Can the Drivers of Property Investment Deliver Value in a Global Economic Downturn - Literature review Example

?Literature Review Can the drivers of property investment deliver value in a global economic downturn? An economic bubble affected the housing marketin almost half of the total states of America, thus being called as the United States housing bubble. During this period, the prices of houses in those states were at their apogee in the year 2006 and started to decline thereafter until they reached nadir in the year 2012. From 2006 to 2007, the increased rates of foreclosure among the homeowners in the USA laid the foundations of the crisis that commenced in August 2008 and affected many financial institutions. The housing bubble imposed innumerable threats to the stability of the American economy. The risk was so big because the collapse of the housing bubble in the USA affected not only the valuations of homes, but also several other agencies, industries, and personnel that included but were not limited to the mortgage markets, real estate, foreign banks, home builders, and home supply retail outlets. The Case-Shiller home price index noted the largest ever drop in the prices of houses by the end of the year 2008. It was because of the anticipated risks imposed by the bursting housing bubble that President George W. Bush announced the housing market’s bailout for those homeowners who could not compensate for their mortgage debts. Economic recession and massive foreclosures of housing caused by the global financial crisis was a potential threat to the investors. When a financial crisis hits a country’s economy, it affects the value of property investment just like it affects all other industries, though there is variation between the value delivered by property investment and other business options in such times. The real estate business has conventionally remained the best investment of all time, including the time of financial crisis. Knowledge of the potential drivers of the business of property investment provides the investors with a way to transform the risks into opportunities. Population Growth during Financial Crisis and Its Impact on Property Investment One of the most fundamental drivers of property prices is population change. People want to dwell in popular areas. Prices of popular areas are higher than the rest because there are more interest parties than the number of dwellings available. Prices of an area go down when the dwellings outnumber the interested parties. According to the Australian Bureau of Statistics (ABS) that conducts a census every five years to publish the trends of population growth, trends of population growth do not show abrupt changes. While the indigenous population does not show rapid changes in growth, there are other factors that contribute to the growth of population, the most important among them being the immigration rate of a country. “Things that do change population growth rapidly - and provide investors with opportunity - are changes in immigration quotas, changes in infrastructure making areas more or less attractive and accessible to live in, and changes to employment such as the booming resources industry” (Moore, 2012). During the financial crisis, there has been a decline in the rate of immigration despite the increased tendency among the governments to increase the immigration rate since every immigrant that is allowed hostage contributes to the growth of the host country’s economy. Although immigration rate is generally perceived to have negative effects on the employability of the indigenous population of a country, yet several studies have found that the long term effects of immigration are opposite of what they are generally perceived to be; immigrants increase the productivity as well as the average income (Peri, 2010b, p. 7). Immigration rate is considerably linked with the employment rate. Fig. 1 and Fig. 2 show how the rate of immigration is affected by the rate of employment in a country. Fig. 1: Variation in Immigration rate from 1995 to 2010 (Peri, 2010a, p. 3). Fig. 2: Variation in employment rate from 1995 to 2010 (Peri, 2010a, p. 3). From Fig. 1 and Fig. 2, it is clear that although immigration rate is not entirely controlled by the employment rate in a country, yet the general profile of the immigration rate from 1995 to 2010 is similar to that of employment rate in this period. With the commencement of the global financial crisis in the year 2008, there occurred a decline in the employment rate in most of the countries across the world, and consequently, the immigration rate declined as well. While there was an abrupt increase in the immigration rate from 2005 to 2007, it abruptly declined after that, thus causing a decrease in the population of the country and making more land available for use to the indigenous people. Accordingly, the prices of property went down. According to Peri (2010a, p. 3), the number of immigrants entering a country decrease by 10 with the loss of every 100 jobs in a country. Various economists and historians have recorded this rule in the past (Hatton and Williamson, 2009). Since it takes a loss of 100 jobs to caused a decline in the number of immigrants by 10 (Peri, 2010a, p. 3), there is still a considerable number of immigrants making their way to the foreign countries despite the financial crisis. The net effect on the value of property investment is still positive, though not as large as it is when there is no financial crisis. Although the net rate of immigration is responsive to the labor market and economic conditions prevalent in a country, yet the number of new of visas issued and the number of people becoming permanent residents are largely insensitive to the effects of financial crisis. Therefore, it can be said that population continues to grow even during the financial crisis and consequently, keeps delivering value in property investment. When the financial crisis is over, the rate at which the population of the country increases because of the increased rate of immigration. “When the economy is growing, new immigration creates jobs in sufficient numbers to leave native employment unharmed, even in the relatively short run. During downturns, however, new immigrants are found to have a small negative impact on native employment in the short run (but not the long run)” (Peri, 2010b, p. 7). Macro and micro economic factors that drive value in property investment  The literature on the macro and micro economic factors that drive the value in property investment particularly the residential property commences from the concept that housing is a special kind of asset that is used both as an investment opportunity and for consumption. In the long run, the price paid by a household for the residential property should be equal to the present discounted value of the services that the property would provide in the future. These prices particularly include the resale value and the future rents. In the short run, the prices of residential property may show deviation from the basic values depending upon the idiosyncratic traits of the market of real estate. Several empirical studies have been conducted in the past to determine the drivers of residential property and most of them have identified three fundamental types of drivers, namely the funding arrangements, the macroeconomic drivers, and the geographic factors. A number of papers have documented the interrelationship between the residential property price movements with the market-specific conditions and the macro variables including Hilbers, Lei, and Zacho (2001), Hofmann (2004), and Gerlach and Peng (2005). These researchers have used aggregated data for different countries. For example, Berger-Thomson and Ellis (2004) have estimated an equation for the mean or media prices of the residential property in the UK, the USA, Canada, and Australia. Their equation describes the short-run fluctuations in the prices of residential property as controlled by the fluctuations in the prices of houses including land, income, the prices of interest rates, and the improved quality of housing. The policies and academia have emphasized upon the role of credit market conditions and interest rates in the boom-bust cycle experienced in the USA. Some of the most fundamental factors that caused the boom of the demand and prices of the residential property in the USA were the low real interest rates and rapid availability of credit. Factors that caused large swings in the real estate markets also included the high rates of mortgage approval and low down payments. In addition to that, several geographical, institutional, and demographical factors were also responsible for the rise in the prices and demands of housing. The conveyance of the monetary policy shocks to the investment in real estate market is considerably stronger in the countries that have more developed as well as flexible mortgage markets. The role of deduction of the mortgage interest in the working of the residential business was investigated by Swank et al. (2002). They studied the way homeowners’ tax treatment meddles with the constraints upon the credit enforced by the lending organizations, and its impact on the mortgage industry’s profitability. The theoretical model proposed by Swank et al. (2002) distinguishes between the starters and movers upon the housing ladder occupied by the owners that demand various types of homes, have various levels of income, and encounter different costs of ownership. The starters’ and movers’ segments of the residential property market are interlinked by the supply of formal dwellings provided by the movers to the starters. This also closely connects the respective prices of property in the two segments. “With expectations of future home prices entering into the user costs of starters and movers, expectation formation turns out to be crucial for the emergence of stable equilibrium prices” (Galati, Teppa, and Alessie, 2011, p. 5). There is a huge influence of the housing market on the economy in terms of financial stability, output growth, and the mechanism of transmission of monetary policy. “Cross-country evidence points to the purchase of a house as one of the most relevant decisions for households, since it involves typically a large fraction of a household’s total wealth as well as of its expenditure” (Galati, Teppa, and Alessie, 2011, p. 2). According to Davis and Heathcote (2005), market value of stock of residential property’s nearly equals the annual average GDP in the USA. The category of main liability for the households in the USA is represented by the housing loans and there has occurred a noticeable increase in them over the last decade. For instance, in the euro area, the outstanding amount of mortgages that made only 27 per cent of the GDP in the year 1999 increased to 42 per cent in the year 2007 (European Central Bank, 2009). These facts draw the policy makers’ attention towards the macro and micro economic factors that drive the value in property investment. As a result of the recent global financial crisis, a need of improving the awareness about the drivers of the residential property has been felt. Consequently, the economists’ interest in the modeling of the role of residential property in the macroeconomic fluctuations has increased manifolds. There is a whole range of house-specific and household-specific factors to which the prices of residential property are linked. Such factors include but are not limited to the year of construction, education level, cohort, income and financial status, the existence of mortgage, the type of mortgage, and the rate at which it is paid by the owners of the residential property. The long-term interest rate also has an impact on the value placed by the household on the residential property. In addition to that, a lot of empirical evidence about the dynamics of the subjective prices of the residential property exists in terms of mean reversion as well as persistence. There exists heterogeneity and segmentation in the subjective prices of residential property to some extent, particularly along such dimensions as the conditions of funding, degree of urbanization, income expectations, and geographical region. Can the property investor create value in the current economic climate? Presently, most of the countries across the globe are recovering from the effects of the global financial crisis while many have already recovered to a significant extent. Although the socio-economic and political conditions in many countries is not as favorable as it was before the start of the global financial crisis, yet the conditions are much better and favorable as compared to the past three or four years. Investment in the business of residential property in the current economic climate can be profitable provided that the investor follows certain strategies as discussed by Tomasetti (2009). These strategies include but are not limited to short sales, fix and flip, and buy and hold. With the high numbers of foreclosures and the struggle made by many banks to make more profits, it is not very difficult to make short scale transactions. Although the negotiation of the short sales is a tedious activity, yet there is immense room for profitability with persistence and patience. It does not require a very large investment to enter into the business and with little education and experience, many potential sources of funding can be identified and availed. The fix and flip approach provides the investors with a great opportunity of making money if they purchase at deep discount from a wholesaler or a bank. This requires adequate management of the costs as well as the timeline of construction. A very important principle of making the business of residential property profitable is to correctly price it before selling it. There is a very strong competition for sales because of an increase in the number of properties available for sale over the past few years. The households need to ensure that the price point they select is the presently moving inventory in their region. Another very useful strategy that helps the investors make profit out of the business of property is the buy and hold strategy. The buy and hold strategy is a very old and widely practiced strategy in the real estate business and has benefited a lot of investors in the past. Working on this strategy, the investors purchase the land at a lower price than the price at which they sell it. The present time provides a very good opportunity to buy the land at a low price as the prices are expected to increase in the future. “Knowing the local rental rates is critical. The properties should be cash-flow positive and you must budget for ongoing maintenance and repairs. Knowing local rental rates is critical” (Tomasetti, 2009). Why would an investor invest in property via a vis other investment choices There is no objective rule of investing as investment in a certain field bears some profit while others make losses. The easiest way to evaluate an investment in a particular field is to assess the percentage of successful investors who were able to draw their investment back while another rule of thumb is to assess the percentage of profitable investments in that field. Generally, successful investors take hedged risks in that they tend to take risks in a periodic manner but not more than what is important to achieve their goals. Past performance suggests that investment in certain fields has provided the investors with more financial gains while investment in other fields has been the source of financial disappointments. Although past performance is not an objective criteria of assessment, yet it provides the nonprofessional investors with a fair idea of whether the investment they want to make is detrimental or financially rewarding. Certain good and bad investment options on the basis of past performance are discussed below: According to Crown Financial Ministries (2012), the best investment options for the Americans include residential housing, residential properties, mutual funds, insurance products, company retirement plans, and government backed securities, whereas the worst investments include commodities speculation, partnerships, tax shelters, precious metals, gemstones, collectibles, and stones. Value of the stock of residential capital in the USA far exceeds the business capital’s value (Greenwood and Hercoqitz, 1991). Residential housing is the best investment option for a vast majority of Americans because the housing sector has not only kept pace with inflation in the past but has also appreciated by 4 per cent every year on the average. This makes prioritizing the ownership of residential housing the simplest and the most convenient investment plan. Besides, most of the Americans are good at evaluating the rental properties in general and the residential housing in particular. They can make money from this business because they know it. However, it takes certain tactics to make the rental properties profitable; the owner needs to avoid becoming a landlord and should be able to evict the nonpaying tenants. Michael Gregory, the BMO Economist shares his views regarding this, “People who already own a house should make sure they evaluate the percentage of real estate exposure already in their investment portfolio and then decide if they want to invest more. Evaluate whether the benefits you earn from tax breaks on your second house are worth the risks associated with investing more” (Gregory cited in househunting.ca, 2007). A very important aspect of the rental property is that it does not require a large amount of investment in most of the areas. An additional benefit of the rental properties is that the mortgage of the property is paid by the tenants after it has been set on rent. Ray White chairman Brian White considers rentals a long-term investment option. “Real estate is a comforting concept for a broad range of investors and people like buying investments close to where they work and where they live. Investors have pushed the market and owner-occupiers have gone with them” (White cited in Chunn, 2012). Some people tend to invest in businesses other than construction because they consider it a risky business or they do not have sufficient investment to execute a project from their own investment. Joint venture is a useful option for such investors because not only it helps them arrange sufficient capital to invest in the construction business, but also divides the risk between the partners so that the loss, if any, is not borne entirely by a single investor. “The intent is to limit the liability of the limited partners to their financial investments only. But because of recaptured deferred taxes, seldom do investors recoup their initial investments in the length of time originally proposed, if ever” (Crown Financial Ministries, 2012). It is more favorable for an investor to invest in the property rather than other investment options because the prices of property have risen for the most part of the history. Occasionally they may decline depending upon the socioeconomic and political conditions of a country but such periods are temporary, but eventually the prices do increase, thus paying the investors more money than what they had invested in the property. While this may be said, to some extent, for some other businesses as well e.g. investment in precious metals or the commodities speculation, but the level of risks these businesses encompass is far greater as compared to the risk in the business of property. “As mining and energy giants begin projects that will reap riches from under the ground, property investors are seeking gains from what’s more conveniently located above ground” (Chunn, 2012). The investors of residential property play a very important role not only in the housing market but also as the borrowers from banks (Kearns, 2007). Sometimes, investors of residential property are thought to pose a risk to the housing market’s stability in case they try to exit the market immediately. However, such events are generally unlikely to happen because of the strength of capital growth as well as high return on investment in the property. The pace at which the prices of residential properties increase may slow down for occasionally, but they hardly ever decline whereas there is a lot of risk of decline in the value of such other investment options as gold and trading as the prices of these things keep fluctuating and may show dramatic decreases at times. Conclusion Like all types of businesses, the construction business is also affected by the global financial crisis or the economic downturn in a particular area. Factors like population, development, and the opportunities of employment that serve as the key drivers of the residential property business reduce when there is economic downturn. However, several studies to date have found that the decrease in the number or frequency of these drivers is not significant enough to cause a heavy loss in the business of residential property. Property investment delivers greater value as compared to other investment options. Financial crisis causes a decline in the rate of employment because of the companies’ attempts to downsize to sustain the profitability of business. As a result of this, the number of immigrants decreases, but the number of people choosing not to migrate is far lesser than the number of people still immigrating to the foreign countries. The resulting growth of population sustains the delivery of value in the property investment. On the other hand, the residential property business is one of the businesses which drastically increase in magnitude and margin of profitability as soon as the economic conditions of a country start to improve and stabilize. There is lack of robust evidence to suggest that the immigrants in any country have a negative effect on the socio-economic status or wage rate of the indigenous population in the long run whereas the positive effects like rapid opportunities of employment, increased rate of employment, and improved infrastructure have been documented by several studies in the past, which the prime reason that countries continue to offer immigration to the foreigners even during the times of economic downturn. The increase in population thus caused consequently increases the demand of residential property. In comparison to other kinds of businesses, the risks in investing in the residential property are lesser while the opportunities are greater. The drivers of investment in the business of residential property deliver more value as compared to other businesses, and also continue delivering value during the economic downturn. The subjective prices of the residential property are intrinsically linked with the microeconomic house-specific factors including the type, geographical location, and the year of construction of a house. A very important role is played by the financing conditions including the presence and type of mortgage as well as its rate. Several household-specific factors also determine the value of residential property including the income, financial status, and the level of education. In addition to the micro variables driving the value of residential property, several macro drivers including the long-term rates of interest also affect its value to a considerable extent. Empirical evidence supports the existence of well behaved and subjective dynamics of the prices of the residential property in terms of mean reversion as well as persistence. The prices of residential property tend to converge to the equilibrium value in the long run. There exists a certain level of segmentation and heterogeneity in the subjective prices of residential property, particularly along such dimensions as funding conditions, level of urbanization of the area, geographical location, and the average income of the households. Investment in the residential property is a much more favorable option for the investors as compared to other options of investment because of numerous reasons; the residential property can be lived in while their prices keep increasing, the residential property can be given on rent or lease so that it generates a certain profit every month without the need for the household to loose the ownership rights over the property, the prices of the residential property usually go up and any retardation in the rate of increase in prices is temporal, the development of infrastructure and other educational and recreational facilities directly causes the prices of residential property to increase, and the risks involved are very less and become negligible as one gains more experience in this business. 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