Zoltan Szelyes

Real estate analysis after the burst of the global real estate bubble

Residential real estate markets in the US, Europe and Asia saw a spectacular boom between 2000 and 2006. Prices more than doubled in this timeframe in many countries such as US, France, Ireland, Spain or most Asian countries.

The bubble in commercial real estate was masked by the yield or cap rate shift. In commercial real estate you usually not refer to prices but to cap rates, the ratio of rental income to the transaction price or the appraised value of an object. Commercial real estate yields or cap rates compressed between 2003 and 2007 mirroring the price increase in housing. Some people argued then, that this decrease in yields was justified by the structural change in financing or the generally lower interest rate environment. That might be true to some extent. But when prime yields decrease considerably below the level of government bond yields, one has to become skeptical.

So both residential and commercial real estate markets were then driven by a global factor: capital and abundant liquidity. The turnaround in the US housing market marked in autumn 2006 an end of this era. The falling house prices in the US triggered a series of events, which we know today as “the financial crisis”. These events had broad repercussion on real estate markets around the world, as the global liquidity bubble burst. There was the effect of the financial crisis on the demand for real estate, as the global economy slipped into a recession and employment figures started to rise. Some homebuilders, who had expanded the units under construction in previous years, were then caught on the wrong foot, as they expected a further increase in demand. They brought the projects to market despite the recession and vacancy rates spiked. Supply, especially in the US, was not only pressured by new buildings but also by foreclosures, as people defaulted on their mortgages. At the same time the weakness of banks’ balance sheets brought in some countries an abrupt halt to new lending to households and to commercial real estate investors. The mortgage markets that relied on the refinancing of mortgage lending from the capital market were additionally hit by the loss of investors’ confidence in securitizations. Issuance of new private label securitization dried up completely in 2008.

Inflated real estate prices came increasingly under pressure in one market after another. However, the speed of the downward adjustment has differed between the markets and countries. In the US, house prices already have corrected by more than 30% since peak. However, in some markets in continental Europe, like France and Spain, the decline of house prices has progressed very slowly so far. It is never a good sign, if the problems are not tackled and the solution of a problem is delayed. We Swiss remember that adjustment processes can take a long time. In Switzerland it almost took a decade till the real estate market recovered from the burst of the bubble of the late 80ies.

From both an academic and practical research point of view interesting times are ahead. Between 2000 and 2006 market selection did not matter much from a practical point of view, as real estate prices were inflated in practically all markets. Then risk assessment was (or would have been) important. The question was, when to leave the boat to cash in gains or to avoid a shaky see after years of sunshine.

Today the situation is different. Real estate markets are not all at the same point in their cycle nor just driven by one global factor, liquidity. So market selection, cyclical timing, an assessment of market fundamentals and longer term drivers should be crucial going forward. Not all markets will be able to quickly rebound. Residential and commercial prices in many markets and segments are unfortunately to decline further. For some markets the risk is that a recovery could take a decade. But there is also hope for markets that look fundamentally sound and are just suffering from a cyclical but not structural downturn. Local supply and long term demographic trends will be key. On the commercial real estate markets it is material, how the refinancing risk, which seems to be the most critical depressing factor, can be resolved.

I will address such questions in my Blog in future and if interested, please subscribe. (It’s free, see RSS or other means) Both positive and negative comments and inputs are always very welcome.