VALUE & WORTH Column
By ELVIN FERNANDEZ
THE Global Financial Crisis (GFC) of 2007/2008 is a watershed event that calls into question the robustness of the global financial system. The system itself, to take a long view,is a continuously evolving system.
Crises and events in the past have aided in the evolution of the system and this recent crisis ought to spur even greater evolutionary improvements and that includes down-the-line restructuring of real estate markets (clearly central to any modern economy) and the valuation profession (central to a modern and efficient real estate market).
What caused the crisis? Roberts Samuelson in his book The Great Inflation & Its Aftermath takes a board view, spanning 40 years, as he builds up to the crisis. He focuses on the rise of inflation in the 70s (the oil shocks being symptoms rather than causes) to heights of 13% per annum in the United States and the subsequent taming of it by Paul Volcker (Federal Reserve Chairman) as an important background setting for the subsequent, extraordinarily low interest rates regime (easy money) that enabled the unusual economic conditions, among other parallel frameworks, for the tech bubble to form and burst, in 2000, and then shift into the housing bubble, that also burst, in 2007, and which precipitated the global financial crisis.
Root cause
Joseph Stiglitz in his book Freefall identified that a root cause of the crisis was the stagnant household incomes of the United States and said that house prices began running in parallel with increasing household debt.
Is the crisis over? Yes, by many who point out that the synchronised actions taken by central banks in 2009 averted “a depression greater than the Great Depression”.
No, by many others who feel that the loose monetary and fiscal policy engendered by QE1 (quantitative easing) and QE2 and other measures, may have saved the world from a depression greater than the Great Depression, but the measures are temporary stop gap measures that have not restored underlying aggregate global demand on a more permanent basis and more importantly have not solved many of the ills in the global financial system for it to go forward on a more sound footing.
Standing at this point in time, post a few months of heightened turmoil caused mainly by the Euro Zone debt crisis, and the US credit rating downgrade and anaemic recovery and growth, there are very serious concerns about the global outlook.
The outlook for Asia looks more promising but that too must be viewed with a jaundiced eye as the global economy is more linked that most admit or know and the majority of final demand still emanates from the west.
Real estate plays a complicit role in financial crises.
In the Japanese decades-long economic downturn, it began with the bursting of a highly inflated real estate bubble. Twenty years later house prices have retreated from highs of 18 times household income to a benign six times.
The Asian Financial Crisis of 1986/97 was one which afflicted this region and we in Malaysia have very personal and clear memories as to the role played by real estate in the build up to the crisis and the subsequent bust.
Luckily for us, taking the cue from the formation of the Resolution Trust Corporation in the United States Savings and Loans crisis, we formed Danaharta which acquired bad loans from banks and financial institutions, timely, and restored the banking system and put the economy back on track, quicker.
Real estate's role
As for the GFC itself, there would be few who will not be able to appreciate the complicit role of real estate. As the Federal Reserve cut interest rates after the Tech bubble burst, the final run up to the housing bubble began. By late 2005 and early 2006 there were many who saw that the peak was at hand (those who saw it coming) but who could not stop the process because the bigger system had a life of its own. One must acknowledge that it is not possible for smart people to stand in the way as bubble go on self-sustaining, aggressive build up when “the herd is in a full run”.
When the bubble burst in 2007, fingers initially pointed to the “sub-prime” mortgage market with the suggestion that that was a small part of the housing market in the United States and that it was not a very serious problem.
But the so called sub-prime mortgage crisis rolled on and morphed into a full blown housing crisis which went on to affect the huge edifice of structured securitised products that were built upon the housing market (collateralised debt obligations) and these markets froze, which resulted in a credit crisis, so big, and which reverberated around the world, in a way that suggested a global depression, greater than the Great Depression.
When the tech bubble burst in 2000, the world was not brought to the edge of the financial cliff. But when the housing bubble burst, that was exactly what happened. When asked, the Nobel Prize winning economist, Paul Krugman said that the stock market bubble burst was not as impactful as the subsequent housing bubble burst because it was “widely diffused”.
Seven years later, when the property market bubble burst, the impact was substantial because it was concentrated in the financial sectors and there were large edifices of new financial products built upon it, the tentacles of which were global in reach and the cascading knock-on effects, global in extent.
To prevent or tame the emergences of financial crises, we ought to also better understand the fundamentals that drive property prices and contain emerging property bubbles, timely. Is this possible? Monetary policy by itself it is said is not good enough to control the formation and development of real estate bubbles.
Arresting speculation
In this connection, the Federal Reserve Chairman of the United States, Ben Bernanke himself has said that “Monetary policy is a blunt tool; raising the general level of interest rates to manage a single asset price would undoubtedly have had large side effects on other assets and sectors of the economy.”
We need, instead or additionally, permanent, anti-speculative devices such as the Real Property Gains Tax for real estate so that its rates can be adjusted timely to arrest speculative fervour, as well as administrative devices such as directives that tweak property rules appropriately to derive the desired result.
Many East Asian countries, fearing the flow of speculative funds into their markets from carry trades have tweaked loan-to-value ratios, introduced sellers stamp duties, required banks to stress test based on percentage increases in interest rates as to their mortgage portfolios and so on.
For residential properties the generally recognised key fundamentals that drive house prices are household income levels since residential properties are largely bought for owner-occupation.
In most matured economies, when they are not inhabited by undue speculation, they reflect an average household income to house price ratio that revolves around three times. In many emerging markets, for various reasons, the ratio can be higher and even more than ten times is evident today in some hot spots around the globe.
In Malaysia, the long term ratio is four times. When the ratio moves up it is an indication of a bubble formation in the market and market participants and regulators should stand alerted.
A second fundamental that drives the residential market is rental returns, because apart from owner occupation, houses are also purchased for investment purposes. Net returns from residential property usually occupy a lower value, in the hierarchy of returns.
In Malaysia the residential rental returns are 3% to 6% net depending on whether it is a landed property or a strata property and depending on a number of other factors.
The range itself moves glacially over time depending on risk levels in the general market, and again, in Malaysia, over the past few decades yields have been moving downwards in sympathy with the era of easy money worldwide and its effect on asset returns generally. With the coming to the end of this long period of easy money, post the global financial crisis, the trend should be for the entire spectrum of residential yields, other property yields in general and global asset yields to be moving north.
Valuers, who undertake professional valuations on a day to day basis in the residential market are well placed to upload information on the property market to market participants and other stakeholders in the property market, including regulators, and this upward flow of information into the market helps to stabilise the market and alert all involved when the market is in need of tweaking towards fundamentals.
Rental is fundamental
The fundamentals that bear watching for the office market are rents, but rents are a function of business profitability. Ultimately the profitability of businesses in any city sets the sustainable level of rents for that city and it also explains the different levels of rents that prevail in different cities.
In Kuala Lumpur the long term yield for Grade A office space has been about 7% net. From time to time this yield has compressed to lower numbers, as low as 5%, but over the long term the market seems to return to the equilibrium level of 7% when the exuberance dies.
The fundamentals that drive the retail sector are also rents but rents for this sector are driven in turn by retail turnovers and it is this that bears closer monitoring. Turnovers depend on the multitude of shoppers including tourists.
In Kuala Lumpur the long term rental return on average for the Grade A, downtown shopping centres used to be about 8% but this is, I believe, on a structural transit towards 7% as shopping centres become more mainstream assets. Real Estate Investment Trusts or REITS have helped and are continuing to help in this re-rating.
The fundamentals that drive the hotel industry are usually a combination of sustainable average room rates and average occupancy rates. This business income can be translated to an equivalent yield that usually sits on the higher end of commercial property yield spectrum.
By understanding the workings of the property market through the key driving fundamentals and by the dissemination of that market information to market participants and other stakeholders in the property market, we can prick real estate bubbles. Professional Valuers who operate in the market on a day to day basis, can help enormously in bringing about stability in the market.
The greater use and appreciation of valuations help in diffusing real estate bubbles and bring about financial stability.
Elvin Fernandez believes in the free market and timely nudging by policy makers and key market participants to iron out any, and only where needed, imperfections in the system. To do this, and over time, they need a steady stream of in-depth market knowledge and insight.
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