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Why the housing price “bubble” in Bulgaria won’t burst
submited on 06.10.2007 in category Political stability | Fiscal affairs | Monetary policy | Regulated markets | Privatisation | Macroeconomic developments
submited on 06.10.2007 in category Political stability | Fiscal affairs | Monetary policy | Regulated markets | Privatisation | Macroeconomic developments
The housing crisis in the USA focused many analysts’ attention onto Eastern Europe and Bulgaria in particular, as some opinions stated that the housing price “bubble” might burst. On the other hand, most local experts communicated the thesis, that the mortgage crisis in the USA will probably have limited impact on real estate prices here. Most experts however, regardless of whether defending the first or the latter thesis, make one and the same mistake. The following lines show why using the price as a starting point is wrong when analyzing the housing market, at least in the short term.
Although housing credit kept high growth rates in August as well, the impact of some external and internal factors on the credit expansion became more notable. On one hand, BNB raised required minimal reserves, and on the other – external financing became more expensive in a state of global credit contraction, especially after the occurrence of the primary effects of the housing credit in the USA. In theory, potential mortgage credit contraction must lead to housing demand decline, other things equal (this is the most simple market model). According to most experts housing demand contraction directly reflects on the price, which must lower; i.e. it is automatically accepted that the housing price quickly responds to changes from the side of supply or demand. This statement, however, does not take into account one important peculiarity – the housing market is characterized not by a price cycle, but rather a volume cycle, i.e. the number of sealed deals. In other words, housing prices are downwardly inelastic and, in case of demand contraction, what changes, at least in the short term, is moreover the number of houses sold, rather than prices.
Namely the slow adaptation of prices to new market terms predetermines the importance of housing market to economic development. Potential drop in the volume of sales indirectly leads to contraction of employment in construction, financial sector, and real estate agencies. That is why namely sales, rather than prices, are important to real GDP. By rule, normal volume of sales occurs, when buyers expect that prices will go up at a moderate pace, or at least will not decline. If prices were sufficiently elastic and could fast restore equilibrium after the market enters a new cycle, then moderate price growth and volume of sales would have been steady over time.
Maintaining relatively high housing prices and in the same time sharp contraction in the volume of sales in a state of market crisis is notable in the real estate market in the USA as well. Whereas the number of houses sold drastically falls, prices just slow down their growth rate. This does not mean that housing prices do not change. On the contrary, but this happens at a rate, considerably slower than the pace, at which volume of sales changes. In the same time, owners’ unwillingness to sell under deteriorated market conditions might keep nominal prices relatively high, but real prices to decline, especially in a state of increasing inflationary pressure.
Furthermore, empirical data shows that under normally functioning economy, even in the long term, nominal housing prices rarely fall and if that somehow happens, the decline is not that big. The reasons, which explain that phenomenon, are mostly psychological and are attributable to market participants’ behavior. Sellers, base their judgment upon terms of closed transactions (i.e. the past), and buyers – on their expectations of the future value of the property (i.e. the future). When the market is rising, owners evaluate their property lower than potential buyers, which makes the deal possible. In case the market is in stagnation however, owners avoid selling at lower prices, and buyers wait for potential additional price drop. This way, transactions rarely happen and the volume of sales sharply drops. In this case, the market is dominated by supply-side prices, rather than equilibrium prices.
Applied to the housing market in Bulgaria, this model shows that a housing price bubble burst is less probable to happen, at least in the short term, if by “bubble” burst we mean drastic and sharp price drop (and not just growth decline or maintaining the same prices). However, we must take into account the fact that, with few exceptions, the housing market in Bulgaria remains underdeveloped and relatively low liquid. That is the reason why focusing the debate on the volume of houses sold, instead of the price, must provide better starting point for a realistic estimate of the current state of the market and the potential threats before its development.
Although housing credit kept high growth rates in August as well, the impact of some external and internal factors on the credit expansion became more notable. On one hand, BNB raised required minimal reserves, and on the other – external financing became more expensive in a state of global credit contraction, especially after the occurrence of the primary effects of the housing credit in the USA. In theory, potential mortgage credit contraction must lead to housing demand decline, other things equal (this is the most simple market model). According to most experts housing demand contraction directly reflects on the price, which must lower; i.e. it is automatically accepted that the housing price quickly responds to changes from the side of supply or demand. This statement, however, does not take into account one important peculiarity – the housing market is characterized not by a price cycle, but rather a volume cycle, i.e. the number of sealed deals. In other words, housing prices are downwardly inelastic and, in case of demand contraction, what changes, at least in the short term, is moreover the number of houses sold, rather than prices.
Namely the slow adaptation of prices to new market terms predetermines the importance of housing market to economic development. Potential drop in the volume of sales indirectly leads to contraction of employment in construction, financial sector, and real estate agencies. That is why namely sales, rather than prices, are important to real GDP. By rule, normal volume of sales occurs, when buyers expect that prices will go up at a moderate pace, or at least will not decline. If prices were sufficiently elastic and could fast restore equilibrium after the market enters a new cycle, then moderate price growth and volume of sales would have been steady over time.
Maintaining relatively high housing prices and in the same time sharp contraction in the volume of sales in a state of market crisis is notable in the real estate market in the USA as well. Whereas the number of houses sold drastically falls, prices just slow down their growth rate. This does not mean that housing prices do not change. On the contrary, but this happens at a rate, considerably slower than the pace, at which volume of sales changes. In the same time, owners’ unwillingness to sell under deteriorated market conditions might keep nominal prices relatively high, but real prices to decline, especially in a state of increasing inflationary pressure.
Furthermore, empirical data shows that under normally functioning economy, even in the long term, nominal housing prices rarely fall and if that somehow happens, the decline is not that big. The reasons, which explain that phenomenon, are mostly psychological and are attributable to market participants’ behavior. Sellers, base their judgment upon terms of closed transactions (i.e. the past), and buyers – on their expectations of the future value of the property (i.e. the future). When the market is rising, owners evaluate their property lower than potential buyers, which makes the deal possible. In case the market is in stagnation however, owners avoid selling at lower prices, and buyers wait for potential additional price drop. This way, transactions rarely happen and the volume of sales sharply drops. In this case, the market is dominated by supply-side prices, rather than equilibrium prices.
Applied to the housing market in Bulgaria, this model shows that a housing price bubble burst is less probable to happen, at least in the short term, if by “bubble” burst we mean drastic and sharp price drop (and not just growth decline or maintaining the same prices). However, we must take into account the fact that, with few exceptions, the housing market in Bulgaria remains underdeveloped and relatively low liquid. That is the reason why focusing the debate on the volume of houses sold, instead of the price, must provide better starting point for a realistic estimate of the current state of the market and the potential threats before its development.
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