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Appendix 6A: Housing Prices’ Driving Forces- a Summary Table

In document by Olena Denysyuk Cand.merc. FSM (Sider 112-117)

Housing price valuation approach/ methodology

Variables Explanations/Results Reference

Equilibrium Determined by Supply and Demand (Neo-classical and Modern Finance)

Efficient Market Hypothesis (EMH): the price of a financial asset reflects all available information that is relevant to its value Measures:

Multifactor modeling Regression analyses

9/10 of the increase since 1993 is explained by fundamentals (Wagner, 2005)

From Wager’s (2005) analysis:

Contributions from general economic development (55%) Increase in disposable income (59 %)

Decrease in real interest rate before taxes (33% ) Increase in value in interest deduction (-21% ) Increase in amount of potential first buyers (26 % ) New houses (-26% )

Changes in taxes on properties (8%) Non- explained factors (19%)

(values in parentheses shows the contribution to housing price)

Wagner (2005) Meen (2002 Skaarup and Bødker (2010)

Denmark, Danmarks Nationalbank (2003) Miles & Pilonca (2008)

Supply variables: construction cost, labour cost

Price reactions to demand shocks – such as those produced by shifts in interest rates – fundamentally depend on supply responses. If supply is perfectly elastic, house prices will not durably deviate from marginal production costs, which include construction costs, land costs and a normal profit margin of the homebuilder. If supply is inelastic, demand shocks generate price increases, which can be amplified by backward-looking expectations and lead to the development of bubbles.

Glaeser et al., 2008.

Equilibrium Price- to- income relationship It is expected that changes in income influence the demand for housing and thus, prices (see “Theoretical Argumentation and Empirical Evidence in the report).

See table “Empirical Evidence on Price- Income” relationship Price- to- rent relationship The measure is akin to price-to-earnings multiple for stocks. This metric is intended to reflect the

relative cost of owing versus renting. Therefore, it the price of renting is increasing/declining more households will choose to live in owned/rented home, influencing the housing demand and prices.

Himmelberg et al (2005)

Financial Markets Affects

Balance sheet channel (no such a model that measures it affect, however, can be used as variables in multi- factor models)

Write- offs In good time the risks and therefore write- downs are undervalued, thus, increased lending activities and feeding the asset prices. In bad time the associated risk is overvalued, thus, pushing prices further down.


Nationalbank (2008)

Leverage and de-leverage of financial institutions (pro-cyclicality in leverage)

Leverage: As asset prices raise, leveraged financial institution’s capital rise relative to their regulatory requirements, thus, banks buy more assets. The rise in leverage feeds back into asset price increase, encouraging more and more leverage

De-leverage: in the falling markets (and declined value of assets), financial intermediaries need to limit their leverage in order to match with liabilities and capital requirements. When banks limit their leverage, they sell assets. That lowers the prices of securities, which puts further incentive on balance sheets leading to further sales.

It sparks further reduction in asset values.

Muellbauer and Murphy (2008)


Collateral /Capital Adequacy When housing wealth is used as collateral,

In times of housing boom and increased housing wealth, collateral ratio raise. Banks are willing to lend more when using housing as collateral. The same process goes in the opposite direction when th home prices fall. When asset prices fall, collateral ratio falls. Banks then cut on lending.

it provides important determinants of private sectors’

borrowing capacity. At a higher house price, households can pose more as collateral, banks, therefore, are willing to lend more.

Akerlof and Shiller (2009)

Interest rate Interest rate developments See table “Empirical Evidence on Interest Rate and Housing Prices Credit availability Tightening and loosening of credit


See chapters “Credits and Housing prices” and “Empirical Evidence on Bank Credit and Property Prices” in the report.

Mortgage market developments

Extension of loan terms

Development of interest- only loans Increased loan- to-value ratio Housing equity withdrawal Subprime market

Securitization Increased credit supply

Securitization: Because of securitization, banks were willing to take more risk and increase borrowing even to creditworthless customers.

Development of interest only loans: Decreased interest payments (improved credit affordability) results in higher credit/ housing demand, and therefore, housing prices.

Extension of loan terms: as price increases made housing less affordable, lenders have tended to lengthen the repayment period of mortgages. Mortgages with terms of up to 50 years are now available in countries such as France, Spain and the United Kingdom.

André (2010) Lunde et al.(2008a) Danmarks

Nationalbank (2011)

Deregulation and mortgage innovations

Deregulation and mortgage finance innovations have significantly reduced borrowing constraints on households in many countries. As house prices went up, reducing the affordability of housing, financial innovations were used to loosen the financial constraint of households, especially by lowering initial repayments. Such innovations have generated two problems. First, while on an individual basis financial arrangements offering households easier access to credit might be desirable, at the aggregate level they boost demand and hence put further pressure on prices.

Second, many financial innovations increase the vulnerability of households through different channels. Delaying the repayment period exposes households to increased interest rate risk.

Furthermore, it is likely that not all households fully understand the risks involved in taking, for example, variable rate or interest-only loans. Many borrowers tend to choose mortgages with the lowest repayments, at the expense of higher risk (Lunde et al., 2008a). The problem is exacerbated in the case of more sophisticated products, such as those offering teaser rates.

André (2010) Lunde et al.(2008a)

Asset Pricing Approach

Discounted cash flow models

The rental value (equivalent to future cash flows)

Interest rate (discount factor)

Net Present value theory (discounting expected free cash flow by free interest rate) would asses real estate investment as a return on investment (the returns are to be proportional to GDP) plus

“dividend” that would take the form of the value of crops that could be grown on the land, the rental value of the land, or other possible benefits that could accrue to the owner while the land is

Akerlof and Shiller (2009. p 153)


The value of crops (for agricultural property assessment)

still owned. The assumptions on future cash flow (for example, rents) are based on expectations of future income, affordability, etc. The future cash flows are then discounted by the interest rate.

Therefore, a decline/increase in interest rate will result in higher/ lower present value of the property.

Risk- Return Correlation

Housing volatility Portfolio

Stock Market (Financial Wealth Effect)

Asset Allocation

Speculative mania led increase in asset prices through allocation of capital in equity. Investors re-shifted portfolios preferences towards equity, placing upward pressure on prices even when unrelated to fundamentals. Thus, portfolio preferences determined the asset level. With higher preferences on equity (housing), investors were willing to pay higher price for asset (housing).

Case, Quigley and Shiller (2006)

User- cost (arbitrage assumption)

Mortgage cost

The sum of maintenance costs A risk premium

The expected capital gain (the expected rate change of house prices The means of housing purchase The risk characteristics of housing (measured by the conditional covariance between house values and the marginal utility of income The extend of credit restrictions Transaction cost (the cost of buying a house)

A change in any of these factors will affect the demand and supply of housing and

correspondingly housing prices. In Denmark, the average user costs of holding a house declined steadily between the mid 1990s and mid 2000s as a result of declining mortgage rates, increased use of adjustable-rate mortgages, and falling property-related tax rates. A phased reduction in the mortgage rate income tax deductibility (from 46 percent in 1998 to 33 percent in 2001) offset some of the forces lowering housing user costs. Nevertheless, lower after tax real mortgage rates improved household’s debt service capacity and user costs are now only a third of what they used to be during the 1990s. (Skaarup, Brødker, 2010).

Himmelberg et al (2005),

Miles (1994), Lunde (1998a)

Macro- Economy Effect

Wider economy in general: correlations

Unemployment Residual Investments Bankruptcies

Consumption: The estimated elasticity based upon US states, 0,034- 0,054, suggest that a 10 per cent change in housing wealth is associated with a 0,3 to 0,5 per cent change in aggregate consumption

Case & Quigley (2008)


Forced sales (Foreclosure) Consumption

Foreclosure (the process by which a home-owner loses their home due to non-payment of mortgage). During the years of the rapidly rising housing prices, delinquency and foreclosure rates declined rapidly, which send even more incentives to lend into housing market and pushing housing prices up.

However, foreclosures happen more frequently in times of housing downturn. When a borrowers loan exceed its housing value (the owners private equity is then negative meaning that mortgage loan on housing is worth more than the home), he can no longer use the option of a pre-payment.

Moreover, if he is no longer employed (due to higher unemployment rate in recession times), he is no longer able to meet his mortgage obligations. Then banks have right to sell his house. This process accumulates houses for sale on the housing market and puts pressure on prices.

Taylor (2009)

Residual Investments

During the expansion of the 1990s, residential investment generally expanded at a moderate pace.

But during the latest expansion, there was a housing investment boom in many countries, particularly the United States, Canada, Denmark, Ireland, Norway and Spain. Measured as a share of nominal GDP, long-term averages for housing investment are typically in the range of 4 to 6%. At the peak of the cycle in 2006, this ratio reached more than 9% in Spain and 14% in Ireland. So, increased interest in residential investments lead to increased housing demand, and therefore, housing prices

André (2010)

Other Factors

Individual Characteristics

Neighborhood characteristics Location

Convenience Year of building

These factors effect housing prices level, however, difficult to incorporate on the aggregate level.

Wendt (1994)

Demographics Population Age Immigration

Environmental restrictions

Changed demographic trends, for example, increased proportion of first- time buyers (30- 39 year old) of a general population, as well as increased population, migration result in increased housing demand, and therefore, housing prices.

Other Schools

Behavioral Finance Risk perception Expectations Beliefs

Backward- looking

See chapter “ Housing price formation under behavioral finance assumption” in the report Shiller (2005, 2007, 2009)

Akerlof and Shiller (2009)

De Bondt (2003) Currency School- The

Monetarist approach

Extended Money Supply Bunk runs

Increased money supply increase interest in investments, which in tern, increases the possibility of price bubbles. Taylor contends that “monetary excess were the main cause of the recent housing

Taylor (2009a) Schwartz (1987)

10 Source: my own production

Inflation boom and the resulting bust”.

Also, inflation leads to heightened risk in lending decisions, as uncertainty over future cash flows increase. Thus, there is a high demand for housing in times of high inflation as it is seen as a

“protection” against the inflation.

Debt- Deflation Theory of Great Depressions

Increased investments Increased indebtedness

Decrease in real value of underlying debt while the value of asses increases

The upswing in business activities lead to an improved opportunities for profitable investments.

This lead to increased fixed investment, as well as speculation in asset markets for capital gain.

Velocity increases and lead to raising prices. Rising prices reduce the real value of outstanding debt, offsetting the increase in nominal debt, and encouraging further borrowing. This leads to a stage of “over-indebtedness”. At some point some events may reduce willingness to borrow and invest. For example, raise in interest rate, a war, a new law, etc. Then agents will need

liquidity.When agents need liquidity, distress selling occurs. Distress selling leads to falling prices, bank deposits declining as loans are withdrawn. Foreclosure, need for new capital to pay off previous debt. Deflation increases the real value of outstanding debt. All this triggers the crisis.

Fisher (1932, 1933)

Debt and Financial Fragility

Euphoria Speculation

See chapter “Theoretical Evidence” in “Credit Affordability” part in the report

Policies and Regulatory Actions

Monetary Policies Measure: Taylor Rule

Interest rate developments A right monetary policy aims to keep prices stable. Thus, monetary policy can be used as an instrument to prevent bubbles.

Trichet (2003)

Quantitative Easing (QE)

Bond Rate QE works mainly through two channels. First, when central banks buys government bonds the extra demand raises bond prices and lowers their yields. Lower interest rates stimulate activity elsewhere in the economy.

Second, when banks sell their bonds to the central banks they get reserves (ie, deposits at the central bank) in return. They have an incentive to swap those low- yielding reserves to something with better returns, like shares or corporate bond. This lowers private borrowing cost and raises asset values, boosting wealth and spending.

The Economist, September, 4th, 2010)

Taxation Property taxes

Land taxes

Tax shield ( the deductable value of mortgage interests related to the main residence from personal income tax) Taxes on transactions

A variety of taxes, tax reliefs and subsidies affect the housing sector.

Advantageous tax treatment of housing may also lead to over-investment in real estate and misallocation of capital, with negative effects on long-term economic growth

Van den Noord (2005) demonstrates that, in the presence of backward-looking expectations, a tax system which subsidises homeownership tends to increase house price volatility. He shows that euro area countries with the highest subsidies for homeownership – Finland, Ireland, Netherlands and Spain – have the most volatile house prices

André (2010)


Appendix 7A: Behavioral Finance Assumptions- Factor

In document by Olena Denysyuk Cand.merc. FSM (Sider 112-117)