False Market

19^th January 2007

The Malta Independent - Friday Wisdom

How can one explain the conundrum that prevails on the local property market where prices keep crawling up notwithstanding supply outstripping demand, resulting in a rapid build-up of unsold housing stock?

Some economic commentators and influential organisations have suggested that there is a false market in our property market. A false market arises when weighty operators intervene to corner the market in order to disrupt the normal flow of supply and/or demand, leading to artificial prices which would change dramatically the moment the artificial blockage is removed.

Governments are the principal operators which regularly enter the market to render it false in order to achieve fiscal and social policies. Take the public water supply service. If water supply prices were to be left to the free mechanisms of the market, prices would be much higher denying some of the lower strata of society from reasonable access to such an essential supply. The government’s social policy force it to intervene in the market by rendering it false through subsidies which make a reasonable quota of water per capita accessible at substantially sub-market prices.

The private sector is also known to have attempted to falsify markets by cornering supplies thus causing prices to rise especially where demand is inflexible to price rises. OPEC did it in 1973 and 1979 by reducing the supply of oil to the international markets, which led to two sharp price explosions in energy prices. The Australian Hunt brothers tried to corner the international silver market to speculate on its resultant artificial high price.

Given that the government is not itself a major operator in the real estate market and given that, if anything, the market is suffering from excess supply rather than shortage due to cornering by any cartel or monopoly, there is nothing to suggest that there are any of the ingredients which are normally associated with false markets.

The conundrum can hardly therefore be explained by the pretence of a false market. I think it has to be explained by the fact that the property market has three characteristics which are quite particular and which slow down the normal working of market mechanisms.

Firstly, property is an asset with a very long-term economic value and in case of its principal value component, land, it is practically eternal. The ingrained perception is that property will continue to appreciate. Consequently buyers are prepared to pay high prices in expectations of continued capital appreciation while sellers tend to hold out for higher prices which if not obtainable today will be achievable tomorrow.

A second particular characteristic of the property market is that it suffers from long lead times. Supplies hitting the market today are the result of decisions taken some two years before. Once a decision is taken and put in course of implementation, the works in progress are not easy to stall even if in the meantime market conditions change enough to render the original decision of questionable economic sense. Consequently supply only reacts to demand or the lack of it with a considerable time lag. Consequently there is risk for the creation of substantial mismatches between the supply and demand leading to either shortage or excess supply.

This tendency to under or over shoot the demand should in normal circumstances lead to substantial fluctuations in property prices. The absence of such price fluctuations leads to the third particular characteristic of the property market. Prices are not only sensitive to supply and demand but are particularly sensitive to the level and changes in the general level of interest rates prevailing in the economy.

Low interest rates stimulate demand. Home buyers find it easier to raise mortgages whereas investors, dissatisfied with the low earnings from traditional investment assets like bonds or straight bank deposits, shift their investments to real estate in the prospect that its long-term appreciation in additional to rental income will exceed the returns obtainable from other investments.

Low interest also makes it more affordable for property vendors to hold out for higher prices. If the interest carrying costs are smaller than the prospected gains that can be realised by holding out for a higher price, the increase in the unsold housing stock will not work to bring down prices.

In the United States where interest rates went up from one per cent to 5.25 per cent in the space of two years between June 2004 to June 2006, the housing boom is slowly deflating itself. House prices are coming down as vendors find the interest carrying costs too stiff in face of reducing property prices.

Interest rates in Malta are also on an upward crawl. At what point will they start hurting enough to force vendors to cut prices in order to offload their excess stock is difficult to tell. But one should not forget that this is the first experience. since removal of exchange controls, which had permitted stable interest rates at a rather low level, that interest rates are on an upward swing. It is a new experience leading into uncharted territory.

If the supply of new property on the market will continue at the prospected rates over the next few years, sectors of the property market will find that the excess supply will reach a dimension where vendors will have to discount in order to offload. This prospect will be substantially accelerated if interest rates continue to increase beyond the foreseeable increases of at least another half percentage point which seem well predictable for the next six months.

Rather than claim false markets perhaps it is more a case that markets need more time to work. But work they will.