The real estate bubble



INVESTING in real estate has become a national craze in Pakistan. The moneyed are taking this newly developed passion to an extreme. They favour speculation in real estate at the cost of industrialization. On a recent trip to Pakistan, an acquaintance forced me to accompany him to a dream investment opportunity. I waited in anticipation as our 4x4 crossed the boundary of our city and raced ahead on the Grand Trunk Road. Massive real estate projects were marked on both sides of the highway– first it was Defence, followed by Bahria and so many others that I lost count.

Suddenly, we took a turn and the vehicle jumped and jolted as it made its way on a beaten-down track. After a while, the 4x4 stopped with a thud. At last, I could see for myself the great investment dream that had made so many millionaires and now it was going to be my turn! Barely controlling my excitement, I leapt out.

Once on ground, the first thing that struck me was the vast span of barren and desolate land that surrounded me. Not a single man-made structure in sight. The dead of the silence was occasionally broken by a donkey’s hee-haw; the poor soul too must have been feeling lonely in the middle-of-nowhere! I was informed that land in this development scheme had doubled in the last six months and one-kanal plot commanded a price-tag of Rs6 million.

Vow! as I remembered that only three years ago, a built-up house in a decent locality within the city could be purchased for this handsome amount instead of undeveloped land more than five kilometres from the city’s boundaries.

In addition, with mechanics of supply-and-demand severely skewed in favour of supply and dozens of similar land schemes being developed or in the process of getting approval, who would want to buy such speculative investment? It’s apparent that this point of view is in minority as land deals are executed at a frenetic pace.

However, a price-tag of Rs6 million seems like a bargain when compared to the dizzying and gravity-defying prices in Islamabad. So high are the valuations, that it seems that Islamabad is not the capital of Pakistan but that of England with a house in some sought-after sectors putting you back by as much as Rs80 million, an amount that could buy you a five-bed fully detached house in London’s financial district of Docklands!

To understand how absurdly high property prices are in Islamabad, one has to compare wealth generation or net worth of the two cities. London is the world’s second largest financial hub with an estimated Gross Domestic product (GDP) of $350 billion and GDP per capita of $44,000. Compare this with Pakistan’s total GDP of approximately $90 billion.

If we are extremely generous with Islamabad and assume that it generates a disproportionately high 15 per cent of the entire country’s wealth, even then the city’s GDP per capita amounts to $16,000, about one-third of that of London. With this glaring difference in wealth per capita of the two cities, how is it that house prices in Islamabad are comparable with those in London?

Die-hard proponents of the property boom will retort that Rs80 million will buy you a 1250 square yard house in Islamabad, while the property in London will be at the most a quarter of its size. But then we are talking about Docklands, an exclusive district boasting the second highest concentration of elite financial institutions after Wall Street in New York.

Also, a property’s value is rooted in its ability to generate return for its owner. If the return on property is below that on comparable or alternative investments, it indicates that property is over-valued. This is because investing in alternative assets would generate greater return for the investor and therefore demand for these alternative assets should rise relative to that of property.

Economic theory dictates that as demand for property declines due to its lower comparable return, price adjusts downwards until property’s return comes at par with other assets and thereby equilibrium is restored. Simple mathematics reveals the irrationality of the real estate bubble.

However, Pakistanis should draw comfort from the fact that we are neither the first nor the last ones to succumb to such bouts of irrational behaviour. In early seventeenth-century Netherlands, demand for tulip-bulbs became so frenzied that prices shot up tenfold in just one month. The more expensive the bulbs became the more people viewed them as smart investments, similar to what’s happening in the property market today!

In the end, prices became so high that some people sold to lock-in their profits. As others followed suit, selling pressure intensified and panic reigned. Even government intervention could not halt the slide in tulip-bulb prices, eventually selling for no more than the price of a common onion – sanity eventually prevailed.

Such events are not confined to ancient history, but have frequently happened in recent past as well. In early 1920s, stories of investment doubling or tripling attracted speculators to the real estate market in Florida. Just like today, easy credit terms added fuel to the speculative frenzy.

Just like today, real estate developers opined that prices can only go up. At the peak of the property boom, there were seventy-thousand real estate agents in Miami, one-third of the entire population of the city! Eventually, the boom became bust with investors losing their lifelong savings.

These events show that markets have a painful yet efficient way of correcting any excesses in asset prices. A vacuum cannot exist in nature. Similarly, asset prices cannot stay at inflated levels forever and they will always revert to their fundamental or intrinsic value. That is why we have seen periods of phenomenal growth in prices of tulip-bulbs, real estate in Florida or dot.com companies, but in the long-term valuations always come down to the asset’s true worth.

When this correction takes place, it is an extremely painful process and is generally accompanied by a prolonged recession. The property bubble could also pose a serious challenge to the country’s macro economic stability.

There is a saying on Wall Street: markets are driven by emotions of fear or greed. At the moment, the pre-dominant emotion is greed, but it takes just a trigger for this sentiment to change to fear. Investors on NASDAQ stock exchange experienced this first-hand in March 2000 when the index tumbled by more than 10 per cent within a few hours.

My counsel will be to learn from the mistakes of the dot.com investors and those before them; like all spates of irrational exuberance, the property prices will reverse sooner-or-later!


http://www.dawn.com/2005/09/12/ebr13.htm