Explaining Real Estate Price Bubbles

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Bubbles form in investment real estate, leading to the questions: Where is the top? When will prices no longer rise? An answer to both of these questions is: when the money runs out. In real estate investment there are two sources of funds: the buyer's investment (down payment) and the lender's capital (the loan amount). The lender operates as a sort of governor, investing less as prices rise, thereby refusing to finance the speculative part of the bubble (that part unsupported by commensurate increases in net rent). With the lender's withdrawal, given fixed prices, buyer down payments must rise, placing downward pressure on investor yields. Fewer buyers become willing to accept those lower yields and the market at those prices falls.
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Contributed by: Roger J. Brown (March 2011)
Reproduced by permission of Academic Press from Private Real Estate Investment ©2005
Open content licensed under CC BY-NC-SA
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There are some interesting subtleties in this analysis. In theory the lender can fix both LTV and DCR. In practice the lender must choose one and forgo the other. The reason is found in the mathematics of real estate investment analysis. It can be shown that by fixing both LTV and DCR the lender is implicitly forbidding the use of the most modern and appropriate valuation tool, discounted cash flow analysis, and consigning itself and its borrower-applicants to the outdated valuation tool of capitalization rate. Only by allowing either LTV or DCR to vary can the lender avail itself of more sophisticated valuation tools and the better-informed buyers who use them.
There are also a number of important assumptions such as constant rent, constant interest rates, and defining capitalization rate as discount rate less growth (known in corporate finance as the Gordon Constant Dividend Growth model). None of these assumptions are fatal to the analysis.
More information is available in Chapter Nine of Private Real Estate Investment and at mathestate.com.
R. J. Brown, Private Real Estate Investment: Data Analysis and Decision Making, Burlington, MA: Elsevier Academic Press, 2005.
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"Explaining Real Estate Price Bubbles"
http://demonstrations.wolfram.com/ExplainingRealEstatePriceBubbles/
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Published: March 7 2011