Several days ago, the National Property Administration (NPA) put up several pieces of prime real estate for auction in Taipei City, stirring up quite a debate.
Just as bankers are concerned about the implications for credit risk management, academics are concerned about how the government seems to be fiddling with property prices.
The NPA has defended itself, claiming that the process is legal, and that the prices are being decided by market mechanisms. However, what are the possible repercussions of these auctions for ordinary people and future trends in property prices?
Property values are assessed using several methods, and we will look at three common ones here: the cost-based method, the income based method and the market-based method. The first of these, the cost-based method, assesses historical costs, taking into account depreciation, and as such is an estimate of the past price.
It is often employed in valuing relatively simple buildings or new builds. The income-based method, by contrast, is an estimate of the future value, reflecting projected income or risks that can be reasonably expected. This gives one a basic value and is most appropriate for valuing buildings such as hotels, department stores and office buildings.
The market-based method is calculated in relation to the transaction price of similar properties within the same neighborhood. This could be considered an assessment of the current value of a given property, although it does come with a caveat: Should the economy falter, or in times of a financial crisis, people will want to hold onto their money and so demand falls, which could lead to underestimates in the market price.
Of course, this works both ways, and when the economy improves there is an influx of hot money that encourages an inflated assessment of the real market price. This is problematic for the banks, as they make loans based on artificially inflated prices and are left holding the bag when the price reverts to its natural level once the boom is over. It is for this reason that an estimate of property prices derived from the market-based method is not necessarily reflective of the basic value, and this leads to higher risks.
However, the market-based method presents another possible problem, and this stems from the fact that the price obtained from the result of prior transactions over a given period can come to be seen as the basis for a parity price level. In a thin market, where little money is changing hands, property prices are more susceptible to manipulation, and this impairs the market’s ability to settle at what economists refer to as the equilibrium price.
Under healthy market conditions, everyone engaging in economic activity becomes a “price taker,” with little or no influence on where prices eventually settle, but when little economic activity is going on, both parties — buyers and sellers — are potentially “price manipulators.” Under these conditions, one should not take the price they arrive at as the equilibrium price.
In the case of real estate or stocks, and particularly when a buyer already owns identical stock or property in the same area that they previously acquired for a lower price, they might want to use the sum total of stock or property they hold, valued at this artificially inflated price, to secure a loan from a bank, thereby benefiting from the credit spread.
Now, let’s assume a bank agrees to finance a property purchase at a certain percentage (let’s say 80 percent) of this ramped up price. If the economy takes a turn for the worse, prices fall or the property sells for less than its anticipated price, and the lender is forced to go back on the agreement, it’s the bank that loses out. This is obviously not ideal. Consequently, when the bank is making the loan it will lower the loan-to-value ratio in relation to the inflated estimate, or base the core loan on the original market price instead to minimize the risk.
Finally, there is something else the government needs to address, and that is how to stop the price of land in Taipei from rising. The main cause of this is uneven industrial development throughout the country. People flock to Taipei in search of employment and the concomitant hike in demand drives inflation in property prices. In the long term, then, the government should be looking at reducing this north-south disparity if it wants to prevent the prevailing trend of high property prices in the north and lower prices down south.
Another explanation lies in the fact that nations were falling over themselves trying to relax their respective monetary policies to save domestic markets ravaged by the recent financial turmoil.
The more purpose was to shore up the economy with low interest rates or an increase in the money supply (eg, by issuing consumer vouchers), but it also had the side effect of inflating equity prices.
As a result, the public needs to take into account more than economic growth when it comes to predicting the price of stock or property values: They will also need to factor in what is happening to interest rates. This is something that the domestic financial sector and the central bank urgently need to address.
Calvin Lin is an economics professor at National Chengchi University.
TRANSLATED BY PAUL COOPER
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