Development of Real Estate Market and Overall Economic Development - Essay Example

Many British people together with residents of other European and USA and even some emerging markets are concerned with the housing prices in the recent 3 to four years which have climbed up dramatically and are seemingly not going to stop. This has become the topic of numerous discussions and research done on this basis in order to estimate where we are may be experiencing to some point a global house prices bubble or if this is a rational process and those in desperate need for own housing should purchase their homes now. The theory states that the real estate market development usually lags behind and follows overall economic development in the region where growing GDP which is also reflected in the growing real income per capita, stable inflation rates, lower risks associated with better economic outlook for the country development and thus lower mortgage rates offered by the banks will be reflected by growing demand for housing1 which will lead in the short run to the upward pressure on housing prices. As it takes time for new housing to be constructed (in case of no overbuilding left from previous periods and thus existing housing stock being insufficient to meet the newly increasing demand) the supply cannot react fast to the demand shocks and thus increased prices will stay for some time until the supply is sufficient. Increased prices motivate construction firms to increase their output levels dramatically as the profit margins to be received from housing due to these high prices are expected to be high. That is why the real estate market is prone to known "hog cycles" or "herd behavior"2 where the construction companies overestimate the market demand and thus are myopic and construct too much supply. Other theories claim that actions of constructors to thoughtfully produce more than can consumed over short span of time are rational acts and are based on their trying to take advantage of economies of scale in production and thus economize on each unit of housing to be produced. Also, it is not irrational to have expectations of the economic upswing to be followed by some structural economic changes which will further lead to economic development or increase in the total population of the region due to this better economic conditions of living. Economic development is cyclical and the influence of the factor that lead to economic upturn has its' term. After the factor is not in power any longer, the economy starts stabilizing with real purchasing power not growing any longer. This is usually the time when the majority of the new housing supply comes on the market and it will be absorbed slowly with the prices dropping and vacancies occurring. The downward pressure on the market will sustain until the next economic upturn or until all the overbuilt housing supply is consumed. The biggest problem is that very often construction firm being overoptimistic about the housing or in general real estate prices develop land by using borrowed money. Once they bring on the market their product, the cycle is already in another stage which makes difficult for companies to generate enough income to pay back their loans. The highest risk of overproduction exists in real estate segments where the construction terms are the longest, demand is most uncertain and construction is irreversible. That is why some developers try to eliminate the risk and deliver to the market not niched products but ordinary housing. This further aggravates the crisis as the stock becomes not varied and overproduction is especially significant within some segments of the market. The similar situation was observed during famous real estate which lead to banking crisis in Sweden in 1991 and was also considered a global real estate crisis with numerous international investors being in the market. The theory behind the occurrence of International housing cycles is the interrelationship of overall economic development in the different global regions and due to this increased interrelationship between economies investors find it now less risky to enter foreign markets than they did, for example, 20 years ago. They are now trying to diversify in different countries and regions believing to see their more opportunities than the local investors do. Another theoretical reason is that increases in housing values for some reason in one country lead to accumulation of wealth here which allows to invest these funds in other regions and further drives prices there. The UK real estate market was also influenced by the global crash in 1991. The theoretical interdependence of macroeconomic factors and real housing prices is presented in the graph 1 below3. As can be observed from the figure, the increases in the interest rates by more than 3 percentage points comparing to previous periods are usually followed by falls in GDP together with falls in real housing prices. The increase in the interest rate makes housing less affordable and makes other assets more profitable for speculators. Further on, propensity to save by consumers increases. But the increase in GDP over the last 10 years was not as dramatic as the increase in housing prices which has lead to another empirical explanation of theoretical backgrounds, while the mortgage rates are being at their lowest now generating high housing demand. Increases in GDP have lead to growing real purchasing power and more capital inflow to real estate market and has motivated consumers to spend more on durables due to lower cost of debt being available as the values of housing collaterals increased. This returned by multiplier to the economy and further pressed the housing prices up. UK housing market reflects to global changes and after corporate crashes in the USA which lead to capital outflow from equity markets, terrorist attack in 2001, weakening dollar and not good signs of economic development in the EU has stimulated investors to transfer capitals to UK real estate market which provides them the best risk to return ratio with UK economy being heavily dependant on housing consumption and prices. The analysis of these factors reveals that in case of no changing situation with USA, EU and Asia economies, UK real estate market will continue to be the best risk to return ratio provider for the investors and the prices can continue to grow due to positive expectations. Bank of England by trying to stop these movements and increase the interest rate may harm other businesses not connected with construction and development and this is the case when foreign investment may not be that favorable for the economic development. The "Economist" magazine has even called it the first global real estate bubble with Spain, Australia, Ireland and UK being the countries mostly affected by it4. The conclusion to be made is that the theoretical relationship between the development of real estate market and overall economic development has again proved to be right and the conclusions made about this interrelationship by the scholars more than 20 years ago have not prevented many investors and simple households from irrational expectations and over investing into this sector. References: 1) Farlow, A. UK House Prices, Consumption and GDP, in a Global Context, University of Oxford, 22nd January, 2005; available from: http://www.econ.ox.ac.uk/members/andrew.farlow/Farlow%20Housing%20and%20Consumption.pdf 2) Gordon, J. N., P. Mosbaugh and T. A. Canter, Integrating Regional Economic Indicators with the Real Estate Cycle, Journal of Real Estate Research, 1996, 12:3, 469-99. 3) Grenadier, S. R., The Persistence of Real Estate Cycles, Journal of Real Estate Finance and Economics, 1995, 10:2, 95-121. 4) The Economist, October, 2nd, 2004, p. 9. Read More