Real Estate Finance

Property and Capital Market,

Bubbles and Crashes

Kwok-Sang (Maurice) Tse 謝國生

The University of Hong Kong
ktse@hku.hk

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Contents
◼ Nature of Property and Capital Market
◼ Four-Quadrant Framework
◼ Equilibrium
◼ Disequilibrium
◼ Bubbles and Crashes

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 I. Property and Capital Markets
◼ Real estate is a durable capital good.
◼ How are its production and price determined in the asset/capital
market ?
◼ In this market, equilibrium is achieved when
Demand to own real estate assets = Supply.
◼ Price of houses depends on (1) how many households wish to own
units and (2) how many units are available for ownership.
◼ For instance, the value or price of shopping center space depends on how
many investors wish to own such space and how many shopping centers
there are available to investors. (Lecture 1: No. of visitors from Mainland
and the price and rent of retail space.)
◼ Everything else held constant, an increase in the demand to own these
assets will raise prices, while a greater supply of space will decrease price.

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 I. Property and Capital Markets
◼ Supply of new real estate assets derives from the construction
sector and depends on the price of those assets relative to the
cost of replacing or constructing them.

◼ Property Price > Cost of Construction + Land -- > Supply

◼ Property Price < Cost of Construction + Land -- > Supply

◼ In the long run, the asset market should equate market prices
with replacement costs that include the cost of land.
Property Price = Cost of Construction + Land
◼ In the short run, however, the two may diverge significantly
because of the lags and delays that are inherent in the
construction process.
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 I. Property and Capital Markets
◼ What are the factors that affect the demand for
ownership in real estate assets to suddenly increase or
decrease??
◼ Are there factors other than simply the price of these
assets?
◼ The answer is yes.

◼ The other factor is the rental income that real estate

assets can earn.

◼ What is rent?

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 What is Rent ?
◼ Need to consider the market for the use of
real estate.
◼ In the market for real estate use of space
(usu. Referred to as property market),
demand comes from the occupiers of space,
whether they be tenants, owners, firms, or
households.

◼ Reference: “Supply Adjustments to Demand Shocks in the Commercial

Real Estate Market”; by George Lentz and K. S. Maurice Tse, Real Estate
Economics, 1999
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 What is Rent ?
◼ For firms, space is one of the production factors:
◼ Labor
◼ Capital
◼ Space
◼ Firm’s use of space will depend on
◼ Firm’s production technology
◼ Output levels
◼ Relative cost of space.

◼ Reference: “Supply Adjustments to Demand Shocks in the Commercial Real Estate

Market”; by George Lentz and K. S. Maurice Tse, Real Estate Economics, 1999
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 What is Rent ?
◼ For households: They likewise divide their income into the
consumption of many commodities, one of which is space.
◼ Household demand for space depends on
◼ Household Income

◼ Cost of occupying that space relative to the cost of other

commodities, such as food, clothing, or entertainment.

◼ For firms or households, the cost of occupying space is the annual
outlay necessary to obtain the use of real estate-RENT.
◼ For tenants, rent is simply specified in a lease agreement.

◼ For owners, rent is defined as the annualized cost associated

with the ownership of property.

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 How is Rent Determined
◼ Rent is determined in the “property market” for space use, not in the
“asset market” for ownership.
◼ In the property market, the supply of space is given from the asset
market.
◼ Demand for space depends on rent and other exogenous economic
factors such as firm production levels, income levels, or the number of
households.
◼ Role of the property market is to determine a rent level at which the
demand for space use clears the supply of space.
◼ For example, when the number of households increases or firms

expand production, the demand for space use rises.

◼ With quantity of space supply fixed for the moment, rents rise as

well.

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Contents
◼ Nature of Property and Capital Market
◼ Four-Quadrant Framework
◼ Equilibrium
◼ Disequilibrium
◼ Bubbles and Crashes

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II. Four-Quadrant Framework
◼ What is the linkage between the asset
market and the property market?
◼ William Wheaton of MIT Sloan School of Management

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Quadrant I: Property Market for Rent Determination
Rent $
II. Asset Market: I. Property Market:
Valuation Rent Determination
R*
P = R/i D(R,Economy) = S

P* S*
Price $ Stock (sq m)

S = C/d
P = f(C)
C* DS = C – d S

III. Asset Market: IV. Property Market:

Construction (sq m)
Construction Stock Adjustment

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 Quadrant I: Property Market for Rent Determination
◼ Demand for space as a function of rents, I. Property Market
and the state of the economy.
◼ If the economy changes, then the Rent Determination
entire curve shifts. D(R, Economy) = S
$ Rent R
◼ An upward shift occurs with an
Fixed supply in short run

increase in firms or households

(economic growth) and signifies that
more space is demanded for the
same rent.
◼ Economic decline causes a

downward shift in the line, with

opposite implications.
◼ Equilibrium: D(Rent, Economy) = S S

◼ Inelastic demand: Households or firms tend to demand the same Stock Sq m

quantity of space regardless of rent levels -- > the demand curve is nearly vertical.
◼ Elastic demand: Space usage is sensitive to rents, and the demand curve is more
horizontal. zero rent may not clear the market becoz there are maintaining cost

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 demand is not observable but supply is

Quadrant I: Property Market for Rent Determination

◼ Demand for office space as a function of rents, and the state
of the economy??

Office Demand = 𝛼1 𝐸𝑅−𝛽1

◼ E = Office Employment employment level in commercial sector
◼ Ruse=of Rent per square meter
space per headcount

◼ 𝛼1 = sqm/E when R=$1

◼ 𝛽1 = Rental Elasticity of Demand; i.e.
Demand of space

%𝐶𝐻𝐺 𝑖𝑛 𝑆𝑄𝑀 𝑝𝑒𝑟 𝑊𝑜𝑟𝑘𝑒𝑟

𝛽1 =
%𝐶𝐻𝐺 𝑖𝑛 𝑅𝑒𝑛𝑡

--> R = 𝑆/𝛼1 𝐸 −1/𝛽1

◼ Equilibrium: Demand = Stock = S
{downward sloping schedule}
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Quadrant I: Property Market for Rent Determination
◼ Estimation of Office Demand: Office Demand 𝑆 = 𝛼1 𝐸𝑅−𝛽1
ln(use of space per worker)

◼ Regression Model: 𝑆
𝑙𝑛 = 𝑙𝑛 𝛼1 + 𝛽ln(𝑅) + 𝜀
𝐸 sign is not important in regression
◼ E = Office Employment: Persons Employed in
◼ Finance and Insurance,

◼ Import/Export,

◼ Professional and Business Services,

◼ Social and Personal Services,

◼ Civil Servants

◼ R = Rent: Average Rent per Square Meter

◼ S = Stock of Office Space: in square meters
◼ Source: Hong Kong Quarterly data from March 2000 to
March 2017; Census and Statistics Department of HKSAR
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Quadrant I: Property Market for Rent Determination
◼ Estimation of Office Demand: Office Demand 𝑆 = 𝛼1 𝐸𝑅−𝛽1
◼ Regression Model

𝑆
𝑙𝑛 = 𝑙𝑛 𝛼1 + 𝛽ln(𝑅) + 𝜀
𝐸

◼ Estimation Results:
Ln(S/E) Coefficients Standard Error t Stat
Intercept a1 1.977 0.028 70.909
Ln(R): b -0.024 0.006 -4.297

Office Demand = 7.221 × 𝐸 × 𝑅 −0.024

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Quadrant II: Asset Market for Valuation
Rent $
II. Asset Market: I. Property Market:
Valuation Rent Determination

P = R/i
i = capitalization rate D(R,Economy) = S

Price $
Stock sq m

S = C/d
P = f(C)
DS = C - dS

III. Asset Market: IV. Property Market:

Construction (sq m)
Construction Stock Adjustment

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 Quadrant II: Asset Market for Valuation
In the property market, the supply of stock is
II. Asset Market
◼

derived from the asset market.

◼ With the rent level determined in the property Valuation
market for the use of space, the asset market
will determine the price of space (per unit
$ Rent R
price of space).
P = R/i
◼ Let i be the capitalization rate. The value of an
asset with rental income stream R is equal to
R
P=
i
◼ Slope of the valuation curve is the
capitalization rate (rent-to-price ratio) for real
estate assets.
◼ It represents the current yield that investors
require in order to hold real estate assets. Price $ when rent is zero, the property is useless
◼ What are the components of the capitalization steeper: same rent but lower selling price
rate??

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 Components of Capitalization Rate
◼ What are the components that make up the capitalization rate?
higher interest rate, higher cap rate, lower property price
◼ Long-term interest rate in the economy
◼ Expected growth in rent higher growth, lower cap rate, higher property price
higher risk, higher cap rate, lower property price
◼ Risks associated with the rental income stream
◼ Tax treatment of real estate (if any??).
higher tax, higher cap rate, lower property price

• A higher capitalization rate is represented by a clockwise rotation

of the valuation curve.
• Capitalization rate is taken as exogenous in the sense that it’s
based on interest rates and returns in the broader capital market
for all assets (stocks, bonds, short-term deposits and so on).

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 Financial long term: 1 year
short term: 1 cycle (3 months)
Quadrant II: Asset Market for Valuation Economic long term: 20 years

R
◼ Valuation Model: P = ??
i
Private Office Price Index and 12-month HIBOR
16.00 350.0

14.00 Correlation Coefficient between 300.0

12.00
Ln(Price) and Ln(12-M HIBOR) = -0.471
250.0
Jul 96-Jun 17

Price Index (Overall)

12-Month HIBOR

10.00
200.0
8.00
150.0
6.00
100.0
4.00

2.00 50.0

0.00 0.0
May-02

May-09

May-16
Sep-97
Apr-98

Apr-05

Sep-11
Apr-12
Jun-99
Jan-00

Sep-04

Jun-06
Jan-07

Jun-13
Jan-14
Feb-97

Nov-98

Dec-02
Oct-01

Feb-04

Nov-05

Dec-09
Oct-08

Feb-11

Nov-12

Dec-16
Oct-15
Jul-96

Aug-00
Mar-01

Jul-03

Aug-07
Mar-08

Jul-10

Aug-14
Mar-15
12-month HIBOR Overall Price Index

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Quadrant III: Asset Market for Construction
Rent $
II. Asset Market: I. Property Market:
Valuation Rent Determination

P = R/i
D(R,Economy) = S

Price $
Stock sq m

S = C/d
P = f(C)
DS = C - dS

III. Asset Market: IV. Property Market:

Construction (sq m)
Construction Stock Adjustment

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 Quadrant III: Asset Market for Construction
Minimum dollar
◼ Let C be the level of building activity. III. Asset Market value (per unit of
◼ Given the asset price determined in space) required to
get some level of
the asset market, we can now Construction new development
determine the level of construction underway.
as follows: Price $
P = f(C)
◼ f(C) represents the replacement cost P = f(C )
of real estate.
◼ Cost of replacement through new
construction is assumed to increase
with greater building activity (C), and
so the construction curve is pointing
southwesterly. Construction Sq m

◼ If construction can be initiated at any level with almost the same costs, then the curve
will be close to vertical.
◼ On the other hand, supply is inelastic when there are construction bottlenecks, land is
scarce, and there are other impediments to development.
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 Quadrant III: Asset Market for Construction
◼ Let C be the level of construction activity.
◼ Office Construction rate is given by:

𝐶
= 𝛼2 × 𝑃𝛽2
𝑆
◼ P = Asset Price per square meter
◼ [“Q”theory?]
◼ 𝛽2 = Price elasticity of supply:

%𝐶𝐻𝐺 𝑖𝑛 𝐶𝑜𝑛𝑠𝑡𝑟𝑢𝑐𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑒

𝛽2 =
%𝐶𝐻𝐺 𝑖𝑛 𝑃𝑟𝑖𝑐𝑒

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Quadrant III: Asset Market for Construction
𝐶
𝐶𝑜𝑛𝑠𝑡𝑟𝑢𝑐𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑒 = = 𝛼2 × 𝑃𝛽2
𝑆
◼ Regression 𝐶
𝑙𝑛 = 𝑙𝑛 𝛼2 + 𝛽2 ln(𝑃) + 𝜀
Model 𝑆
◼ Estimation Results (1985-2016):
Ln(S/E) Coefficients Standard Error t Stat
Intercept a2 -8.239 2.622 -3.142
Ln(R): b 0.473 0.247 1.916

𝐶
𝐶𝑜𝑛𝑠𝑡𝑟𝑢𝑐𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑒 = = 0.000264 × 𝑃0.473
𝑆
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Quadrant IV: Property Market for Stock Adjustment

Rent $
II. Asset Market: I. Property Market:
Valuation Rent Determination

P = R/i
D(R,Economy) = S

Price $
Stock sq m

S = C/d
P = f(C)
DS = C - dS

III. Asset Market: IV. Property Market:

Construction (sq m)
Construction Stock Adjustment

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 Quadrant IV: Property Market for Stock Adjustment
◼ In the property market for stock adjustment,
the annual flow of new construction, C, is IV. Property Market
converted into a long-run stock of real estate
space. Stock Adjustment
◼ The change in the stock, DS, in a given period
Stock Sq m
is equal to new construction minus losses
from the stock measured by the depreciation
(removal) rate, d:
DS = C - d S
◼ The curve in this quadrant represents the
level of stock (on the horizontal axis) that 𝐶
requires an annual level of construction for 𝑆=
replacement just equal to that value on the 𝛿
vertical axis. ∆𝑆 = 𝐶 − 𝛿𝑆
◼ At that level of stock and the corresponding
level of construction, the stock of space will
be constant over time, since depreciation will
equal new completions. Therefore, Construction sq m

DS = 0 and S = C/d . delta in short run can be +ve or -ve

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 Quadrant IV: Property Market for Stock Adjustment
∆𝑆 𝐶
◼ Stock adjustment for office space: Depreciation (d) = −𝛿
𝑆 𝑆
Stock Adjustment of Office Space
10.0% 6.00%

Avg Delta 0.43% 5.00%

8.0%
Std Dev 0.0102
4.00%
𝐶 ∆𝑆
C/S and CHG in S/S

6.0%
𝛿= − 3.00%

Depreciation
𝑆 𝑆
4.0% 2.00%

1.00%
2.0%
0.00%
0.0%
-1.00%
1988
1986
1987

1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
-2.0% -2.00%
C/S CHG in S/S delta

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 Modeling the Property and Asset markets

◼ Rent Determination 𝑆 ∗ = 𝛼1 𝐸𝑅−𝛽1

Office Demand = 7.221 × 𝐸 × 𝑅−0.024
R
◼ Valuation P=
i

𝐶
◼ Asset Market for Construction = 𝛼2 × 𝑃𝛽2
𝑆
𝐶𝑜𝑛𝑠𝑡𝑟𝑢𝑐𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑒 = 0.000264 × 𝑃0.473
∆𝑆 𝐶
◼ Stock Adjustment for Office Space = −𝛿
𝑆 𝑆
∆𝑆 = 𝐶 − 0.43% × 𝑆
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 Quadrant I: Property Market for Rent Determination
Rent $
II. Asset Market: I. Property Market:
Valuation Rent Determination
R* Demand =
P = R/i
7.221 × 𝐸 × 𝑅−0.024

P* S*
Price $ Stock (sq m)

C*

III. Asset Market: IV. Property Market:

Construction (sq m)
Construction Stock Adjustment
𝐶
= 0.000264 × 𝑃0.473 ∆𝑆 = 𝐶 − 0.43% × 𝑆
𝑆 k s tse 29
Contents
◼ Nature of Property and Capital Market
◼ Four-Quadrant Framework
◼ Equilibrium
◼ Disequilibrium
◼ Bubbles and Crashes

k s tse 30
 IV. Equilibrium Rent $
II. Asset Market: I. Property Market:
Valuation Rent Determination

D(R, Economy) = S
P = R/i

Price $ Stock sq m

S = C/d
P = f(C) DS = C - dS

III. Asset Market: IV. Property Market:

Construction (sq m)
Construction Stock Adjustment
◼ The analysis of the property and capital markets can be summed up as follows.
◼ Starting with a level of stock of space, the property market determines rents,
which are then translated into property prices by the asset market.
◼ These asset prices in turn generate new construction, which yields a new level of
stock of space in the property market.
◼ The property and asset markets are in equilibrium with each other when the
starting and ending levels of stock are the same.
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Contents
◼ Nature of Property and Capital Market
◼ Four-Quadrant Framework
◼ Equilibrium
◼ Disequilibrium
◼ Bubbles and Crashes

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 V. Disequilibrium
Rent $ I. Property Market:
II. Asset Market:
Rent Determination
Valuation
D(R,Economy) = S
P = R/i

Price $ Stock sq m

S = C/d
P = f(C)
DS = C - dS

III. Asset Market: IV. Property Market:

Construction (sq m)
Construction Stock Adjustment

◼ If the ending stock differs from Time T=0 T=1 T=2

the starting stock, then the Rent R0 R1 = R0 R2 < R1
values of rent, price, Price P0 P 1 > P0 P 2 < P1
construction and stock are not Supply C0 C1> C0 C2 < C1
in complete equilibrium. Stock S0 S 1 > S0 S 2 < S1
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 V. Disequilibrium
Rent $ I. Property Market:
II. Asset Market:
Rent Determination
Valuation
D(R,Economy) = S
P = R/i

Price $ Stock sq m

S = C/d
P = f(C)
DS = C - dS

III. Asset Market: IV. Property Market:

Construction (sq m)
Construction Stock Adjustment

◼ If the starting stock is less than the finishing stock, then rents,
prices, and construction must decrease to be in equilibrium.
◼ If the starting stock level exceeds the ending level, then rents,
prices, and construction must all rise to be in equilibrium.
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 Effects of Exogenous Shocks
◼ Exogenous shocks to property market can have different impacts
on the operation of the real estate market than exogenous shocks
to the asset market.
◼ An increase in demand for space in the property market shifts

out the demand curve, increasing rents, which in turn,

increases asset prices, construction, and stock of space.
◼ A decrease in capitalization rate in the asset market increases

the demand for real estate assets, which increases asset

prices. Increased asset prices in turn induces more
construction, increasing the stock of space and decreasing
rents.
◼ An increase in construction costs decreases construction

levels, which in turn decreases the stock of space, driving

rents and assets prices.
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Question
◼ Under what circumstances that supply will
continue to increase despite the demand is
not catching up with the supply?

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Contents
◼ Nature of Property and Capital Market
◼ Four-Quadrant Framework
◼ Equilibrium
◼ Disequilibrium
◼ Bubbles and Crashes

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Bubbles
◼ Bubbles have violent collapses.
◼ They can lead to distortions in resource allocation.
◼ They may be associated with financial collapses.

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 What is bubble
◼ A bubble is a situation where asset prices move
because they are expected to move.
◼ In a bubble the price moves away from fundamentals
based solely on expectations of further movements.
◼ Expectations become self-confirming.
◼ Examples abound….
◼ housing bubble, telecoms bubble, tulipmania,

South Sea Bubble, Great Crash of 1929,

commodities etc….

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Example: Japan Stock Price Bubble 1985-1991
Nikkei 225
45000
40000
35000
30000
25000
20000
15000
10000
5000
0
1970 1975 1980 1985 1990 1995 2000 2005
◼ The Japanese asset price bubble was an economic bubble from 1986 to 1991 with
real estate and stock prices greatly inflated. The bubble's subsequent collapse lasted
for more than a decade with stock prices initially bottoming in 2003, although they
would descend even further amidst the global financial crisis in 2008. The Japanese
asset price bubble contributed to what some refer to as the Lost Decade. Economist
Paul Krugman has argued that Japan fell into a liquidity trap during these years.
k s tse 40
Example: Nasdaq Bubble 1999-2000
• Between 1999 and early 2000, the U.S. Federal Reserve
increased interest rates six times:
• The economy began to lose speed.
• The dot-com bubble burst on Friday, March 10, 2000, when
the technology heavy NASDAQ Composite index, peaked at
5,048.62 (intra-day peak 5,132.52), more than double its
value just a year before.

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 Post-Crisis Property Market in Hong Kong
Price and Rental Index (All Classes): 1999 Price Level
350.0

REAL ESTATE BUBBLE

300.0
FORMED ??
250.0

200.0 1997 Levels

150.0 Post-Crisis Levels

100.0

50.0

0.0
95Q2

01Q2

07Q2

13Q2
93Q1
93Q4
94Q3

96Q1
96Q4
97Q3
98Q2
99Q1
99Q4
00Q3

02Q1
02Q4
03Q3
04Q2
05Q1
05Q4
06Q3

08Q1
08Q4
09Q3
10Q2
11Q1
11Q4
12Q3

14Q1
14Q4
15Q3
16Q2
Price Index (All) Rental Index (All)

k s tse 42
What is bubble
◼ Bubbles
◼ Where do they come from? What to do about
them?

k s tse 43
Bubbles
◼ Two broad (and polar) views:
◼ There is a shortage of store of value — bubbles

help fixing this problem.

◼ Agents misbehave (either an agency problem or a

behavioral problem).

◼ Other: “irrational exuberance” and more formal

behavioral stories
◼ More likely to arise when the above conditions

are present.

k s tse 44
 Rational Bubble

◼ Investors realize price is divorced from fundamentals,

but believe that price rises will persist for some time,
and that price growth will compensate for risk of
collapse.

◼ Investors know that the bubble will collapse but

believe they can get out before it does.

k s tse 45
 Rational Bubble
◼ Irrational bubbles then involve unrealistic expectations
about asset’s future prospects
◼ fad

◼ mania

◼ Irrational exuberance (Unsustainable investor

enthusiasm that drives asset prices up to levels that

aren't supported by fundamentals.)

◼ Let us consider a rational bubble ….

k s tse 46
 Rational Bubble—Simple Characterization
◼ Let vt be the property price; suppose fundamentals
imply that vt = v* for all t.
◼ At some time t0 the price jumps by a bubble b0 to v0
◼ suppose agents expect Dvt = 1 + r in each future

period t.
◼ i.e., bt = b0(1 + r)
t for arbitrary b . See Figure.
0

◼ Why are agents/investors willing to pay increasing

prices for the property?

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 Rational Bubble—Simple Characterization
◼ Why are agents/investors willing to pay increasing prices
for the property?
◼ expected capital gains are self-fulfilling -- this is a

rational bubble, the capital gain on property

compensates for the alternative returns.

◼ Notice this requires the price to grow forever.

◼ If everyone knew that at period (T + j) that the bubble

would burst (that is, v --> v* or bt --> 0), then no one

would pay the bubble price at period (T + j – 1).
◼ The bubble unravels.

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 Rational Bubble—Simple Characterization
◼ A bubble in housing market
If everyone knew that at period T + j that the bubble would burst
(v -- > v* or bt -- > 0), then no one would pay the bubble price at T + j - 1.
The bubble unravels.
v bt = b0(1+r)t

V0 = v* + b0
v*

t0 T+j Time
k s tse 49
 Rational Bubble—Simple Characterization
◼ Since prices cannot rise forever, are bubbles ruled out?
◼ No, as long as the date of price collapse is uncertain!

v bt = b0(1+r)t

V0 = v* + b0

v*

t0 T+j Time

k s tse 50
 Stochastic Rational Bubble*
◼ Since prices cannot rise forever, are bubbles ruled out?
◼ no, as long as the date of price collapse is uncertain

◼ Suppose that in each period agents believe that the probability

the bubble will not burst is q.

q No Burst: Expected Bubble = bt+1
bt (1+r)bt
1-q Burst: Expected Bubble = 0

◼ Since the bubble is expected to grow at growth rate r, we have:

(1 + 𝑟)𝑏𝑡
𝑞 × 𝑏𝑡+1 = 1 + 𝑟 𝑏𝑡 → 𝑏𝑡+1 =
𝑞

◼ The ACTUAL bubble at t+1 is written as :

◼ et+1 is a white noise with mean 0.

k s tse 51
 Stochastic Rational Bubble
◼ Since prices cannot rise forever, are bubbles ruled out?
◼ no, as long as the date of price collapse is uncertain

◼ Suppose that in each period agents believe that the probability

the bubble will not burst is q. Then we have

◼ et+1 is a white noise with mean 0.

◼ If the bubble follows this path it is rational.
◼ The expected value of the bubble in period T +1 is exactly bt+1.

◼ To see this, note that

--our initial expression for the bubble path. See Excel.

k s tse 52
 Stochastic Rational Bubble
◼ Notice that the stochastic bubble grows faster than under
certainty, because investors must be compensated for the risk
of the bubble bursting.
(1+r)bt
> (1+ r)bt
q
◼ Analysis: From rational bubble we can back out the market’s
expectation of it bursting.
◼ At any time t, you know the actual price (vt) and the interest

rate, and if you know v*, then you can calculate bt = vt - v*.
◼ If the bubble has not burst yet then

(1 + 𝑟)𝑏𝑡 (1 + 𝑟)𝑏𝑡
𝑏𝑡+1 = →𝑞=
𝑞 𝑏𝑡+1
k s tse 53
 Stochastic Rational Bubble
◼ If the bubble has not burst yet, then
(1 + 𝑟)𝑏𝑡 (1 + 𝑟)𝑏𝑡
𝑏𝑡+1 = →𝑞=
𝑞 𝑏𝑡+1
◼ This probability can be then compared to the amount of time the
bubble has been growing.
◼ This notion of a rational bubble is used frequently in analysis

of asset markets.
◼ (e.g. CNN also reports the probability that the FED will raise

interest rate in next meeting as reflected by the current

market yields on Treasury issues.)

Ad hoc Example: Hong Kong Property Market

k s tse 54
 Example: Hong Kong Property Market
Median HH Income/Month
25000

19872 20667
20000

15000

10000

5000

0
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

◼ Suppose an average household can only commit up to 1/3 of its income to

mortgage payment.
◼ Suppose mortgage terms are 20-year, monthly payments, with mortgage rate
equal to Prime Rate (5%) minus 2.5%, and 30% down payment.
k s tse 55
 Example: Hong Kong Property Market
◼ Suppose an average household can only commit up to 1/3 of its
income to mortgage payment.
◼ Suppose mortgage terms are 20-year, monthly payments, mortgage
rate equal to Prime Rate (5%) minus 2.5%, and 30% down payment.

◼ What is the maximum home price the household can afford in 2012?
◼ Based on the median household income and the mortgage terms, the
maximum mortgage an average household can borrow is determined
as follows:
◼ Mortgage Loan =
−12𝑛 −12𝑛
1 − 1 + 𝑟/12 20667 1 − 1 + 2.5%/12
𝑃𝑀𝑇 =
𝑟/12 3 2.5%/12
= 1,300,042
◼ Affordable home price = HK$ 1,300,042/0.7 = HK$ 1,857,203
k s tse 56
 Stochastic Rational Bubble
Property Price:
Class A Residential (40 square meters)
$3,500,000 3224262.8
Afforable Price
2931148
$3,000,000
Actual Price
Size of
$2,500,000
Bubble
$2,000,000 $1,857,203

$1,857,203
$1,500,000

$1,000,000

$500,000

$0
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
◼ Affordable Property Price is calculated based on 1/3 of median household
income, 20 year mortgage, 5% minus 2.5% mortgage rate, and 30% down
payment.
k s tse 57
 Stochastic Rational Bubble
Property Price:
Class A Residential (40 square meters)
$3,500,000 3224262.8
What is the Afforable Price
2931148
$3,000,000
market Actual Price
expectation $2,500,000
that property
price will fall $2,000,000 $1,857,203

to the $1,857,203
$1,500,000
affordable
negative bubble
price level? $1,000,000
b2012 = 2931148 – 1857203 = 1073945
$500,000 b2013 = 3224262 – 1857203 = 1367060
Mortgage rate = 2.5%
$0
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

(1 + 𝑟)𝑏2012 (1 + 𝑟)𝑏2012 1.025 × 1073945

𝑏2013 = →𝑞= = = 0.805
𝑞 𝑏2013 1367060
k s tse 58
 Stochastic Rational Bubble
Property Price:
Class A Residential (40 square meters)
What is the $3,500,000 Afforable Price
3224262.8

market 2931148
$3,000,000
Actual Price
expectation
that the $2,500,000
property price $1,857,203
$2,000,000
bubble will
burst within $1,500,000 $1,857,203

the next 5
years? $1,000,000

$500,000
(1 + 𝑟)𝑏2012 1.025 × 1073945
𝑞= = = 0.805
𝑏2013 1367060
$0
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

• Probability that the price bubble will NOT burst at the end of 5 years is
(0.805)5 = 0.339
• Probability it will burst within the next 5 years is 66.1%
k s tse 59
 Stochastic Rational Bubble: Implications
◼ Fact that bubble has to grow at an expected rate of r allows
one to eliminate many potential rational bubbles.
◼ commodities with close substitutes puts limits

◼ a bubble on a non-zero supply asset cannot arise if r

exceeds the growth rate of the economy, since the bubble

would outgrow the aggregate wealth in the economy
(Tokyo Imperial Palace worth more than the sum of all the
real estates in California in the 1980s ??).
◼ Hence, bubbles can only exist in a world in which

the r < the growth rate of the economy.

◼ In a rational bubble setting an investor only holds a bubble
asset if the bubble grows in expectations for the indefinite
future.
k s tse 60
Effects of Bubbles
◼ Bubbles have violent collapses.
◼ They can lead to distortions in resource allocation.
◼ They may be associated with financial collapses.

k s tse 61
 End
◼ What is bubble?
◼ Are bubbles irrational?
◼ Causes and consequences of bubble
◼ Is Hong Kong Property Market a bubble?
◼ Reference:
◼ “Supply Adjustments to Demand Shocks in the
Commercial Real Estate Market”; by George Lentz
and K. S. Maurice Tse, Real Estate Economics, 1999

k s tse 62