As of May 2015, the average house price in the greater Auckland region was $828,502. In May 2012, it was only $562,454. That is nearly a 50% increase over only three years. Can anything justify this incredible growth in prices, or is it all a bubble?
Peter C.B. Phillips and I address this question in a recent article to appear in New Zealand Economic Papers: Hot Property in New Zealand: Empirical Evidence of Housing Bubbles in the Metropolitan Centres. One of our key conclusions is that there is an ongoing bubble in the Auckland real estate market.
In Hot Property, we try to restore some objectivity to the difficult task of determining whether or not there is a bubble in New Zealand’s real estate markets. But what exactly is an asset bubble, and how can we spot one? A bubble describes a situation in which an asset price is substantially inflated relative to the asset’s fundamental value, which is the present value of expected income from the asset. But while we can easily observe asset prices, it is harder to observe expected fundamentals. Many arguments over the existence of asset bubbles boil down to whether or not high asset prices can be justified by expected incomes. These arguments sometimes persist long after the prices have come crashing down. For example, see this exchange between Eugene Fama and Ivo Welch from 2002 on the famous NASDAQ bubble: http://www.ivo-welch.info/teaching/famaconversation.html. Fama is one of the most frequently-cited financial economists, and is known for the efficient markets hypothesis. Arguments over the existence of bubbles lead to a large experimental literature that has established the existence of asset bubbles in the laboratory setting (see, for example, Smith, Suchanek and Williams, 1988). Outside of the lab, however, it is remains difficult to spot a bubble by focusing only on asset prices, because we never really know what market participants’ expectations are.
It may be more productive to focus on the growth rate in prices, rather than the price level, when trying to spot a bubble. Bubbles occur because sufficient numbers of market participants purchase an asset in anticipation of future price increases. This can generate a self-fulfilling prophecy, in which asset prices spiral upwards simply because market participants think that prices will increase. As more and more buyers enter the market in anticipation of future returns, prices increase, and they increase at an accelerating rate. As I will discuss below in more detail, it is harder to justify this accelerating price growth in terms of changes in expected future income from the asset. We therefore look for accelerating price growth when trying to spot an asset bubble. This general approach to bubble detection was first proposed in the 1980s (See, e.g., Diba and Grossman, 1988).
The statistical bubble detection tests we employ are designed to establish whether prices are growing and at increasing rate. Peter and his other co-authors provide the theory for these statistical methods in a series of papers (Phillips, Shi and Yu, 2015a; 2015b). A key feature of the methods is that acceleration in price growth must occur over a sustained period in order for us to identify it with any acceptable degree of statistical precision: We are not talking about accelerating price growth over a few months, but a few years. The methods provide not only an indicator of whether an asset is currently experiencing a bubble, they also provide date stamping mechanisms for identifying when the bubble begins and ends. In other empirical applications the methods have proved to be very adept at capturing the onset of bubbles in other asset markets, such as stocks and commodities. And importantly, the end of the bubbles always coincides with a fall in the nominal price of the asset in these empirical applications.
Using this method we identify an earlier, broad-based bubble in most of the regional real estate markets of New Zealand. The bubble appears first in Auckland and Wellington in mid- 2003, before spreading to the other main centres. The onset of the bubble suggest that it was part of a broader global bubble in real estate. The bubble burst with the onset of the worldwide recession in 2007, and coincided with about a 10% fall in nominal house prices.
More recently however, the tests show that Auckland once again entered bubble territory in mid 2013. As yet, the bubble in Auckland has not ended, nor has it spread to other parts of the country.
Many readers will disagree with our conclusion and argue that the accelerating price growth in Auckland is entirely justified by the fundamentals. We mitigate these concerns to an extent by normalizing house prices by an indicator of asset income – in the paper we use either rents or incomes – before running our battery of statistical tests. By doing so, we rule out the possibility that asset prices have been growing exponentially because rents and incomes have been growing exponentially. This leaves open the possibility that price growth reflects exponential growth in expected future fundamentals. But while it is easy to generate a fundamentals-based narrative that results in price growth, it is difficult to construct a narrative that can generate accelerating price growth over a prolonged period of time. This is because asset prices incorporate news relatively quickly, and certainly not over a period of several years. Consider, for example, that the Reserve Bank recently cut interest rates and signalled the beginning of monetary easing in the economy. If this cut was a surprise, and all else being equal, this should lead to an increase in house prices, but not an acceleration in house price growth over the next few years. Many of the common rationalizations for high prices in Auckland – such as lower interest rates or high migration rates – fall into this category. An unexpected increase in migration, or an unexpected decrease in mortgage rates, is good news for property owners, and should lead to a relatively quick increase in real estate prices. But in order to generate accelerating price growth over a sustained period, we would need a sequence of good news that persists over several years. No one is that lucky.
Do bubbles always collapse? Nobel Laureate Jean Tirole provided the conditions for a bubble to survive in an economy (Tirole, 1985). These conditions include durability, scarcity, and common beliefs, and housing sure does appear to be scarce right now. Up until this point in time, urban zoning restrictions have tied real estate to land in Auckland: We do not have the same high density planning as many other cities in the world, and so the number of dwellings per unit of land has been more-or-less fixed. Right now, housing is scarce because land is scarce. If this link between land and real estate persists, then we may just be sitting on a rational bubble. Happily however, the current version of the Auckland Unitary Plan allows for a potentially large increase in the number of dwellings within the city limits. If approved, the land restrictions on dwellings will be significantly relaxed, allowing supply to better respond to the price signal.
Where to from here for Auckland? Unfortunately, the empirical bubble detection literature currently offers little in terms of predicting the future. It is apparent, however, that it can be a long time between when the bubble is first diagnosed and when it finally collapses: Periods of five years or longer are not uncommon. It would be foolish for me to make any claims regarding when the best time to buy or sell a house is, or whether prices will increase or decrease next month. But can real estate price growth continue to accelerate indefinitely? I wouldn’t bet the house on it.
Diba, B. and H. Grossman (1988). “Explosive Rational Bubbles in Stock Prices?” American Economic Review 78, pp. 520-30
Greenaway-McGrevy, R., and P.C.B Phillips (2015). Hot Property in New Zealand: Empirical Evidence of Housing Bubbles in the Metropolitan Centres. New Zealand Economic Papers, forthcoming.
Phillips, P. C. B., Shi, S. and J. Yu (2015a). Testing for Multiple Bubbles: Limit Theory of Real Time Detectors, International Economic Review, forthcoming.
Phillips, P. C. B., Shi, S. and J. Yu (2015b). Testing for Multiple Bubbles: Historical Episodes of Exuberance and Collapse in the S&P 500, International Economic Review, forthcoming.
Smith, V. L., Suchanek, G. L., and A.W. Williams. (1988) Bubbles, Crashes and Endogenous Expectations in Experimental Spot Asset Markets. Econometrica 56, 1119-1151.
Tirole, J. (1985). Asset Bubbles and Overlapping Generations Econometrica 53, pp. 1499-1528