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Real estate is a controversial investment. Some are of the opinion that it is the best investment that one can make and that real estate has created more wealth than any other asset classes for the poor and middle-class citizens. Several others are of the opinion that real estate investments are substandard urban houses that are largely overpriced and made available to the masses. The masses then have to spend their lives chained to a job that they may not like to pay for this very expensive debt that they have picked up.
People may have different points of view about the effectiveness of a real estate investment. However, the facts remain the same. Real estate sector has been one of the most volatile if the past five decades or so are considered. The age-old saying of “safe as houses” does not seem to be applicable any longer.
In this article, we will hypothesize that this boom-bust cycle in real estate is being caused by the availability of easy financing or its lack thereof.
Real estate boom in almost every country has been the result of the availability of easy financing. This is truer in the case of developing nations like India. In these countries, there was no mortgage system till the late 80’s and the early 90’s. Houses had to be brought on cash. As such, only people who had a significant amount of money could afford to buy houses.
This changed with the entry of multinationals in the Indian market. The Indian economy grew by leaps and bounds, and the banking system had to evolve to keep pace with it. Banks started providing easy financing on real estate. People could put down a mere 10% or so and pay the balance in easy installments. This created a massive crowd of people who were willing to buy homes vis-a-vis a limited supply of homes. As time passed, prices started spiraling out of control and have ended up in a property bubble. Today, the cost of an apartment in Mumbai is about the same as an apartment in London. However, the salaries drawn by Mumbai residents are less than a fifth of the salaries being drawn by London residents.
This signals the massive boom that the Indian real estate market is in. For the past five years or so, the nominal prices have remained unchanged. This means that the real prices have reduced by almost 30% when inflation is taken into account.
A similar case of increasing real estate prices was seen in the United States. The United States is not a developing country like India. It has had a flourishing real estate market for a very long time, and financing systems are well developed and stable. However, in the early 2000’s they introduced a new form of financing.
They securitized old loans which were backed by government guarantees and sold them on exchanges as debt securities. This gave banks an almost unlimited ability to lend money to people. This is because they did not have to keep the loans on their books for very long. They could just sell the loans to a third party who services them. This increased ability to lend money and the absence of any risk created a flood of credit in the American market. This excessive money was once again chasing a limited stock of houses leading to a massive rise in their prices. As soon as this securitization system dried up, there was an immediate and unprecedented fall in the prices of houses. Entire neighborhoods had to be destroyed to reduce supply so that the prices of other houses were prevented from falling.
Japan was one of the first countries to experience this mega real estate boom and bust during their lost decade. The property prices in 1985 rose so high that it became impossible for the average worker to buy a house in Japan. To fuel the real estate boom, interest rates were dropped to near zero levels. Once again, too much money was being created in the market. This too much money was chasing too few real assets, and the prices of those assets reached new highs. When interest rates rose, the property prices collapsed, and people’s life savings were wiped out. Today, over three decades later, the prices are yet to reach the same level. The Japanese homeowners are still paying off their homes which they bought at extremely inflated prices.
Another major cause of the real estate boom is a rising immigrant population. As, the population increases, so does the need for housing. As a result, a supply shortage is created, and this exerts an upward pressure on the houses. However, this is not the problem. The problem is that these migrants tend to have access to cheap finance in their home country. A lot of them are willing to take the foreign exchange risks and invest in other countries. This is what is happening in Canada as their housing bubble is created mainly by Chinese billionaires who are borrowing at home and investing heavily in the Canadian reality markets.
To sum it up, financing is an integral part of any housing bubble. Prices cannot rise until there is access to easy finance.
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