.

Let’s take a concrete example: a comparative market analysis of a one-bedroom apartment in a given neighborhood suggests that its market value at any given time is $420,000. Analyzing the rental market, we find that that type of apartment is rented in the neighborhood at an average of $4,300 per month. In this case, the Price-to-Rent Ratio is: 420,000 / 51,600 = 8.14: this is a property for which it is much more rational and convenient to buy than to rent; a property that even yields a gross cap rate of about 12% per year.

This figure, extended to the average of a certain period and a certain zone, suggests that the price of 420,000 is underestimated. The correctives to wait for will be, on the one hand, a probable decrease of the rents; but, on the other hand, a probable increase of the purchase price. In any case, from the point of view of the purchase price, we can affirm that we are not in a speculative bubble phase.

Every year there are studies and reports that try to predict the trend of the real estate market through the study of speculative phenomena. An interesting study by UBS, for example, assigns a risk index to the main cities in the world where speculative phenomena occur 1.

bubble risk index 2021

Of course, there are many other factors to consider when it comes to speculation, and most often they depend on local markets.

 


1 Source: UBS Global Real Estate Bubble Index 2021, www.ubs.com/global/en/wealth-management/insights/2021/global-real-estate-bubble-index

Facebook
Twitter
LinkedIn
WhatsApp

Leave a Reply

Your email address will not be published. Required fields are marked *

Post comment