The Future of Global Real Estate Investment: Back to Basics or Fundamentals

Professor Jarjisu Sa-AaduChester A. Phillips Professor of Finance and

Real Estate &Associate Dean of Tippie School of

ManagementUniversity of Iowa

Outline of Presentation Brief overview of the on-going economic and

financial crises The magnitude and duration of house price cycles The link of house price cycle with overall business

cycle House prices and economic fundaments The Great Moderation Future prospects for real estate investments China and Taiwan Free Trade Concept: The Economic

Co-operation Framework Agreement (ECFA)

Current Sage: Don’t Worry be Happy; the Sky is not Falling

“All that said, given the fundamental factors in place that should support the demand for housing, [we] believe the effect of the troubles in the subprime sector on the broader housing market will likely be limited, and [we] do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system”

Ben Bernanke, May 17, 2007, Federal Reserve Bank of Chicago, 43rd Annual Conference on Bank Structure and Competition, Chicago, Illinois

Some Perspectives on Global House Price Boom-Bust and the Global Financial Crisis

The global house price boom that started in the late 1990s and burst in late 2006 is unique in its perspective

It was worldwide in nature and there appears to be no prior example of such dramatic boom occurring in so many countries (advanced and emerging) concurrently

It was preceded by “democratization of credit” and unprecedented borrowing by companies and households alike

Largest and most important financial institutions either declared bankruptcy or rescued financially

It defies explanation based on rational markets and economic fundamentals alone

Despite coordinated easing of monetary policy by governments, trillions of dollars in intervention by central banks and governments, and large fiscal stimulus packages, the crises appear not over

Exhibit 1: Origins of the Global Financial Crisis: The Rise and Fall of Risky Debt

Source: Congressional Research Service

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The Magnitude and Duration of House price Cycles

The house price boom started in the late 1990s and ended with a bust in 2006 was global in nature – See Exhibit 2

Started in US and other industrialized countries but quickly spread to emerging economies

House prices started to fall in June 2006 in the US and spread around the globe – see Exhibits 3 & 4

The boom-bust cycle is generally viewed as major catalyst for the global financial crisis

Exhibit 2: The Global Boom and Bust in House Prices(and deterioration and other credit markets)

Exhibit 3: The History of U.S. Housing Boom-Bust

$100,000(1890)

$66,000(1920)

$199,000(2006)

Note: Over the long run the distinctive feature of US house prices has been the cycles rather than the trend

Exhibit 4: The Inevitable and Dramatic Decline in House Prices

“The Faster they Rise the Harder they Fall”…… SUSTAINABLE

(12) 3

The Magnitude and Duration of House Price Cycles: What Amplitude?

Exhibit 5 puts the recent run-up in house prices in perspective by comparing it with previous cycle

The rise in house prices from 1970- mid 1990s in 18 OECD economies lasted just over 5 years, and real house prices increased by +40%

The subsequent downturn lasted about 4.5 years and house prices fell about -20%

In contrast the recent rise in house price in the same 18 OECD countries lasted twice as much (10.25 years) and house prices rose by almost three times (or 114% real terms) – See Exhibit 5

Cycle Duration Price Swing2 Duration Price swing3 1970-mid-1990s 21 quarters +40 percent 18 quarters -22 percent Mid-1990-present 41 quarters +114 13 quarters -15 percent

1. The upturn in house prices in 18 advanced economies that started in the mid 19902 and continued for a decade eclipsed that of earlier cycles. The downturn began three years a go and it continues. The 18 countries are: Australia, Canada, Denmark, Finland, France, Germany, Ireland, Italy, Japan, Korea, Netherlands, New Zealand, Norway, Spain, Sweden, UK and USA2. Real Prices from trough to peak3. Real Prices from peak to trough

Source: Prakash Loungani 2010 Housing Prices, Finance and Development

Exhibit 5: The House Price Cycle (upturn and downturn from 18 advanced economies1)

UP-TURN DOWN-TURN

Exhibit 6:

Record decline in annual rate of return of -19.1% in 2009Q1

January 2000 Base index = 100

Peak 2006Q4

Index value at start of run-up in prices 1996Q1 = 80.23

Index value at peak 2006Q4 = 186.91

Index value at trough 2009Q1=130.46=-56.45 points

=+106.68

Exhibit 7: Behavior of House Prices in the Current and Previous Housing Episodes Panel A: Real Terms Episode 1 Episode 2 Boom Bust Boom Bust Time window [1988:1-

1989:4] [1990:1-1991:4]

[2004:3-2006:2]

[2006:3-2008:2]

Beg 60.74 65.20 95.00 112.08 Real House Price Index Value End 65.20 56.43 112.08 82.97 Real House Price Return 7.34% -13.45% 17.98% -25.97% HPI σreturn 0.417% 0.587% 0.596% 0.948% Panel B: Nominal Terms Episode 1 Episode 2 Boom Bust Boom Bust Time window [1988:1-

1989:4] [1990:1-1991:4]

[2004:3-2006:2]

[2006:3-2008:2]

Beg 70.22 82.35 179.45 226.29 House Price Index Value End 82.35 77.99 226.29 180.38 Index Change 12.13 -4.36 46.84 -45.91 House Price Return 17.27% -5.29% 21.07% -20.29% HPI σreturn 0.437% 0.548% 0.504% 0.833% rf 7.206% 6.410% 2.954% 3.892% Sharpe Ratio 23.030 -21.350 35.944 -29.030

Driving Forces Behind House Price Cycles: Why do house prices go through cycles?

The on-going downturn in house prices is nearing the past downturn in both duration and amplitude

It is likely the price declines will eclipse that of the past episode, because prices rose much more and sharply

So why do house prices go through cycles? Long-run equilibrium relationship view

In the long run house prices, rent and income should move together

When prices and rent get outline with each other households will switch between owning and renting – See Exhibit 8

Likewise in the long run house prices can not stray far away from peoples’ income (affordability problems) – see Exhibit 8

Exhibit 8: Evidence of Long-run Equilibrium Relationship in house pricesWith rents and income in the USA and UK

Ratio of house prices to rent reverted tolong-run average 4 times from 1970 -2000

Ratio of house prices to income hovered its long-run average fives times between 1970-2000 in UK

The Short Run View of House Price Cycles – drift from the fundamentals

In short run house prices do drift from the long run equilibrium (or the fundamentals) for various reasons Strong demand momentum leads to increase in house

prices, often not fully explained by the fundamentals The Case of Ireland

Robust income growth between 1992-2006 Population also grew after 1992 House prices grew nearly 20% per year in the same period (10

times the previous decade) Other factors: (1) Supply lag, (2) housing and financial

markets – feedback effect, (3) psychological and social factors

Exhibit 9: The Rise in US House Prices and FundamentalsDID THE FUNDAMENTALS SUPPORT THE HUGE RUN-UP IN PRICES?

Exhibit 10: US House Price Boom and GDP GrowthThe Recent House price Boom Seemed Out of Step with Real

EconomicActivity

So Where are We in the House Price Cycle?

House prices in the US fell about 30% from 2007 to 2009 They fell an average of 5% in real terms between 4th Q of 2007 and

3rd Q of 2009 in 18 OECD countries HOW LONG CAN PRICES GO DOWN?

In most countries house prices are well above their levels at the beginning of upturn in early 2000

In many countries house price to rent and income ratios are still above the long-run equilibrium relationship, suggested by theory

There is evidence that the increase in house prices between 2000-2006 cannot be fully explained by short-run driving forces or long-run relationships (behavior of the fundamentals)

Lastly, the current house price boom was strikingly out of step with business cycle or output growth

The above four points suggest more price correction ahead

Exhibit 11: How Much do House Prices Need to Fall?

CHEAP

INCREASEDAFFORDABILITY

Exhibit 12: MORE PRICE CORRECTION NEEDED FOR THE FROTHEIST HOUSING MARKETS

Are we near the bottom of the House Price Cycles?

At this point the correction has not thus far eliminated the excess in house prices that occurred over 2000-2006

Exhibit 11 shows how much the ratio of house price to rent and income in each of 18 OECD countries would have to fall to bring it down to its long-run equilibrium

Hence the conclusion is that global housing markets have not bottom out yet

However on both ratios the USA appears to be in much better situation than most OECD countries

But real estate investment (housing) like politics, is always local

The Rise of China’s Property Markets

The boom in property markets continues unabated (See Exhibit 13)

1.87 billion square meters of living space under construction as of 1st quarter 2010

Bank have expanded mortgage lending About 10% of China’s GDP is now in real estate House prices in 70 Chinese cities rose roughly 13% year to April

2010 Total sales value of homes (72.4m squares meters) in April 2010

was about US$56.3 billion Mortgage borrowing is increasing (See Exhibit 14)

Attempting to slow the party Restriction of housing speculation Raising down-payment Raising interest mortgage rates Limitation of number of house purchase in Beijing

Exhibit 13: The Downturn in Chinese Housing Appears Over

Exhibit 14: Mortgage Utilization is Growing in China ( mortgage ratio to GDP is still low, 15.3% compared to 79% for USA)

The Great Moderation One of the most remarkable features of past two

decades or so was the substantial decline in macroeconomic volatility

The volatility of quarterly growth in real GDP and quarterly inflation have in most industrialized countries have declined since mid 1980s, with the exception of Japan

This twin growth and stability has been dubbed the Great Moderation

The global prosperity (rise in output, house prices and wealth), have all occurred during this period

Going forward the future prospects of real estate investment (all investments) may hinge on the repeat of this phenomenon

What Caused the Great Moderation?

Three classes of explanations have been proposed

Structural changes in the economy Technological innovations Improved management of inventory (supply chain) Financial markets innovations Increased openness to trade & international capital flows

Improved performance of macroeconomic policies Monetary policy

Plain Good Luck Economic shocks to countries became small and infrequent

Exhibit 15: The Quarterly Variability of US Output Growth Rate 1966 to 2010

Exhibit 16: Quarterly Variability of US Inflation 1966 to 2010

Future Investment Prospects: Some Key Factors to Consider

1. Great Moderation: Is it due to (a) Structural Changes, (b) Good Monetary Policy, or (c) Pure good luck will hold

2. The level debt 3. Wealth Effect 4. Trade and oil surpluses 5. The health of banks 6. Demographic Changes

The Debt Hangover The rise in debt levels accompanied the Great

Moderation Debt increased at all levels: consumers, households,

companies, banks, whole countries (national debt) In 10 matured economies private and public sector

debt rose from average 20% of GDP in 1995 to 300% in 2008 (see Exhibit 17)

In general the Asian countries (China, India, Korea, Taiwan) are less indebted.

China and oil exporters built huge current-account surplus which was lent to current-account deficit western countries to buy more of their goods

Exhibit 17: The Debtor Nations and Creditor Nations

Exhibit 18: Significant Foreign Ownership of US Debt Obligations

Exhibit 19: Banks with Biggest Profits and Banks with Biggest Losses

The Economic Cooperation Framework Agreement (ECFA) between China and Taiwan

What is the objective of ECPA? Promote and normalize economic relationship

between China and Taiwan Internationalization of Taiwan’s economic relationship

Initial steps – early harvest Elimination of trade tariffs on 539 export items from

Taiwan by China worth US$13.8 billion Elimination of trade tariffs by Taiwan on 267 China

export items to Taiwan worth an estimated US$2.9 billion

Exhibit 20: Taiwan’s Trade with China

Perceived Impact of ECPA on Real Estate Investment

Capital flow from China into Taiwan and vice versa Reduction in cost of capital

Investment in tourism-related real estate Hotels and Motels Restaurants Retail Shops

Increased ability of Taiwanese banks to participate in Chinese service sectors including banking

Participation infrastructure developments by Taiwanese companies

The Investment Clock Cycle for Real Estate

The investment clock or the economist clock was first published in London in 1937

It is based on well known phenomenon that major business cycles occur roughly every decade

It depicts the movement of markets within this longer-term cycle It is suppose to assist with timing major market moves As shown in Exhibit 20 the progression of economic cycle

through time with 12 o’clock representing the boom down to 6 o’clock repression the depth of recession (bust)

Real estate investment is at its most dangerous phase in terms of liquidity when the cycle enters the credit squeeze mode

Exhibit 21: The Investment (or Business) Cycle Clock forReal Estate – Where do you think we are on the cycle clock?