Real estate: Attempting to explain the increase in prices.

First, let us take into account the fact that the price of buildings, flats and houses do not closely follow the economic cycle. We can remember the long slum that took place between 1993 and 1999 even when the economy was experiencing strong growth.

What are therefore the principles which explain changes in real estate prices? The rule of thumb consists in establishing the link between a real estate good and the economic rent that can be derived out of it. This provides the Price to Rent ratio. We then compare this ratio to its historical average to determine whether the real estate good is over or undervalued (respectively greater or less than the historical average”. The Economist regularly publishes such estimations for various countries (here for example). According to this measure, French real estate was overvalued in 2010. The only problem is that this method does not seem to be able to explain most price changes…Said otherwise, its predictive powers are weak.

We need to come back to the fundamental principles of asset valuation. Let us suppose that an apartment provides a yearly rent of 10000 Euros and that this rent only increase with inflation to keep things simple (For example, it increases by 2% if inflation increases by 2%). At this stage, try to come to an approximate estimation of this apartment’s price by basing yourself on your knowledge of the real estate market.

Let us suppose as well that the nominal interest rate (displayed) is 3.3% (10 year French Government bond yield on the 31st of December 2010). If expected inflation reaches 2% then the real interest rate is 1.3%. In these conditions, the price of the flat is simply equal to:

P = Annual Rent / (Nominal interest rate – annual rent growth)

P = Annual Rent / (Nominal interest rate – annual rent growth net of inflation)

C’est la formule de valorisation d’une perpétuité avec croissance, c’est-à-dire un actif qui paye chaque année un certain montant (le loyer), lequel peut éventuellement croître dans le temps.

Which gives:

P = 10 000 / (3,3% - 2%) = 769 231€

P = 10 000 / 1,3% = 769 231€

This price might seem relatively high but it is perfectly justifiable by the current economic fundamentals.

Let us note that this valuation formula is very sensitive to interest rates. For example, in 2007 – 2008, the above mentioned rate was close to 4.5%. By using the same formula, the price of the same apartment during that period would be equivalent to (only) 400000 Euros. The model has therefore factored in a price rise of 92% over three years! Based on this measure, the current prices seem undervalued. .

It is of course a fairly simple method to evaluate the real estate market. Finer analysis would take into consideration factors such as taxation, mortgage possibilities (those are nevertheless already partially taken into account with interest rates)…

We shall limit ourselves to highlighting the three factors which contribute to an increase in real estate prices.

 Firstly, an increase in the amount of precautionary savings in the world. It’s a fact that the economy has become more unpredictable and volatile. In these conditions, households have the tendency to become more prudent and therefore increase their emergency savings to face any future risk. This increase in savings causes long term interest rates to come down and increase the value of assets.

 Secondly, with several countries facing solvability problems, savers are frantically looking for a new risk free asset. If government bonds lose this status, real estate becomes one the few assets that can retain it. This may well lead to a fall in the price of government bonds but a rise in the price of real estate.

 Finally, real estate goods are real assets meaning that the revenue obtained from them (in the form of rent) more or less evolves along with inflation. Bonds on the other hand are typically nominal assets meaning their cash flows are specified in monetary terms. Consequently, while the price of real estate goods increases with inflation, bond prices do not evolve with inflation. Said otherwise, the real value of a real estate good is not affected by inflation ceteris paribus while that of bonds decreases (in real terms) during periods of inflation. As we have explained previously, it is possible that inflation will rise in the coming years. It is a factor which renders real estate goods more attractive and which push prices further upwards.