A bubble about to burst? The Spanish Real Estate Market

Contents

1.  Introduction  3

2.  Real Estate Markets Price Bubbles  4

3.  Demand and Price Evolution for Spanish Real Estate  8

4.  Conclusion  13

  A. Figures Tables  14

1. Introduction

When real estate prices in Spain rose roughly around 160 per cent in the period of 1998 until 2004 [GVM05, S. 9] the country ultimately joined the group of economies currently perceived to be threatened by a real estate bubble. Comparing the increases of home prices from 1997 until 2005 places Spain third behind Ireland and Britain which experienced a similar surge in house prices. ¹ [Eco05] Curently property bubbles receive a good deal of attention since major economies like the USA and UK all appear to be threatened by this process. This paper discusses the phenomenon of asset bubbles with an application to the Spanish real estate market. It is organized as follows: The rst section provides a brief introduction into the subject. It rstly discusses some mechanism of property markets and determinants of asset bubbles. For further clarication it secondly refers to some countries which experienced similar processes and respective causes for their bubbles. To wind up the introductory part section 1 briey also mentions potential threats of price bubbles.

Section 2 carries out an analysis of the Spanish real estate market in order to identify possible drivers of demand. It also illustrates some similarities with countries which have in fact experienced a (bursting) price bubble in the past. The section concludes with an evaluation whether or not Spain's real estate market is indeed suering from a bubble. Theoretical ndings will be supported by data supplied by the Spanish Housing Ministry. 2

¹ For additional comparison refer to gure A.1 on page 14.

² Ministerio de Vivienda, www.mviv.es/es/

2. Real Estate Markets & Price

Bubbles

This chapter will reect on theories about the catalysts and mechanisms of real estate markets and asset bubbles. To clarify the introduced concepts additional examples from past bubbles in dierent countries will be provided.

Characteristics of property markets

Rampant house prices are a result of growing demand. In many cases they are commonly also associated with housing bubbles. However when is it accurate to describe a commodity like oce space or ats as overpriced and therefore its market inated? Since price levels depend on supply and demand a concise search of price bubbles in the housing market should embark on two aspects: 1. What is causing an adjustment in demand and therefore price uctuations? and 2. Is the reaction of prices reasonable? i.e. their upward tendency is solely caused by present or future scarcity of supply. Any residual increment left unexplained might suggest the existence of a bubble. Prices (and overpricing) on the housing market are however notoriously hard to assess: This is mainly due to the great heterogeneity of the goods traded and the mass of additional price determinants such as neighbourhood, bay view etc. Another particularity which distinguishes the housing market from just any other commodity market is the existence of a time lag between demand and supply. In case of a surge in property demand supply tends to respond with a certain amount of sluggishness. [TZ04, p. 68] Since the search for suitable land and construction requires time the moment in which all demand for property will be met is usually delayed. In the meantime residual demand generates upward pressure on property prices causing them to "over-react". [dM04, p. 4] The next paragraph analysis some causes of demand.

Given the nancial constrains individuals tend to face when nancing a house, external funding plays an important role. ¹ Thus the potential costs of taking out a mortage can inuence

¹ As [MMS98, p. 56] illustrate real estate also constitutes an important factor for the economy as a whole,

2. Real Estate Markets & Price Bubbles

the decision to carry out a real estate purchase. Demand (and thus prices) of property are therefore directly correlated to interest rates. [TZ04, p. 68]

As [Ren97, p. 16.] highlights, in 1985 the costs of credit in Japan dropped considerable when the Central Bank lowered rates to as low as 2.5 per cent. ² Cheap credit triggered real estate investments: The share of capital destined for property investments hiked from 7 to 17 per cent of total credit. "Inelastic urban land supply" in the presence of a soaring real estate sector boosted land prices. Consequently companies with land holdings (gaining in value) were able to borrow yet greater amounts of capital for further property investments. Thus an asset bubble was fuelled in parallel to land price ination. Easier access to credit also triggered additional capital outows into the real estate markets overseas. [Ren97, p. 18] Nordic countries made similar experiences upon transforming their banking system from being one of the most "tightly regulated" in the 1980s [Ren97, p. 22] to a more liberal design. In addition [San04, p. 81] writes that the Scandinavian tax system even encouraged borrowing by making interest payments deductible from taxable income. (see also [DP95, p. 28].) Additionally thanks to ination the real cost of borrowing was very low or even negative. All Nordic countries experienced a drastic expansion of loans in relation to GDP. ³ As observed in the case of Japan property prices in the Nordic countries skyrocketed as a consequence. ⁴ Ination might also provide additional motivation to engage in real estate purchases. As [TZ04, p. 75] write individuals can invest their money into property to avoid erosion of their wealth by ination.

since "Residential investments usually comprises around a fth of gross domestic capital formation", the construction sector provides about 510% of European employment and "housing expenditure, except in the Mediterranean area, typically compromise 510% of total public expenditure. (or 14% of GDP)"

² The drop in the interest rate was induced by the 1985 Plaza Accord, among other measures such as DollarYen exchange rate stabilization.

³ Norway: from 40% in 1984 to 68% in 1988, Finland: from 55% in 1984 to 90% in 1990

⁴ According to [HO98, p. 113] real house prices increased roughly 50% in Finland, 44.4% in Norway and 37.2% in Sweden. After their peak prices declined 50.1%, 36.6% and 26.7% respectively.