California Dreamin’ Rational and Irrational Exuberance in Property Markets

8/14/2019 California Dreamin Rational and Irrational Exuberance in Property Markets

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California DreaminRational and Irrational Exuberancein Property Markets


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Bubbles and the Winners CurseSnap, Crackle and Pop:

How to Win in a Bubble Economy

Randall ZislerManaging Director and Chief Investment Officer

Griffin & Company, LLCA Real Estate Investment Bank

Beverly Hills


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Outline

What is a bubble?

What causes bubbles?

How can investors minimize the likelihood of

overpaying during a bubblewinners curse? What are the warning signs a bubble exists?

How can investors profit during a bubble?


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Thank You! to Our Contributors

Irrational Exuberance

HeitmanA Real Estate Investment Management Firm


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Popular Bubble Definitions Irrational exuberance

Speculative mania Self fulfilling

prophecy

Vicious cycles

Speculative orgy

Markets out of line Analytic approach


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What is a Bubble?

A psychological state of irrational exuberance

and investor enthusiasm

Spreads like contagion

A cascade of amplifying stories Price and volume increases

Doubts about fundamentals crumble in theface of investor envy


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Famous Bubbles

Japanese stock market in the 1980sPalm stock and the NASDAQ run-up

U.S. real estate in the 1980s

Stock market and DOT COM 1994 through 2000

Real estate 2004 - ?


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South Sea Bubble

0

100

200

300

400

500

600

700

800

900

1000

1720.0 1720.5 1721.

perfullyp

aidshare


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South Sea Bubble


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TulipmaniaOne of the early experiments in

financial engineering

0

10

20

30

40

50

60

70

1634 1635 1636 1637

PriceofG

oudatulipbu

lbs,

Guilders


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Teapot Dome Scandal


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Bubbles are easier todetect with the benefit of

20/20 hindsight!


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What is Not a Bubble? A rapid price increase

Relative prices can change due to

regulatory or tax changes, cartel-inducedoil price hikes

Have fundamentals changed?

Are expectations of future price increasessustaining the market?

Are these expectations creating anxieties? Is there sufficient confidence in diverse

expectations to generate trades


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Housing and Apartments are the

Most Bubbly


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Single Family Homes and

Condominiums are Bubbly

Disentangling bubbles from fundamentals is difficult.

One comparable period of home price increases isthe period just following WW II.

Smart money does not typically speculate in homes

Real, quality-adjusted, housing prices have notappreciated significantly over the decades.

Stock and housing market booms have a two yearlagged correlation.

Booms are contagious across asset classes.


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BubblesMacro Correlates

Prices are significantlyabove trend

High prices in relationto incomecap rateshave fallen rapidly

High price volatility Trading volume is high

and rising

Increase in frequencyof portfolio and megadeals


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Bubbles-Micro Correlates

Winners curse and participant irrationality

More bidders increase probability ofoverestimating the value of an asset

Increased bid dispersion Bubbles do not typically crash if there is a lot of

market noise and investors are not

synchronized Many positive feedback channels, not all

evident to investors


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Positive Feedback

Difficult to identify precipitating factors orspecify causality; feedback can last for

years Feedback occurs in response not to a

sudden price increase but a consistentpattern of price increases

Price-to-GDP-to-price

Price-to-price Wealth-to-price

Price-to-corporate earnings-to-price


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Not all bubbles are bad!


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Stock Market Interlinkages

Stock markets can play a significant stabilizing ordestabilizing role

Where countries have different financial risk,interlinkage reduces dispersion of asset prices.

Where countries differ to asset payoff risk, linkagecan increase price dispersionhigh prices arehigher and low prices are lower

Financial liberalization, short-run inelastic supply ofassets, and absence of short sales.

Central bank must make difficult choices: Stabilizeexchange rates? Consumer prices? or assetprices?


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Agency Problems

Intermediaries with agency problems buymost real estate.

Leverage accentuates the agency problem.

Borrowers increase payoffs in good times

by shifting risk to lenders in bad times. In the aggregate, this risk shifting can bid

up prices.

The riskier the asset, the more risk to beshifted and the larger the bubble.


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And now for some fun

technical stuff!


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Our Bubble Model 1

Assumptions

High trading costs

Short sales not allowed or practically too costly

Heterogeneous and asymmetric information Investors differ in assessment of fundamentals

Inelastic supply of real estate assets

Many risk neutral agents


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Our Bubble Model 2

Preliminaries and predictions

Coexistence of high prices, high trading volume, and highvolatility

Asset prices may exceed fundamental value when agentsdisagree or when short selling is not possible

Agents disagree regarding probability distribution ofexpected income

Information signaled through noisy indicators; each classof bidders has a special indicator

Agents are overconfident in the accuracy of their indicators.

Thus, there are different forecasts.

The noisier the information, the more trades.


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Our Bubble Model 3

The Bubble

Asset owners have an option to sell the asset in thefuture to agents in other bidding groups

Determining the option value is an optimal stoppingproblem

Value of option (the bubble) is difference betweendemand price and fundamental value

Fluctuations in bubble value contributes to priced

volatility Bubble is consequence of divergence of opinions by

overestimation of informativeness of distinct indicators


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Our Bubble Model 4

When to sell?

The critical amount, K, is the amount by which the pricemust exceed the agents valuation

K determines turnover and sales volume

K is zero when there are no trading costs, C

Low C increases the size of the bubble and volatility

As C increases, K increases and the expected profit fromeach trade increases.

Forecasts oscillate and information flows, thusgenerating trades

The greater the overconfidence of heterogeneous beliefs,

the greater is the size of the bubble


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Lets check the evidence!


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REIT Trading Volume is Up

0

500

1000

1500

2000

2500

19

90

19

92

19

94

19

96

19

98

20

00

20

02

20

04

AllREITs

,averagedailytradingvo

lume,

millionsofdollars

Volume

Predicted


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NCREIF Cap Rates Have Fallen

4%

5%

6%

7%

8%

9%

10%

11%

923 943 963 983 003 023 043

Year-Quarter

C

apRates

Cap Rates - All Sold Props

Current Value (Appraisal) Cap Rates


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Total and Apartment

REIT and Returns

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

Returns

tandarddeviatio

n,

monthly,

% all stdev

apt stdev

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

Returnm

ovingaverage,monthly,

% all mov

apt mov


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NCREIF Regional Cap Rates

5%

6%

7%

8%

9%

10%

11%

12%

91 93 95 97 99 01 03Year-Quarter

Cap

Rates

East West

South Midwest


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Total Private NCREIF Sales

0

100

200

300

400

500

600

700

78 82 86 90 94 98 02

Year

Prop

erties

0

5,000

10,000

15,000

20,000

25,000

MarketValue(millions)

# of Properties

Market Value


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If you win the bid, are

you losing the game!


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Winners CurseWhat is it? People often overestimate the precision of their

knowledge; Illusion of knowledge; experts estimateswill vary substantially

Asymmetric bargaining and incomplete information Winning the bidding is a Pyrrhic victory Each player estimates the value of the asset. If bidders estimates are unbiased, then the highest

bidder almost certainly overestimates the value,and, on average, overpays

Perceptive, rationale bidders place a bid below theirestimate of value

The greater the winners curse, the greater thenumber of bidders, the uncertainty of the price of theasset, and the dispersion between the highest and

lowest bid.


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Avoiding the Winners Curse Rationality is an assumption, not a demonstrated

fact!

The curse is about cognitive illusion and systematicerror, especially in bubble economies

Hubris hypothesis and takeovers

Collusion (which is probably illegal) or sharingknowledge with competitors to reduce their bids

Bidding lower than ones estimate of value, and being

prepared to lose more auctions and to avoid loses. Avoiding auctions and focusing on off-market

transactions.


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Focus on California


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California Apartment and Total

Cap Rates and Trading Volume

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

2001 2002 2003 2004 2005

Averagecapr

ate,

%

$0.0

$1.0

$2.0

$3.0

$4.0

$5.0

$6.0

$7.0

$8.0

$9.0

Totalvolumesales,

$billions

CA apartment average cap rate

CA apartment volume, $

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

2001 2002 2003 2004 2005

Averagecapr

ate,

%

$0.0

$1.0

$2.0

$3.0

$4.0

$5.0

$6.0

$7.0

$8.0

$9.0

Totalvolumesales,

$billions

CA office average cap rate

CA off ice volume, $

2005 Real Capital Analytics, Inc. All rights reserved.2005 Real Capital Analytics, Inc. All rights reserved.


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U.S. Apartment and Total

Cap Rates and Trading Volume

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

2001 2002 2003 2004 2005

Averagecaprate,%

$0.0

$5.0

$10.0

$15.0

$20.0

$25.0

$30.0

Totalvolumesales,$billions

US apartment average cap

rate

US apartment volume, $

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

2001 2002 2003 2004 2005

Averagecapr

ate,%

$0.0

$5.0

$10.0

$15.0

$20.0

$25.0

$30.0

Totalvolumesales,$billions

US office average cap rate

US office volume, $

2005 Real Capital Analytics, Inc. All rights reserved. 2005 Real Capital Analytics, Inc. All rights reserved.


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Is Real Estate in a Bubble?

Probably, we observe high prices, increased

volatility, high trading volume, and increaseddispersion of bids

Maybe we are witnessing a massive institutionalportfolio shift toward real estate

The bubble component varies by market, assettype, and location

Single family homes and apartments/condos are the

most bubbly How will the bubble break? What are the likely mechanisms of a burst bubble?


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Will the bubble break?


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Profiting During Bubbles 1 Brokers (paid based on trading volume):

Punctured bubbles are Darwinian herd-thinners Agents benefit from volatility and heterogeneity

Break up portfolio if assets have low correlation

Otherwise, reap potential portfolio premium

Research as story telling generates trades andreinforces environment of heterogeneous views


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Profiting During Bubbles 2

Agents (paid based on asset performance)

Big question: Bubble or change in fundamentals?

Answer suggests different strategies

Avoid auctions

Focus on non-bubble markets

Build strengths that permit preemptive moves

Specialize in controlling certain kinds of systematic risks

Pursue economies of scale

Pay for value-added research that is not a sophisticated

front end for the sales or marketing department


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My beach has the BEST bubbles!

California Dreamin’ Rational and Irrational Exuberance in Property Markets

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