For any asset, at least two types of value are relevant. The market value is the price at which investors can acquire the asset. In liquid asset markets, such as the markets for the shares of the largest companies or the markets for the foreign exchange of major currencies, this price can be readily observed from the sales transactions that take place. On the other hand, the fundamental value of an asset is the present discounted value of all the cash that the asset is expected to generate. In a bubble, asset prices become much higher than the asset fundamentals can justify. What makes the analysis particularly difficult is that fundamental values are not directly observable. Their calculation requires estimates of the cash that the asset will generate in the future and of the discount rate used to obtain the value today of the stream of future cash flows. This discount rate should reflect the risk of the cash flows that the asset is expected to generate.
For example, during the dot-com boom, the share price of many internet companies rose to levels that were difficult to justify based on the companies’ current and future cash-generating prospects. The same valuation concepts can be applied to real estate assets. The cash that a property is currently generating includes the rents received as a cash inflow and property maintenance, taxes, insurance and other expenses as a cash outflow. The difference between the two is the net operating income of the property. For some types of properties it is much easier to obtain data on rents than on property expenses, so the focus is usually on the former.
Is a given increase in real estate market prices a sign of a bubble in the making, or can it be explained by the asset fundamentals? It will be explained by fundamentals if the higher price is due to improved cash-generating abilities or to a decrease in the discount rate required to calculate the present discounted value of future cash flows. It is instructive to consider the following valuation formula:
(1+ % Change in property prices T,T’) = (1+ % Change in rents T,T’) x Multiplier
In the left-hand side we have one plus the percentage change in property sale prices between two dates, designated by T and T’, with T’ occurring later than T. The first term in the right-hand side of the equation is one plus the percentage change in rents between the same dates. These changes in sale prices and in market rents (cash that the property is currently generating) can be directly observed. If the increase in property prices is accompanied by an increase in market rents, this is obviously a sign of good fundamentals.
To make things more concrete, consider the case of residential real estate prices in Dubai (data is available from REIDIN.com, a real estate information company focusing on emerging markets). Let us take T to be June 2011 and T’ to be June 2014. In a detailed analysis, one should consider other time periods, different property types and geographical locations, since real estate assets are very heterogeneous. But to illustrate and explore the issues, it is sufficient to consider the evolution of general residential real estate prices in Dubai.
From June 2011 to June 2014, sales prices increased by 77 per cent, from US$227.4 per square foot to $402.4 per square foot. Therefore in the left-hand side of the above equation we have one plus this number, which gives us 1.77. Between the same dates, rent prices rose by 46 per cent, from US$1.50 to $2.19 per square foot. This means that the first term in the right-hand side of the equation is 1.46.
Importantly, and even though the increase in sales prices has been accompanied by an increase in rents – a sign of good fundamentals – property prices have increased at a faster rate than rents. If the evolution of property prices is to be explained by sound fundamentals, then the gap between the evolution of sales prices and rents has to be explained by the second multiplier term in the right-hand side of the equation.
The value for this term depends on the expected future growth rate in rents (which we denote by g), both in June 2011 and in June 2014. It also includes the discount rate used to calculate the present value of future rents (which we denote by k) at the same dates.
Since between June 2011 and June 2014 property sale prices increased by roughly 20 per cent more than rents, the second term in the right hand side of the above equation should be equal to 1.20. For that to be the case, future rents must be expected to grow at a faster rate in June 2014 than in June 2011 (g2014>g2011), or the discount rate that one should use to discount the future cash flows must be lower in June 2014 than in June 2011(k2014>k2011). Let us consider each of these possibilities in turn.
Rents (both current and future) are determined in the “market for space”. This is the market for the use of the space that the property provides. On the demand side of the market, tenants are the users of the space. On the supply side, property owners provide or let out the space. In the short term the supply of space is relatively inelastic because it takes time to plan and build. Increases in market rents, such as the one observed in Dubai between 2011 and 2014, are the result of an increase in the demand for the use of the space.
The economic factors that drive such an increase in demand depend on the type of property under consideration. For residential properties, relevant factors include population growth, household formation and income. The same factors are important for retail properties. For office buildings, employment in the service sector is among the most important. For hotels, tourist numbers and average spend per visit are measures that deserve special consideration.
For logistics, geographical location and transport infrastructure are important. Some of the recent increases in rents in Dubai have been associated with improvements in these economic variables, which drive the demand for the use of the space. But if property sale prices increase at a rate faster than rents, for prices to reflect sound fundamentals future rents must now be expected to grow at a faster rate than before (that is g2014>g2011). Is that likely to be the case? From a demand perspective, it is not unreasonable to view the higher current demand for space as a signal of even higher future demand. As a result, higher current rents may also be a signal of higher future rental growth. The crucial issue is the extent to which the factors driving higher demand today are likely to persist well into the future. Will they prove sustainable? For example, Dubai won the right to hold Expo 2020, which will lead to increased tourist numbers and higher demand for the use of space, but what will happen after 2020? Will higher tourist numbers be sustained? Real estate assets are long-lived and the increase in future rents that shows up in the formula refers to rents far into the future.
Perhaps the more significant risk to sustained higher future growth rate in rents is the reaction of the supply side of the market. As property prices (and rents) increase, many development projects are planned and started. When completed, they will add to the supply of space, which will put downward pressure on rents. Furthermore, such projects are often undertaken by different developers, sometimes in an uncoordinated manner. The danger is that the resulting increase in supply will outstrip the future demand for space and future rents will decline or grow at too low a rate to justify the high property prices, which may end up falling.
What can be done? Information on planned additions to supply and coordination among different developers are key factors. It is important that they do not build and add to the supply of space at a rate that outstrips demand. The recognition and the optimal exercise of the real options embedded in real estate development projects will also help. A considerable number of large real estate projects are suitable for phasing, which allows additions to the supply of space to take place gradually and at a time when it is clear that the increase in the demand for the use of the space is sustained.
In general, it is important to be able to explain increases in property prices without relying on too large an increase in the expected future growth rate of rents (or more accurately, of the cash that the property is expected to generate in the future). Properties are real assets that depreciate physically and economically. The expenses required to counteract physical depreciation will tend to increase with property age. The economic depreciation refers to the notion that the features of the property which the users value may change over time. What may be desirable features to have in a property when it is first built may no longer be fashionable some years down the line. The space may still be usable, but the rents it can achieve may be lower. Alternatively, the property may be redeveloped in order to achieve higher rents, but this is likely to require significant investment that will reduce the future cash flow from the property.
Even if one does not rely on a higher future growth rate in rents to justify the large increases in property prices, one can still make sense of such increases through a decline in the discount rate used to compute the present value of future property cash flows (that is k2014
In some instances, the decline in the required risk premium has been larger for assets that enjoy some form of safe haven status. The stability that Dubai offers, particularly when compared to the turmoil in other countries in the region, means that the risk premium required to invest in Dubai real estate will be lower than the risk premium commanded by real estate assets in other countries in the region. Such safe haven effects in house prices have been documented for other major cities such as London and are likely to be at play in the recent appreciation in property prices in Dubai.
Although it is possible to justify the increase in property prices based on fundamentally lower discount rates, the major risk is that the conditions that have led to the reduction in discount rates are reversed: interest rates may rise; other countries in the region may become more stable; investors may become less risk-tolerant. These are largely global risks arising from the actions of monetary authorities in the major economies and from the behaviour of global investors, whose capital is very mobile. They are significantly beyond the direct control of property companies or the Dubai government.
What should the focus be? My research suggests the focus should be on the market for space, both on the demand for use of the space and on additions to the supply of space. Some of the questions that should be answered are: What are the factors that have been driving the demand for space? How likely are those factors to persist well into the future? What can be done to make sure that is the case? How can you prevent a rush to development and an over-supply of space?
Large real estate developments financed with high leverage ratios should also raise alarm bells. High leverage will pose significant challenges in a scenario of increasing discount rates and declining real estate prices, even if the market for the use of space remains healthy and rental values are sustained. Asset values lower than outstanding debt will make it difficult or even impossible to refinance outstanding loans. Any resulting defaults will have a negative effect on the value of other real estate assets. An important way to mitigate the risk of such a scenario is the use of significant equity capital for the acquisition of real estate assets and financing real estate investments.