The evolution of the housing market is driven by two factors: stock of housing capital and flow of housing service (Dong-An, 2005). The stock of housing capital determines house prices, while rents are determined by the flow of the housing service market (Dong-An, 2005). Consequently, Grimes et al. (2005) argue that rents reflect house prices. This is due to the impact of shocks on house prices, which can be seen from either of these markets due to, the linked of these two markets via the rent levels. Furthermore, Cheng et al. (2009) explain that the same people- the owner occupants - determine rents and price of houses.
A house (and other types of real property) is a differentiated or heterogeneous assets which implies that every unit is unique and different (Lecat & Mossonnier, 2005). As a result, many researchers (see Goodman & Thibodeau, 1998; Maclennan, 1982; Whitehead, 1999) reject the existence of a unitary housing market model. This is due to the presence of various interrelated markets (Yu, 2004) which cause different movements in house price based on different regulations and policies governing a country’s housing market. The structure of housing markets and levels of home ownership are closely connected to various markets /sectors, which include the mortgage market, economic sector, construction sector and consumption sector.
A housing market is generated by the interaction of demand for housing and supply of housing (Kenny, 1998). In theory, equilibrium house price occurs when both the demand for, and supply of, houses is equal (Hong et al., 2007). An increase in housing demand against fixed housing supply will cause an upward movement in house price, encouraging developers to supply more houses (Pornchockchai, 2007). However, in the residential market, the adjustment or reaction caused by changes
(shift) in housing demand is slow due to inefficiency which characterize most of the real estate market (Pornchockchai, 2007).
According to Warnock and Warnock (2008), demand and supply factors govern the availability of housing. A traditional view of the housing market suggests that the interaction between housing demand and supply determines house price relative to other goods (Kenny, 1998). According to Quigley (1992), housing is different from other goods or services due to the high cost of supply, durability, fixed location and heterogeneity. These factors create greater difficulty in analysing housing market.
Case and Shiller (2003) and Himmelberg et al. (2005) use housing demand equation which consists of disposable income, changes in demographic factors, tax system, interest rates and wealth accumulation in their housing market studies. In Case and Shiller (2003) study, the authors conclude that the increase in US house prices since 1995 is caused by fundamentals factors. Similar result are found by Himmelberg et al. (2005) study on US city level data in 2004 where house prices in US are in line with fundamental factors. However, several cities such as Boston, San Francisco and New York are considered expensive (Himmelberg et al., 2005).
In the long-term, the demand factors which affect house prices, are income, interest rate and inflation (Tsatsaronis & Zhu, 2004). According to Whitehead (1999), most of the analysis conducted in housing demand function involves estimating the house price and income elasticity relationship.
Housing supply factors consist of the cost of land, construction cost and the existing stock of housing (Malpezzi, 1996). The housing supply factors are used to differentiate between the factors which affect investment in the existing housing supply (existing stock of houses), and the factors which determine the new supply of housing (new houses). Thus, Malpezzi (1996) explains that researchers in the housing market seldom use housing supply factors. This may be due to the lack of reliable techniques for examining supply factors (Quigley, 1979) and various restrictions imposed on housing supply factors (i.e. land restriction, types of houses produced by developers) (Garcia & Hernandez, 2008). These restrictions cause an inelastic housing supply in the short-run (Capozza et al., 1997; Garcia & Hernandez, 2008). The
inability of housing supply to meet housing demand is also caused by other factors such as the large number of second houses available in the market and the longer time for new house to be completed (Levin & Wright, 1997). For these reasons, many researchers (for example Green & Hendershott, 1992; Mankiw & Weil, 1989) prefer to use only demand factors which influence house price. Warnock and Warnock (2008) suggest that housing demand and housing supply be examined separately due to the complexity of the housing market. The effective demand for houses is translated into supply for houses through the availability of mortgage financing by the banks and other financial institutions (Mackmin, 1994).
4.2.1 Financial Sector and Mortgage Market’s Factors
The mortgage market is reported to be the main factor contributing to the boom in the real estate market (Kallberg et al., 2002). The mortgage financing offered to borrowers depends on two factors; the credibility or financial condition of the borrower and the collateral (security) offered for the financing of the property (Mackmin, 1994).
Warnock and Warnock (2008) explain that mortgage financing is a significant factor in generating housing demand. In the short-run, house price is affected by the cost, availability and flexibility of the mortgage market (Tsatsaronis & Zhu, 2004). For example, the International Monetary Fund (IMF) (2006) reveals that the increase in most house prices in industrial countries in late 1990s was caused by a decrease in the short-term interest rate. Mortgage financing become cheaper as mortgage payments for borrowers were reduced (Hering, 2006).
Another factor believed to have caused an increased in the industrial house prices involved new developments in the secondary mortgage market which improved credit terms (IMF, 2006). This includes the Real Estate Investment Trust (REIT’s) and different types of mortgage rates, which are more flexible to borrowers. The booming of the real estate market caused banks and other financial institutions to expand credit to the real estate sector (Kallberg et al., 2002). However, the plunge in real estate markets caused banks to suffer losses due to their over-exposure to the real estate market (Kallberg et al., 2002). This banking crisis then spread to other housing- related sectors such as the consumption, construction and economic sectors.
4.2.2 ConsumptionSector Factors
Housing is a necessity for people since they cannot avoid purchasing it (Grimes et al., 1997). An increase in household income or wealth causes an increase in purchasing power and leads to higher consumption of better housing (Ofori, 1990; World Bank, 1993). A bubble is believed to cause excess consumption (Grimes et al., 1997). For example, during a boom in the housing market, people are very optimistic about the future increase in prices (Pornchockchai, 2007). This in turn creates ‘mania’ (Kindleberger, 1989).
Several studies in the housing market show the relationship between house price and the consumption of homeowners (see Engelhard, 1996; Hoynes & McFadden, 1997). For example, using the Panel Study of Income Dynamics (PSID) data, Engelhard (1996) found a relationship between the increase in house price and consumption for homeowners. The result shows that marginal to consume for homeowners based on real capital gains is 0.03. However, this result is based on an assumption that homeowners respond similarly. Engelhard (1996) explains that homeowners who experience profit from increased house prices (capital gain) do not change their consumption and saving immediately. The consumption behaviour of homeowners only changes when they experience capital losses. Hoynes and McFadden (1997) studied the US housing market using PSID data. The authors found no correlation between individual saving rates and capital gains from appreciated house prices. These inconsistent findings may suggest that households regarded buying a house as a necessity rather than realizable purchasing power (Elliot, 1980).
Muellbauer and Murphy (1990) explain that the consumption is stimulated by the increased in asset prices. In relation to house prices, Pagano (1990) and King (1990) describe the upward movement of expected future income may possibly push the demand for housing service and consumption to increase.
4.2.3 ConstructionSector Factors
Housing is supplied through the construction sector. The construction industry produce housing to homebuyers through the development of housing projects.
According to Case and Quigley (2007), the residential construction is important to the banking sector due to the over-exposure of the bank’s balance sheet in the residential mortgages. During a property market boom, ‘myopia’ (rule of thumbs) causes property prices to be overvalued (Hendershott, 1994; MacFarlane, 1998). Therefore, more housing is demanded, causing the increase in the construction of houses. However, in the short-run, the easy credit for mortgage financing boosts the property market causing excessive supply of new housing construction in the long-run (Davis & Zhu, 2004). Developers and constructors build new housing projects when the real estate price increases above replacement cost (Chen & Leung, 2003). The housing stock (supply) is oversupply due to the longer period for housing construction to complete and the slow adjustment process (Chen &Leung, 2003). Therefore, this would also affect the activities and productivity in the economic sector
4.2.4EconomicSector Factors
The housing industry represents an important indicator of the economy’s health (Alhashimi & Dwyer, 2004). The development of the housing market contributes to expansion in the economy. For example, a booming property market causes the banking, financial, consumption and construction sectors to expand, creating more opportunities and employment (Roehner, 1999). This shows that the housing market can have a significant impact on the economy.
However, the collapse of the housing market, caused by bubbles has a negative impact on the economy due to the high transaction cost, illiquidity and heterogeneity of housing characteristics (Helbling & Terrones, 2003). For example, banks and financial institutions suffer losses due to their overexposure to real estate markets (Kallberg et al., 2002). The problem in the financial sector spreads to other economic sectors resulting in different types of financial problems such as a currency crisis, a banking crisis and a stock market crisis (Kallberg et al., 2002).
The discussion above provides an explanation of the housing market structure and other housing-related sectors (see Figure 4.1). Understanding how each sector and market works provides better information for modelling house price bubbles.
Figure 4.1 Structure of housing market with various inter-related sectors