Bubbling Spanish Housing Jose G. Montalvo Universitat Pompeu Fabra

What’s a bubble? "If the reason the price is high today is only because investors believe that the selling price will be high tomorrow - when 'fundamental' factors do not seem to justify such a price - then a bubble exists." "If the reason the price is high today is only because investors believe that the selling price will be high tomorrow - when 'fundamental' factors do not seem to justify such a price - then a bubble exists."

Is there a bubble in housing? Difficult to assess: Difficult to assess:  Do the fundamentals justify the prices?  Are expectations of future increase in prices driving the demand? Economics is not so advance as to estimate with a good degree of confidence the existence of a bubble. Main problem: expectations (remember the tech bubble?) Economics is not so advance as to estimate with a good degree of confidence the existence of a bubble. Main problem: expectations (remember the tech bubble?)

Are there signs of a bubble? YES. Many of them: YES. Many of them:  Fundamentals (income, employment, demography, etc.) are unable to explain most of the variability of house prices (28%-35%).  PER (price to rent ratio) in historical maximum.

PER ratio

Finacial return (no rents)

Are there signs of a bubble? Expectations: Expectations:  65% of recent buyers confirm that the investment side of buying a house was important for their decision  94,5% of recent buyers believe that there is a bubble (40% of them think that it is more than 50% of the price). But the same individuals believe that prices will grow 20% yearly over the next 10 years. Economic experiments.

Are there signs of a bubble? Close to 40% of recent buyers know a friend or a close relative that got into the housing business (at leas as a part time job) Close to 40% of recent buyers know a friend or a close relative that got into the housing business (at leas as a part time job) Taxi drivers tell you how much they are making in the last two houses they bought. Remember Joseph Kennedy and the tips of the shoe-shine boy Taxi drivers tell you how much they are making in the last two houses they bought. Remember Joseph Kennedy and the tips of the shoe-shine boy Taking about the prices of housing and the incredible profits you can make has become a major topic of conversation in any meeting with friends, relatives or fellow workers. Taking about the prices of housing and the incredible profits you can make has become a major topic of conversation in any meeting with friends, relatives or fellow workers.

When is the bubble going to burst? Ask banks and savings and loans. Ask banks and savings and loans.  Suicidal competence for mortgages. Very small spreads. Lowest mortgages rates in the EU. Are Spanish banks so efficient?  Reduction in the requirement to get a mortgage: temporary contract OK, extended mortgages (40-50 years), more than 100% of the price, no extra guarantees, etc.  Weakest link: credit to intermediaries in the housing market.

When is the bubble going to burst?

Gross return on housing (rents)

Simple (optimistic) calculation Houses initiated in 2005: Houses initiated in 2005: Spanish new households (net): Spanish new households (net): Immigrants new households: Immigrants new households: Secondary houses: Secondary houses: Foreigners demand: Foreigners demand: Where are the missing houses? Where are the missing houses?

Missing houses

How would the bubble end? Increase of interest rate. 99% of new mortgages are at variable rate. r=3.1% Increase of interest rate. 99% of new mortgages are at variable rate. r=3.1% Cyclical downturn of employment and economic activity. Cyclical downturn of employment and economic activity. Overproduction and problems to return credits for the new developments Overproduction and problems to return credits for the new developments Change in expectations of profitability of the housing sector in Spain Change in expectations of profitability of the housing sector in Spain

Foreign investment growth rate

And them, what should we expect? Wealth effect going south. Wealth effect going south. Economic growth compromise since most of it in recent years, has relied on the construction sector. Economic growth compromise since most of it in recent years, has relied on the construction sector. Problems for the financial system because of the high proportion of risk concentrated in the sector and the overconfident risk management Problems for the financial system because of the high proportion of risk concentrated in the sector and the overconfident risk management

And them, what should we expect? Would prices go down (burst) or inflation will erode slowly the real value of the housing stock? Would prices go down (burst) or inflation will erode slowly the real value of the housing stock?  Just look at what happen in the past in Spain.  Look at what happen in this sector in other countries. IMF report on volatility of prices.

And them, what should we expect?

It is your call! Would you buy an illiquid asset with a PER=50 when you cannot even calculate the return on the average and the production of the sector is double the demand? Would you buy an illiquid asset with a PER=50 when you cannot even calculate the return on the average and the production of the sector is double the demand?