Unmasking the housing deficit trap

BY KOSTA KIOLEOGLOU

Between 2007 and 2015, the average price of a 1-3 bedroom apartment in Kenya has risen from Sh5.2m shillings to 13.4m shillings, rendering into a compounded annual growth rate (CAGR) of 14.5% as revealed by available reports.

The housing deficit in Kenya stands at 2 million and continues to grow at a rate of about 200,000 units a year as per available data. These two elements should excite every investor and prescribe a brilliant path for the Kenya real estate market. Under normal circumstances, Kenya’s real estate market would have attracted all major construction companies around the world, as well as many foreign investors.

Theoretically speaking, if we accept the efficient markets theory—and believe that real estate is an efficient market—then these prices and data are based on “new and accurate information,” even if we don’t know what that information is.

The problem with this kind of thinking is that the efficient markets theory is at best a half-truth, as a voluminous literature on market anomalies shows. The housing market operates in its own way. It is far less rational than even the often-irrational stock market, for a couple of important reasons.

First, most investors find it difficult to understand how housing supply responds to changes in demand or to clearly understand the type of available supply and demand. Only a small minority of people thinks carefully about such things. Second, it is very hard for the minority of smart-money investors who do understand such matters to bet against bubble-level prices in real estate markets. In housing, the smart money has relatively little voice.

A given fact is only the cyclicality of the behavior of the markets and the investors. A few years ago, in A Nation of Gamblers: Real Estate Speculation and American History, a presentation at the 2013 American Economic Association convention, Edward L. Glaeser of Harvard University reviewed real estate booms and busts. He showed how real estate investors have repeatedly made the mistake of neglecting the supply response to rising prices. In the Alabama cotton farmland boom of 1815 to 1819, for example, high cotton prices seemed to justify high prices for cotton land. What most investors failed to see at the time was that these cotton prices would induce new farmers around the world to begin to grow cotton. That same failure to anticipate how supply can respond to demand applies to many forms of real estate today. Developers and builders will, one way or another, exploit overpricing, increasing effective supply, in that way bringing real estate prices down.

Most economists and financiers point out something that should have been obvious; efficient markets require the possibility of selling short. In the stock market, for example, with short selling, people who think the market is overpriced and headed for a fall can borrow shares and sell the borrowed shares at the current high price. If share prices do indeed fall, they can buy the shares back at a lower price and repay the loan, with a profit. This is not an option for the traditional real estate market. Short selling helps prevent bubbles from forming, but such negative bets cannot easily occur in the housing market. You can’t routinely borrow a house and sell it, promising to buy back the same house later to repay the loan.

Markets without the possibility of making these negative bets are inefficient. That’s because if it is not possible to short, investors can do no more than avoid holding an overpriced asset. In the housing market, that poses an enormous problem.

Suppose that you are convinced housing prices are too high. How can you profit from this insight? You might consider shorting the residential real estate investment trusts (REITs) that invest in residential properties and are themselves traded on stock exchanges. However, REIT prices do not have a consistent correlation with housing prices, and tend to resemble stock prices instead.

During the global financial crisis, some professional investors did manage to profit by correctly forecasting home price declines. They used mortgage derivatives such as collateralized debt obligations to place their bets.  But mortgages are not homes, and this way no one can beat down the emerging housing bubble before it grows out of proportion.

Experts claim that there is a way for investors to profit from an understanding of high prices. It is to build new houses and sell them before prices fall. This is a time-consuming process but it is what we are starting to see now, as housing starts and permits data show. This obviously requires a lot of information, market analysis and of course includes the risk of a wrong forecast.

Still, despite rising prices, international investors do not dominate the domestic housing and property market overall. On the contrary, we observe a turn towards the affordable housing rather than commercial and residential properties for the middle and upper class, which was the centre of the investment interest for the last ten years. This reverse trend of the market preferences is creating new opportunities and possible negative effects on existing projects.

Usually, the real median for annual house and real estate price increases over the next ten years is much lower than returns that investors expect and speculate. In Kenya as well as other countries people believe that the property market will continue rising with huge pace forever. These people are apparently not thinking about the supply response that a price increase would generate. People like these could bid prices in some places so high that eventually the local market will collapse. Yet investors can’t find a profitable way to correct such errors today.

For several years in Kenya, people believed that the unrealistic rise in property prices was due to the widely publicized housing deficit. Only a few were trying to analyze and understand the actual characteristics of the country’s housing deficit. As a result, a potential bubble is now ready to burst. The extensively used argument about the housing deficit is finally recognized as a housing shortage for the poor and the need for affordable housing, a real need that could be the tombstone of the overvalued real estate market in Kenya in the near future.

Luxurious, expensive and over-valued properties remain empty, as there are not enough end users to occupy, use, buy or rent these types of properties. Developers and government with the help of foreign institutions and organizations now focus mainly on the affordable housing sector.

The bottom line is that there is no reason to assume that the real estate market is even close to efficient. You may want to buy a house if you love it and can afford it. But remember that you cannot safely rely on “comparable sales” to judge that the price is fair. You cannot depend on rumors and unfounded speculations in order to invest in the property market. The market isn’t efficient enough for that.

Before you make your next investment decision, make sure that you have the correct information and market understanding. This will assist you to minimize your risk exposure and protect your interests.    

REV Valuer – Tegova

Civil Engineer Msc/DBM

Managing Partner Avakon Ltd

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