Real estate bubble or housing bubble refers to a situation where the real estate prices increase artificially, irrespective of demand and supply mechanism, till such time when the artificial incremental growth fails to sustain any more. Once this level is achieved the bubble bursts and the prices start falling down to their realistic values. Unlike stock market, the period of real estate bubble is more lengthy and unpredictable. The effects of real estate bubble are felt by a common investor when it is close to burst.
Now the question arises as to how the prices increase artificially over and above the average growth rate? In this regard the economists are of the view that there are many factors attributable to such situations. Normally when the economy is growing, people have sufficient disposable income to invest in real estate. Low interest rates results in strong credit growth, particularly house financing. This leads to high speculation and invasion of investors in the market, leaving behind the genuine buyer. When the investors dominate the market, the speculative forces entangled the market and the prices start increasing artificially. Furthermore, irrespective of economic growth momentum, the global shift of investment from stock and bullion markets to real estate sector also contributes towards formation of bubble through creation of artificial boom in the market.
The recent United States housing bubble of 2008 coupled with the downward economic trend, greatly affected the US economy. The bubble that shaped out in 2005-2006 was controlled and corrected by economic managers through interest rate adjustments which brought down the real estate prices to its reasonable value in 2012.
The real estate artificial prices in US, which were at its peak in 2005-2006, took almost seven years to come down to its reasonable levels. Furthermore it is quite interesting to note that this bubble must have also taken some considerable time to reach its peak in 2005-2006, so we can say that the life cycle and the effects of these bubbles may spread over decades.
It is however imperative here to mention that it is not like that the bubble cannot be predicted. There are many early warning indicators which clearly predict the creation of bubble. Although there are many other indicators like low interest rates and leverage, high living expenses against low salary level and increasing role of investors in the market, etc. , yet I have examined one of the most common indicators, i.e., the gross annual rental yield indicator.
A gross rental yield is calculated as follow:
Gross Rental yield = (Annual Rental Income / Cost of Property) X 100
In Pakistan, the standard average annual rental yield on residential properties is 3% to 4%. As such the property prices when compared to their rental value clearly reflect the excess fat. An analysis of the property prices of Pakistan’s major cities, in comparison to their rental values, reveals that the real estate bubble is in the offing.
Luckily with the change in government and an expected tight monetary policy, the interest rates will likely to be increased again in near future. Resultantly the real estate market is definitely going to be affected appropriately enough to get its excess fat evaporated.
Construction of 5 million houses, as per 100 days agenda of the new government, will also play its role in rationalizing the market. However the details, in this regard is yet to be unveiled, as such, once the same is presented, a much more clear picture will emerge, which will set the trend accordingly.
Let our fingers crossed that the real estate market of Pakistan will respond rationally and positively in the near future to get it self corrected from artificial effects.