The Influence of Macroeconomic Conditions on the Property Market Development in the UK - Essay Example

Introduction According to Erdman (1992, p.3) ‘the UK property market is highly sophisticated and based on well-established traditions, customs and codes of practice, and it is widely recognised within UK – as elsewhere – that every major business decision has a property dimension.’ It is also noted that the property market in UK is remarkable in terms of liquidity, institutional involvement, transparency and ease of trading than any other property market in Europe. Many studies have shown great influences of the macro economic conditions on the property market development in UK. However, the influence of macro economic conditions in the early 1990s and since 2007 is reported to have some differences (Sentance, 2010). The comparison of the influence of macro economic conditions in the early 1990s and since 2007 on the property market development in UK is examined in detail in this essay. This essay is organized as follows. Section 2 discusses the theoretical views in this regard. Section 3 discusses the property market development and macro economy in UK in the early 1990s. Section 4 discusses the property market development and the macro economy in UK since 2007 and section 5 concludes the report. 1. Theoretical Views An ideal property cycle according to Ball et al (1998) can be characterized as business upturn and development, business downturn and overbuilding, adjustment, slump and the next cycle. Many economic theories have been put forward to explain these five patterns. The business cycle approach (Barras, 1994; Key et al, 1994), based on accelerator principle has established clear causal links from economic fluctuations to property cycles. The two major factors affecting property development cycles are exogenous occupier demand for space and pro cyclical exogenous availability of finance according to this approach. However, this approach does not account for the construction completion lags .Further there can be causalities from development cycles to economic activity also. Hence the building lag model developed by Baras(1983,1994) tries to produce an endogenous mechanism to explain development cycles. Here, the lag between demand and supply together with the accelerator principle explains the development cycles. This model ignores the role of interest rates, prices, expectations and adjustments to rent and capital values. The dynamic model based on historic data for UK property development by Barras and Ferguson (1987a, 1987 b) establishes an endogenous development cycle mechanism. This model identifies the level of user activity and the level of investment activity as the two major economic factors affecting property cycles. This model, however, explicitly includes an endogenous cycle mechanism, which is problematic .Further, the exogeneity assumption for variables like rent, capitalization rates, building costs etc are also questionable. Several explanations based on irrational behaviour of valuers, developers and lenders like slowness of these agents to respond to clear market signals and failure to learn from experience are also given to property cycles (Baum and Crosby, 1995). However, these models implicitly assume irrational behaviour, which is its limitation. The model of property cycles and option pricing based on owners and developers (Grenadier, 1995) shows that the stickiness of vacancy rates increases with the rise in uncertainty and adjustment costs. Further, the probability of overbuilding rises with the rise in construction period, adjustment costs and uncertainty about future demand. However, this model is based on the assumptions regarding preferences in finance theory, which is unlikely to hold good in property markets. This reduces the predictability of the model (Ball etal.1998).Thus all the models discussed above have some shortcomings. Their predictability cannot be generalized and depends upon the context only. In addition to the above theoretical models, the property markets especially the housing markets are obtained to have reverse effects on the macro economy through their impact on the consumption expenditure of households, through the effects on financing constraints and through their effects on the financial system (Cameroon, 2005). Studies show these reverse effects strongest for UK among the OECD nations (Cameroon, 2005). Hence, the reverse effects also need to be considered while examining the impact of macroeconomic conditions on property market. 3. Property Development and Macro economy in UK in the early 1990s In the UK, around 7percent of national output is accounted by construction and is often seen as ‘a crude indicator of the well-being of the economy as a whole’ (Cooke, 1996:13). The analysis by Ball etal(1998) of the UK commercial property output data shows that there are two cycles since 1980.One from 1980q4 to 1990q1(trough to peak) and 1990q1 to 1996q1(peak to trough). Attempts were done to explain the property cycles in terms of business cycle approach(RICS,2002). However, many studies have shown that though the starting of construction activity in UK coincides with the economic cycle the ending of construction in UK lags with it by some years(Keyeatl,1994a). Further, the data analysis by Bara,1983;Bal et al(1998) etc also identifies different patterns and magnitudes for property output and national output. A consequent attempt to explain the demand for construction is done using the building lag model for UK office markets (Baras, 1983.1994).It identifies the lagged output as the main variable affecting demand for space in UK. However, this model ignores the role of many market variables as explained earlier. The other economic models that can explain the demand for construction in UK are the dynamic property development model for UK property development and the Baum and Crosby model (1995) based on irrational behaviour. According to the first model, both the level of user activity and investment activity are the main variables that can explain the demand for construction in UK. The second models explain the demand for construction in UK in terms of slowness of these agents to respond to clear market signals and failure to learn from experience. The predictability of models based on option pricing to explain the demand for construction in UK can be considered as low. This is because in the UK commercial property market, the tenant has to bear many adjustment costs other than rent. It can be concluded that the UK commercial property market has experienced sharp rises and falls but highly pro cyclical with national output growth .Hence models like building lag model and dynamic property development model can explain the demand for construction rather than business cycle approach in UK. In the early 1990s, reports show a he recession in UK with high interest rates, high unemployment and a consequent reduction in demand for housing and hence fall in prices (Tutor2u, 2010). The trends in London housing market from 1981 to 2000 show great volatility especially in England and Wales (Figure 1).The main reasons for these trends can be explained in terms of the violation of assumption of housing markets. The financing constraints and irreversibility are given as explanations for the housing market volatility. The institutional changes in UK especially the deregulation were obtained to have affected the housing markets through the financial markets. The deregulation affected the mortgage liquidity and increased volatility. Due to high inflation, interest rates increased and hence the financial instability affected the mortgage markets. The main institutional changes other than the above that has resulted in the recession in the early 1990s were the entry of banks into mortgage market resulting from the removal of restrictions on banks in this regard, transition to a market based interest rate , entry of new centralized lenders, starting of mortgage securitization and the removal of restrictions on building societies(Joseph Rowntree Foundation,2008). The inability of many borrowers to adapt to the high interest rates together with unemployment and high personal debt levels resulted in high defaults in the early 1990s. In addition to the institutional changes, fiscal changes like Mortgage Interest Relief at Source and changes in property council tax arrangements affected the demand for housing. The availability and the affordability of finance affected the decisions in the housing market .The different factors affecting the decisions in the housing market are classified into heterogeneity and supply constraints; uncertainty and adjustment costs; information asymmetries and transactions costs; herding effects; affordability and financing constraints(Baddeley,2005). Figure 1: Property Transactions: England and Wales 1981 Q1 to 2000 Q4 Source: Baddeley(2005) The tight monetary policy in the late 1980s resulted in inflationary pressures with high rise in the mortgage interest rates pushing the economy to recession and weakening of the housing market in 1990(Pain and Westaway, 1996). In the early 1990s, at the time of falling house prices the consumer demand was also slow (Figure 2). The prices experienced significant stagnation until 1996 when the economy experienced significant recovery. Thus at the time of the recession in the early 1990s, there was not only considerable decline in prices but also the longevity of the decline was high and remarkable (Pain and Westaway, 1996). From 1996 onwards, the demand in housing sector enjoyed recovery .The housing prices experienced a boom in 1999-2000 period. The housing price inflation reached its peak in this period. In this period, the household spending also increased in contrast to that in the early 1990s(Figure 2). Figure 2 Source: Tutor2u (2010) The transactions in the housing market are also reported to have multiplier effects through their effects on other businesses. These are reported to have increased the spending power and in addition, it is reported to have a positive wealth effect also (Tutor2u, 2010). The studies also show great indirect links between rising housing prices and inflation through the rise in aggregate demand and the consequent rise in demand-pull inflation and a greater increase in UK trade deficit (Tutor2u, 2010). In addition to this, reports show that the hosing price volatility together with low investment levels and high owner occupation levels increases macroeconomic volatility through the changes in private consumption (Barker review final report, 2004). Reports also show that lower homebuilding rates adversely affected the economy through reducing the living standards , reducing labour mobility and competitiveness and increasing employment in the early 1990s(Barker review final report, 2004). The study by Pain and Westaway(1996) based on the housing market data in UK in the early 1990s modelled the house prices by conditioning directly on consumer expenditure and capturing the effects of financial liberalization on the relative consumption of housing and non housing goods and services. The study obtained structurally stable parameters across the housing market for the proposed model especially for the early 1990s. In the studies by Chesterton (2000) and Chesterton (2002) for London property markets, it was obtained that proximity to railway stations has positive impact on residential vales but varying impacts for different types of occupancy. The impact was positive for commercial property values but only for limited areas. At the same time, the study by Pharoah (2002) based on London property markets, obtained the impact of proximity to stations as positive on residential property values but only in limited areas and highly variable. The discussion on housing markets and macro economy in the early 1990s thus shows the importance of demand and supply analysis affecting the housing market in UK. The housing market in the early 1990s shows the importance of demand side analysis on housing market especially from income levels and mortgage rates, which depends on the interest rates. The discussion also shows the existence of speculative demand depending on the expectations on future changes in house prices. The supply side is inelastic compared to the demand side and hence the influence of macro economy comes mainly from the demand side. 4. Property Development and Macro economy in UK since 2007 The housing market in UK showed boom in the late 1990s, which helped in maintaining economic growth in the economy. Since 2005 the housing market showed excellent performance which was a reflection of the good performance of the overall economy. The housing market again entered into a crisis since 2007 with the origin of the global financial crisis. The global financial crisis, which originated in USA in 2007 spreaded to countries all over the world. The financial crisis had its origin in USA with the sudden boom in housing prices creating high optimism among investors and enders between 1990 to 2006.This resulted in the creation of many mortgages and finally as the hosing price boom came to an end in 2006, subprime defaults started rising. Since the households became unable to repay their debts, the leading financial institutions worldwide had to write off their investments since August 2007. This deteriorated their balance sheet positions which ultimately resulted in a tightening of supply of credit to households and firms so as to finance their consumption Thus the financial crisis led to economic crisis which spreaded all over the world (Agarwal et al, 2008; Vyuev,2008;Gwimmer and Sanders, 2008). The regulatory system in UK failed to cope up with the complexity of these instruments and the risks associated with them were underestimated there. This resulted in the liquidity problem, which ultimately resulted in financial crisis in UK also (House of Lords, 2009). The housing price cycle and the property cycle in UK also have been identified to have played important role in creating the crisis in UK (Financial Services Authority, 2009). The prices of houses and housing affordability have got adversely affected by the crisis. From 2004 onwards, the housing affordability indicators started declining due to the continued house price rises together with the rise in the interest rates. The housing price affordability decline has reached its peak in 2007(Joseph Rowntree Foundation, 2008). There has been significant decline in the house price inflation from 11.4 per cent in August 2007 to –0.9 per cent in April 2008(Figure 3). Figure 3: Monthly and Annual changes in Nominal House Prices Source: Joseph Rowntree Foundation (2008) The significant decline in demand in housing market which is reflected in the decline in gross lending from the third quarter of 2007 and the financing constraints due to the worldwide credit crunch have been the two characteristics of the housing market since 2007. Due to these, many mortgage products have reported to be withdrawn. The rapidly growing internationalization of the mortgage markets in UK has been reported as one main reason for the decline in housing market prices and the recession .Among the main financiers of the UK mortgage markets include whole sale market funding, securitization vehicles and the Northern Rock Bank. Due to the credit crunch, the amount and price of bank lending can be affected through various channels. First, the risk on capital markets can increase funding costs in banks which will be transferred to interest rates. The next channel is through the fall in the capital ratio of banks which in turn can adversely affect fund availability. Third channel is through the deterioration in the financial position of bank borrowers. In UK, Northern Rock, the leading mortgage provider was the first one to be announced affected by the credit crunch. Rather than getting direct exposure to US subprime assets, through the wholesale money markets using complex securitisation instruments ,covered bonds etc , it has been funding UK mortgage lending. The credit crunch problem had its impact on Northern Rock in August 2007 following the unanticipated congestion in these instruments. Northern Rock was prevented from being bankrupt due to the intervention of Bank of England (UK Economic Outlook, 2008).This had a spill over effect to the other mortgage lenders in UK and they restricted the availability of credit to firms and households. During the credit crunch , the bond markets served the economies well as an alternative source of financing during the periods of loss of bank financial intermediation (UK Economic Outlook, 2008). However, whether bond markets constitute an effective source of alternative financing depends on the absence of co movements of bank and bond markets, and also the absence of contagion in the international capital markets. The decline in the market fundamentals since 2007 adversely affected the real estate owners and investors in a same way (Stratton and Hobbes, 2009). In this period, the declining market fundamentals made it very important for the landlords to retain the tenants to avoid any lease event. Consequently, the landlords and tenants agreed to many innovative terms .The credit crunch made it difficult for the landlords to make developments on the building and work on nonperforming assets rapidly (Stratton and Hobbes, 2009). In addition to these, the difficulty in valuation due to the shorter and complex leases resulted in diverse bids and filtering of transaction prices. Thus, the length of leases has become very important to the investors since 2007 in the appraisal of investments. In some cases, the transactions have been even got stopped by the shorter leases (Stratton and Hobbes, 2009). The importance of leasing structure of the building and the covenant strength also has increased very much and consequently the need for these to be reflected in the buying price also has become important (Stratton and Hobbes, 2009). Figure 4 shows the trends in real GDP and the housing market. It shows deep decline in real GDP and the housing market trends since the first quarter of 2007. Figure 4 Source: Sentance(2010) The comparison between the recovery of housing market in the present crisis to those of the 1980s and the 1990s shows the present situation similar to that of 1980s than the 1990s(Sentance,2010).The reports show more positive balance of demand and supply for hose prices and investment than in the recovery of the 1990s(Sentance,2010). The problems in the banking sector especially the interest rate problems are reported to have acted as a dampening factor on housing market prices (Sentance, 2010). Moreover, though in both the crises, the cyclical nature of the housing market is seen, the social, institutional and policy changes leading to the present crisis, which has affected the housing market, are obtained to be significantly different from that of the early 1990s. The above discussion shows these to be very different for the housing market in the present crisis when compared to that in the early 1990s. Reports show lack of liquidity in the commercial property market mainly due to the pricing uncertainty (Invisita, 2008). The lower economic growth is reported to have affected occupational demand except City market (Invisita, 2008).Moreover, the low economic growth is obtained to have damaged the rental values (Invisita, 2008). Falling prices and competition from the internet are obtained to have affected the retail sector. The decline in inflation is obtained to have affected positively retailer costs (Invisita, 2008). Shopping centres are obtained to have been more resilient in the recent economic crisis compared to the other markets (Invisita, 2008). The consumer confidence is obtained to have deteriorated worldwide especially in UK which is obtained to have affected consumer confidence in the property market. It is likely to have impacted the property prices (rightmove plc 2010). 5. Conclusion In this essay, the comparison of the influence of macroeconomic conditions on the property market development in UK in the early 1990s and since 2007 is discussed. The theoretical discussion shows the difficulty in a generalization of the impact of macro economic conditions on property market cycles. The discussion hence shows this as context specific. The discussion shows significant influence of macro economic conditions on the property market development in UK. The importance of demand side on the housing market is seen from the discussion in the crisis of the early 1990s and the 2007 crisis. The supply side is seen as relatively unimportant due to the inelasticity. The housing market affects the macro economy in turn through affecting the consumer spending as seen from the above discussion. In both the periods, the property market especially housing market got affected by crisis. The cyclical nature of the housing market is seen in both the periods. However, compared to the early 1990s, the balance of demand and supply on housing prices and investment became more positive in the present crisis since 2007. The institutional, social and policy changes under both the crises, which have affected the housing market are obtained to be extremely different as seen from the above discussion. The balance between demand and supply in the housing market appeared to be more positive in the present crisis than in the early 1990s. Moreover, the lease length became very crucial in investment appraisal unlike the 1990s. The credit crunch made it difficult for the landlords to make developments on the building and work on nonperforming assets rapidly unlike the early 1990s. The consumer confidence also deteriorated significantly since 2007, which is obtained to have affected the property prices. The discussion thus shows significant impact of the macroeconomic conditions on the property market particularly the housing market in UK .However the impact of the macro economy like the influence of demand and supply in the housing market seems to be significantly different in the early 1990s crisis and the present crisis. References Ball,M, Lizieri,C, Macgregor,B,D(1998) The Economics of Commercial Property Markets, London, Routledge. Baddeley M(2005): “Hosing Bubbles, Herds and Frenzies: Evidence from British Housing Markets”, CEPP Policy Brief No. 02/05, University of Cambridge. Barker Report Final Review(2004): “ Barras, R. (1983) A simple theoretical model of the office development cycle, Environment and Planning A, 15: 1361–94. Barras, R. (1994) Property and the economic cycle: building cycles revisited, Journal of Property Research, 11, 3: 183–97. Barras, R. and Ferguson, D. (1987a) Dynamic modelling of the business cycle:1. 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