What is a real estate bubble anyway?

bubble

A housing bubble is a run-up in housing prices fueled by demand, speculation and exuberance. Housing bubbles usually start with an increase in demand, in the face of limited supply which takes a relatively long period of time to replenish and increase. Speculators enter the market, further driving demand.

This is a definition that’s provided by Investopedia. I often hear myself and others talk about a real estate bubble while not really knowing what it means. The question for me is whether there is truly any speculation developing in the market. It’s rather difficult to tell, but one thing I do know is that the Toronto Real Estate Board and others have been consistently looking at the shortage of real estate product that is available on the market.

“The conditions underlying strong demand for ownership housing remained in place, including a relatively strong regional economy, growth in average earnings and low borrowing costs. Unfortunately, we did not see any relief on the listings front, with the number of new listings down compared to last year. This situation continued to underpin very strong home price growth, irrespective of home type or area,” said Mr. Cerqua.

This I believe is normal in that those who are thinking of selling continue to believe that tomorrow’s prices will be higher than today, hence the laws of supply and demand are working as they should. With supply constricted, demand will continue to drive up prices.

There is a lot of talk about whether or not foreign investors are driving up prices. Many point to the fact that foreigners are likely only a small percentage of the buyers. This misses the point. With the small number of detached houses available for sale, one buyer can drive up prices. It has to do with the concept that it’s the last house that sells that sets the price for the following houses that sell. It that “marginal unit” that sets up the price for the next house. Foreigners can, therefore, drive up the prices for all houses by bidding up the price for that marginal house that sold. You don not need a massive influx of bidders to drive up prices.

I don’t believe that there is any reliable data available for houses that have been recently sold and are vacant. There is only some unreliable anecdotal information available. at best. But, in my opinion, these vacant houses might have an impact on overall housing prices if they were released into the market. They would drive house prices down.

There have been problems in other cities and countries with housing units being held off the market by speculators. Usually, there are looking for price appreciation for their investment returns, not rental income. Other the other hand, foreign investors might take a “buy and hold” approach as they are not speculating on price but are looking for a safe heaven for their investment capital. I have been unable to find any data that supports this hypothesis one way or another.

Regardless, the end result is the same, supply is constricted, hence prices rise with even modest demand.

So what’s the way out

One possible solution would be through taxation. Taxpayers who speculate in residential housing are supposed to declare gains or losses on income account rather than claiming the principal residence exemption. The tax burden would then be quite punitive. But the problem with this is that the tax would only be payable when the house is sold, even if we can find them.

Another possible mechanism is to have higher property taxes for vacant residential properties (all types). The tax burden would have to be onerous in order to compel the owners’ to reconsider leaving the property vacant. This might be accomplished simply by having the owner provide a sworn statement and sign the property tax bill indicating the properties’ status. The city involved would be the beneficiary of the higher property taxes and the homeowner would have to recalculate the economics of their return.

I cannot imagine that this creates any long lasting market distortions. It simply increases the cost of carry. The tax would not discriminate against foreign or domestic buyers and is within the control of the municipality concerned. It would have no impact on transactions between homeowners, those intending to occupy the property. There would have to be some enforcement mechanism, such as audits on a random basis to ensure compliance. The penalties would need to be material in order to encourage compliance. It would be consistent with the concept of “self-assessment” of taxes. Those not complying would have to pay a price.

Conclusion

I am no expert by any means, but I know a little about human behavior. Greed always comes to the fore in these situations. In order to avoid getting into a real pickle, perhaps we should look at solutions that encourage the right behavior or discourage the wrong behavior.

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