How does real estate affect market cycles?

Real estate has historically been involved in, but hasn’t been the primary cause of, major market cycles.

To search for ways to manage or mitigate damage outside normal market risk, the World Economic Forum and JLL carried out a study, the findings of which were published as Emerging Horizons in Real Estate – An Industry Perspective on Asset Price Dynamics. It finds that real estate cycles are typically ignited by shocks from outside the real estate sector. Examples of shocks that can initiate real estate cycles include financial deregulation, changes in cross-border investment regulations and political events. Once such events occur, real estate can play a role in spreading their impact across the economy.

Real estate occupies a unique position in the transmission of cyclical forces because:

• It is pervasive across economic sectors, especially the financial sector
• Real estate ownership typically involves long-term financial commitments that can be costly and complicated to reverse
• Home ownership has strong ties to household wealth, retail spending and employment

The report emphasizes that cyclicality is inherent in the real estate sector. Demand for office, retail and industrial space can change rapidly, while the construction of new buildings normally takes years rather than months. It is therefore important for policy-makers to distinguish normal cycles from extreme deviations that can lead to the destruction of financial and social wealth.

It is also important to identify ways to manage and limit potential negative impacts. The report highlights three broad categories of policy options:

• Monetary policy can be adjusted to raise interest rates and slow the credit growth that drives many market cycles. But monetary policy can be a blunt instrument that affects all sectors. It can conflict with other policy objectives such as economic growth and rising employment.
• Macro-prudential policies, such as incrementally limiting credit growth during market upturns and requiring banks to build up additional capital reserves as a buffer against future market downturns, are another option. These policies are designed to track and manage the health, soundness and vulnerabilities of the financial system as a whole, taking a broad view rather than a simple focus on individual banks or finance firms.
• Microeconomic underpinnings of markets can help moderate future market cycles. These can include responsive urban planning regimes, flexible policies for dealing with financially distressed assets and consumer protection laws that discourage irresponsible lending by home mortgage providers.

While real estate cycles can have economic and social costs, policies to limit cycles also have costs. Raising interest rates to cool an impending real estate boom can slow the entire economy, for example, leading to lower economic growth and a decline in investment.

The outcomes of this research include recommendations for better market data, improved market analysis and increased communication between the real estate and financial sectors.

The financial crisis revealed problems across the public and private sectors, sending a wake-up call to market regulators and to multiple industry sectors, including real estate. Research like this offers one way to work towards anticipating such problems in the future.

Author: Colin Dyer is President and Chief Executive Officer of JLL

Image: A view of semi-detached homes in Bexleyheath, southeast London, May 12, 2014. REUTERS/Suzanne Plunkett