Are we in a bubble?

When talking about the property market in the country the word that mostly comes out during the conversation is ‘Bubble’. Common statements such as ‘we’re in a bubble’ or ‘it’s about to burst’ are frequently said by the masses. However, when you talk further it’s evident that most don’t really understand what an asset or property bubble is, how it’s formed and how it bursts. Plus, most people equate a bubble to the high property prices.

Firstly, lets look at what really is a property or housing bubble.  A bubble forms when prices are paid that are far too high, is not sustainable at these prices in the long term and defies logic or reasoning. The difference is that rapid price increase alone won’t create a bubble, but unsustainable rapid price rises will.

Bubbles have been part of the human history when people have rushed to buy commodities, which causes others to also ‘jump on the bandwagon’, without any justification on the fundamentals, and causes the price of the commodity to rise rapidly within a short span of time. Once it has been realised that the commodity isn’t as valuable, then the price rapidly declines to the original price, which is termed as a bubble bursting.

The most recent global house price bubble and crash that followed was in the 2007-8 period that affected many countries such as USA and Dubai. There are many factors that lead to a bubble forming, which were prevalent during the 2007/8 crash. These are:

Too lenient and uncontrolled lending by banks

One of the main reasons of a bubble forming is when loans are easily available, rates are low and people who shouldn’t be given loans (based on affordability checks) are given loans and investing in property. Another is allowing a higher leverage on the property – which is a lower down payment or higher Loan-To-Value (LTV).

Such easy access to credit puts the borrower at risk if they are unable to keep up repayments, which can be caused by many reasons including interest rates going up, unemployment going up or change in circumstances. This causes banks to write off their loans, as we saw with the Subprime lending crisis in the USA during the 2007-8 crash.

Sri Lanka’s banking sector as well as global banking sector now have more checks and regulations in place to avoid such a situation. However, if you look at apartment purchases in Sri Lanka, only a fraction of these (around 10%) are financed through loans, meaning that the apartment sector – where most believe that a bubble is forming – is less susceptible to issues arising of bad credit. Plus, with interest rates for home loans at around 13%, there is less risk of people rushing to buy on loans due to low rates.

Banks could also be at risk by lending to developers whose projects are more susceptible to fail due to bad locations or wrong pricing. Through design or default prudence and being risk-averse has been the strength of the Sri Lankan banking sector so far. We have also noticed that the lending by banks for construction has dropped from 40% in Q2 2016 to 18% in 2018. Loans for individual housing has also followed a similar pattern.

 

Unsustainable rapid price rises

Rapid property price rises without any increase in the fundamentals that would drive that increase, is another cause. This happens mainly due to speculative buying where people expect the prices to increase rapidly and others in the fear of missing out on a good deal also buy at higher prices. Flipping, which is purchasing a property for the sole purpose of selling it quickly for a profit is another factor contributing to a rapid price rise.

These factors also contributed to the global property crash a decade ago, but with sound banking lending conditions most of these aspects can be controlled.

Pricing of property is based on supply and demand. The fact that more than half of the units in ongoing projects have been sold shows that there is a demand for vertical living at those price points. According to the House Price Index maintained by LankaPropertyWeb.com, the overall house price growth has been steady throughout the last 6 years with houses (4-bed) increasing by 19% and apartments (3-bed) by 11%, compared to last year. This is in comparison to Dubai when house prices increased by as much as 80% before the crash in 2008. The high property prices in Colombo can be put down to the high price of land in the area, which is scarce and limited in supply.

In terms of purchasing property, more and more people are buying property, with a 24% increase in title registrations from 2012 to 2017, as per the stats issued by the Registrar General’s office.

Oversupply of stock

Having lots of unsold stock in the property market is another sign of an impending crash. Spain had half a million unsold houses during the property crash.

It needs to be seen to which price segments the new apartment projects coming up will belong to. Colombo, with a transient population of over a million needs more housing and as we’ve noticed there is a good demand for apartments in the lower-mid and affordable price ranges. If too many luxury apartments are created than there is demand for, then that segment will experience oversupply, but due to the relatively low volume of units (compared with overall property market), it should not have a cascading affect on the rest of the property market and these units will eventually get sold off as these are built mostly by established foreign developers who will be able to absorb it in the short term.

Interest rate rises

The interest rate rising of even 1% will have a major effect in markets where majority of properties have been bought on loans. The rise will increase the repayment amount for borrowers and cause many of them to default if correct checks haven’t been done on the affordability of borrower. As mentioned earlier, any rate rises will have less of an impact in Sri Lanka due to most purchases being done through equity.

Foreign and other factors

Having the property market exposed to too much foreign speculative buying risks it collapsing if they decide to sell off in rapid succession due to changes in macro-economic factors. This is what happened in Dubai in 2008, where majority were foreign buyers. In Sri Lanka foreign buyers make only 5-10%, which is a small minority.

Decline in disposable income, rising unemployment, slow urbanisation, more multiple property owners in the market, increase in number of off-plan properties unsold and political intervention such as rate increases, new taxes will all influence in the formation of a bubble.

So, when does a bubble burst? It’s when the demand drops, supply increases and the prices see a sharp drop.

How is a bubble averted? There is no hard and fast rule to say when a bubble is forming and when it’s about to burst. If the buyers, sellers and lenders all act prudently then a bubble can be averted.

From the developer’s side a developer needs to have the correct pricing based on the demand in that area and what the buyer will be willing to pay for their development. A good feasibility study and market research will enable the developer to get a good understanding on the demand vs supply.

Banks should make it easier for buyers to get on the property ladder or else there will be an excess of supply but have correct checks so that they only lend what is affordable to the borrower.

From a buyer’s perspective, the buyer should always look at the property being affordable for them in the long term and not stretching their finances. When buying a property make the decision for yourself on the price that you’re willing to pay and that you can afford without stretching yourself too thin. If that decision is made correctly, then they will be safeguarded even during a market downturn.

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