Real Estate Bubbles: A New Analysis Based on the Lender-Borrower Relationship
||Brown, Roger J. and Beate Klingenberg
||Real Estate Bubbles: A New Analysis Based on the Lender-Borrower Relationship
||Book of Abstracts: 2005 European Real Estate Society conference in association with the International Real Estate Society
||Markets are cyclical. In early 2005, anecdotal evidence suggests that some United States real estate market sectors are in a "bubble". Furthermore, it is widely accepted that timing is everything. Easy to say and hard to implement, knowing when to get out is very often the key to investment success. In this paper the authors examine the interaction of lender risk management tools as an early warning sign to head for the door. The analysis centers on if and when the lender-borrower difference of opinion about the future suggests the market has gone as high as it can be expected to. There is a three-way relationship between capitalization rates, interest rates and inflation. When inflation expectations increase, interest rates rise as lenders build inflation expectations into their rates. Since capitalization rates include the cost of funds (interest rates), one would expect capitalization rates to increase also. That this is not always true is an anomaly. Buyers of income property, anticipating higher future income, bid up prices causing capitalization rates to fall. Tension is created by this anomaly because everyone knows that it cannot continue forever. Price inflation traceable to this anomaly introduces concern about a bubble in the market. Much has been written about the difference between expected and unexpected inflation. However, our interest is about how two parties to a transaction behave when their separate opinions differ in these areas. Previous research define bubbles in the context of irrational investing, where momentum drives prices higher as irrational investors or consumers find the assets more attractive, see for example the discussion in Hendershott, Hendershott, and Ward (2003). What is missing in that analysis is the role of the lender. Lenders operate as a sort of governor, acting out the unpopular role of guarding the punch bowl, adding just enough joy juice (easy credit) to keep the party interesting but not enough to allow it to become unruly. Why would lenders provide capital to sustain such a bubble? Indeed, consider the lender's concern that the buyer is overpaying. Suppose that for a period of time buyers gradually abandon the use of better analysis tools in favor of short cuts. This sort of behavior is met with lender restraint, a sort of benign paternalism. The manifestation of that restraint is in the lender's choice of underwriting tool. The theoretical model and empirical analysis presented in this paper supports the hypothesis that behavior of lenders is an indicator. In fact, one should be alert to changes in the direction of capitalization rates when setting loan underwriting policy. Furthermore, changes in underwriting standards affect both the quality of loan portfolio and market transaction prices.
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