3.6.1 Expectations
Expectations are a core element in understanding speculative bubbles. Malpezi and Watcher (2005) state that the most common and widely used expectation models are those of myopic expectations, perfect foresight, rational expectations and adaptive expectations. Myopic expectations assume that only “the current market situation matters for the formation of expectations about the future.” In other words, investors are going forward (Wijlnost & Wergeland, 1996; Malpezi & Watcher, 2005). Perfect foresight assumes that people have perfect information about the future, while rational expectations assume that people use all available information to make optimal forecasts about the future, although what ‘all available information’ actually means and how that information is used remain undefined.
Rational expectations assume that the participants in the housing market make optimal use of the information and that participants make decisions using rational rules (Diappi, 2013). Finally, adaptive expectations or backward looking assumes that people make investment decisions based on the direction of recent historical data. Flood and Garber (1980, p.745) explain that ‘‘when current house prices depend partly on the expected rate of market price change, it is possible that the market will launch itself onto a price bubble with price being driven by arbitrary, self-fulfilling elements in expectations.” Recently, a growing body of literature on inflation expectations has suggested that individuals look to past experience to estimate future inflationary outcomes, thus generating ‘adaptive expectations’ (Malpezi & Watcher, 2005). Regarding this view, Stiglitz (1990) supports the idea that the price of an asset will rise only if investors’ expectations change in such a way that they believe they will be able to sell the asset for a higher price in the future. Correspondingly, Case and Shiller (2003) argue that the expectation of rapid and steady future price increases is, in itself, a core motivating factor for buyers.
3.6.2 Speculation
Speculation is held to be one of the main factors behind the formation of housing bubbles. According to Kaldor (1939),
speculation may be defined as the purchase (or sale) of goods with a view to resale (repurchase) at a later date, where the motive behind such action is the expectation of a change in the relevant prices relatively to the ruling price and not a gain accruing through their use, or any kind of transformation effected in them, or their transfer between different markets.
Kaldor adds that if the expectation of an impending change in the ruling market price acts as the sole motive for action (all else being equal), then the purchase or sale is considered to be speculative. This is the main difference between a speculative purchase or sale and a normal purchase or sale.
Following Kaldor and Keynes, Harrison and Kreps (1978) state that “investors exhibit speculative behaviour if the right to resell a stock (asset) makes them willing to pay more for it than they would pay if obliged to hold it forever.” Accordingly, speculation can be described as “a world in which investors’ expectations are formed in some inaccurate way.” For example, many models of speculative bubbles are based on adaptive expectations, or
extrapolations of recent trends. When prices are rising, speculators enter the market and demand increases. When prices are falling, they bail out. The authors also note that speculation correlates with the time horizon of an investment. In most cases, the term ‘‘speculation’’ applies to short-term investors, rather than those who buy and hold for the long term (Malpezi & Watcher, 2005). Similarly, Kaldor (1939) states that speculation is mainly a short time commitment, not a long-term investment; therefore, a successful speculator must possess better than average foresight. In a third proposition regarding speculation, Feiger (1976) asserts that “if all agents are identical in tastes, anticipations, and endowments, the speculative position will be sustained after nature determines the state.” This proposition is in accordance with the notion of a bubble, since the identical tastes, anticipations and endowments of market participants act to sustain speculative bubbles. However, Kaldor (1939) explains that not all economic goods can be used for speculative purposes. In general, certain main factors should prevail, viz. the existence of a perfect or semi-perfect market and low carrying costs. Furthermore, the presence of some attributes is required before a particular asset can be used for speculation. Some examples are as follows:
• The good must be fully standardized or capable of full standardization. • It must be a good that has general demand.
• It must be durable (long-lasting).
• It must be valuable in proportion to bulk.
Stocks possess all these essential characteristics, whereas real estate ‘goods’ are less attractive for speculation (Kaldor, 1939). The fact that property assets are not standardized (identical) products and that they have high carrying and transaction costs minimize the potential for speculation in the real estate market. However, this does not mean that property is an asset immune to speculation. Kaldor (1939) observes that the core reason that speculation occurs is that imperfect foresight in the market allows speculators to behave with more foresight than the average individual in the system possesses. Conversely, in a world of perfect foresight, there is no possibility of speculative gain. If expectations were certain and if perfect foresight prevailed in the market, speculative activity would be unable to affect the current price.
There is a widespread belief among valuers and real estate academics that property markets are not efficient. The debate on whether and to what degree they are efficient is related to the three forms of efficiency: weak, semi-strong and strong. Property has a number of inherent characteristics that prevent it from being valued or priced in an efficient manner. Such characteristics highlight the differences between stocks and property as assets. The following property characteristics are the most important (Brown & Matysiak, 2000; Ibbotson & Siegel, 1984; Webb, Miles, & Guilkey, 1992; Kummerow & Lun, 2005; Farlow, 2004):
• It is lumpy.
• It is heterogeneous.
• It cannot be sold in small units.
• It is difficult and slow to sell (so it is an illiquid asset). • It incurs high transaction costs.
• It is imperfectly marketable. • It cannot be traded internationally. • Information is costly.
Ibbotson and Siegel (1984) note that in real estate, the appraised price is only a good approximation of the market price, which is, in itself, unknown. The transaction price may differ from the appraised price. The uniqueness of real estate assets is one of the most significant causes of valuation errors, providing strong evidence of the imperfect foresight that allows speculative gains. Research done by Brown and Matysiak (2000) in the US used the physical characteristics of residential properties as proxies for current public information and found that the market was semi-strongly efficient after transaction costs were taken into consideration. However, it is a controversial matter as to whether and to what degree the property market is efficient, with the research remaining inconclusive. The majority of studies indicate that the real estate market is not efficient (Gunther & Shanaka, 2009), but different views on its efficiency are reported by Evans (1995), Darrat & Glascock (1993) and Brown (1991). However, such a discussion is beyond the scope of this thesis.
According to Evans (1995), it is more difficult to earn large returns in the stock market than in the property market, since the stock market efficiently discounts the available information.
However, Kaldor (1939) notes that if the market is imperfect and/or carrying costs are large, the difference between buying price and selling price will be large, thus making speculation far too expensive to undertake. It must be noted, though, that the carrying costs of real estate in relation to the transaction price are not excessive. Thus, it can be concluded that the real estate market is open to speculation, although stocks possess all the essential characteristics required for speculation. Generally, Kaldor (1939) argues that in order for speculation to be price destabilizing, one of two things must be assumed: either a change in the current price leads to a greater change in the expected price, or there are impulsive changes in the expected price that are speculative in origin and are not justified by the movement of fundamental factors. The issues discussed above, together with the historical examples, lead us to believe that real estate markets are prone to speculation.