- Introduction
Real estate remains one of the largest industries in UK. According to Conway (2015), real estate is the second largest industry after retail in the country. Being the second largest industry in the country, real estate impact the economy in a bigger way. However, given that the industry is cyclical in nature, the nature of impact it has on the economy varies. This paper will critically discuss the real estate procyclicality and its impact on the macro economy via the lending channel.
- The real-estate pro-cyclical effect and its significant
Procyclicality generally mean a condition of positive correlation between the values of two variables. That is, if one increases the other increases as well and if one decreases the other decreases. In the real estate, procyclicality mean the tendency of house demand and price to increase when the economy is doing well, or a fall of housing price and demand when economy is in downturn (Christensen, 2011).
Procyclicality of the real estate is significant for two main reasons. First, real estate has the ability to destabilize the entire economy. This is the case because real estate is largely funded by debt and is a significant contributor to the economy. For instance, In Europe, the residential debt to GDP equaled to 73.8 percent. Secondly, a significant number of homeowner holds mortgage. In Europe 80 percent of all homeowners in hold, mortgages with 73 percent of these mortgages being held at variable rate (HYPOSTAT, 2017). These mortgages are usually given out using the loan-to-value approach. If the real estate market were to operate under stable condition, this would not be an issue. However, since the real estate market is procyclicality in nature, it become a significant factor as it has the potential to affect home values and hence the ability to resell, refinance the mortgage and access mortgage (McCoy & Wachter, 2017).
- Importance of lending activities in real estate sector
Real estate is largely dependent on borrowing and more so on mortgage. Many homes are financed by mortgage loans, which form the largest liability on household balance sheet (McCoy & Wachter, 2017). The lending activities therefore play a significant role in ensuring people are able to become homeowners. In Europe alone, 80 percent of all homeowner hold a mortgage loan. That means that 80 percent of all homes purchased in Europe were financed through mortgage loan (HYPOSTAT, 2017). In the absence of lending activities in the real estate, the industry would hardly experience any significant growth, as the amount of money required to purchase a home is to way beyond the immediate affordability of most people. The lending activities do however improves their purchasing power hence making housing affordable to them. This in turn led to an increase in demand for the house as well as increase in prices for houses and supply. As a result, the industry experience some significant growth hence making major contribution to the overall economy. However, the lending activities in real estate is not always stable. It is prone to the procyclicality nature of the real estate.
As pointed out by McCoy & Wachter (2017) the real estate’s procyclicality usually affect accessibility to mortgage. During times of increased economic activities, the real estate demand and prices improves as well and this attract lenders to the industry. During such time, lenders usually expand access to credit by lowering the loan underwriting standards. As results, more people including those consider to be at high risk of defaulting are able to access credit facilities (McCoy & Wachter, 2017, Christensen, 2011).
As highlighted by Pavlov and Wachter (2011), due to the procyclicality nature of the real estate and given the fact that loan-to-value is the most common ways of determining accessibility to mortgage, during the time of increased economic activities the lenders relaxes their lending standards allowing even high risk borrowers to access the credit. Lenders do so to maximize their short-term profitability and return, while at the same time knowing that their loan is cautioned by the increasing value of homes/properties (Pavlov & Watcher, 2011, McCoy & Wachter 2017). On the other hand, during the time of economic downturn, the demand and prices of houses decline. As a results, home equity or value which banks used to advance loans even to the risky borrowers decline significant. To cautions themselves against the risks of increased defaulters, the banks tightens the loan underwriting standards, which make it hard for majority of people to access mortgage loan (Pavlov & Watcher, 2011, McCoy & Wachter 2017).
- Real estate pro-cyclical and its impact on macroeconomic stability via the lending channel
As it has already come out in this paper, real estate is procyclicality in nature. I.e. it has a positive correlation with the economy. When the economy grows so does the real estate and when the economy slow, so does the real estate. As it was clearly demonstrated in the above section, the procyclicality nature of real estate influences the lending activities hence affecting accessibility of mortgage. As literature suggest such relationship between procyclicality of real estate and mortgage accessibly has far-reaching impact on the macroeconomic as will be explained in this section.
Generally, the procyclicality of real estate affect the mortgage and the lending practice, which in turn affect the macroeconomic of the country. As noted by McCoy & Wachter (2017), during the time when the economy is doing so well, the price of houses also increases. As results, less restriction are placed in the mortgage market and hence more people are able to access mortgage facilities (see the relationship between house price and mortgage debt in the figure below). This raise household indebtedness making people more vulnerable to fluctuation in gross domestic product. As explained by Christensen (2011), a growth in mortgage credit/ home loan in turn causes a surge in the house prices. Surge in house prices lead to increased housing construction activities and since the housing market is largely labor intensive, a significant numbers of employment is created. However, at some point the increase in house prices surpasses the purchasing power of homeowners. At that point, the demand for house start to fall and home prices start to decrease. This in turn led to economic slowdown, which lead to loss of jobs. Newly unemployed homeowners start having trouble in meeting their house loan obligation and since the house price has decreased, they cannot retire or sell their home or even refinance their mortgage. With no option left to them, they default on their home loan leading to foreclosure. Foreclosure lead to an increase in house supply, which depresses house prices even further. As a result, housing construction activities and production level are significantly slashed, layoff ensues and the general economy is forced into the recession. Banks are impacted heavily especially by loan losses. As a result, they curtail lending in order to hoard cash. With no credit available, the economy remain in it downturn cycle. It is only through intervention mostly from governments that the economy start to recover.
Source; Cloyne et al (2017)
The procyclicality of real estate leads to fluctuating house prices, which in turn causes instability in the economy via consumer expenditure and borrowing level (Cloyne et al, 2017). During downturn, the houses prices decreases and this impedes credit. When there is an economy upswing, the procyclicality of the real estate lead to increase in house prices, which mean an increase in house value. This in turn encourage people to borrow more using their houses as collateral. An increase in borrowing in turn lead to an increase in consumption not only on house and house related products, but on general items. This generally led to economic growth hence leading to creation of more employment rate (reduced unemployment rate), improved production, and rise in inflation-increases among other. However, at one point the economy may slow down due to the effect of other factors such as high inflation rates, high interest rate among others. Due to the procyclicality nature of real estate, such economic downturn lead to decrease in house price. For a country like UK where real estate is one of the largest industry, decrease in house prices accelerate economic downturn even further. As Campbell and Cocco (2007) explain, this happen mainly through mortgage debt defaulting. Once economic downturn start, subprime mortgage start to default and foreclosure ensue. Foreclosure increases the numbers of houses supply in the market, which forces the prices of house to decrease even further. At that point, access to credit become hand and most people cut on their consumption. Reduced consumption in turn lead to low construction activities and production level slashed causing further loss of employment and fluctuating in interest rate.
Source; Cloyne et al (2017)
However, as pointed out by McCoy & Wachter (2017), even after the economy starts to recover, most banks and financial institutions remain risks averse and home loan stills remain difficult to access. In addition to that, consumers remain largely pessimistic and usually have tarnished credit score, which make it difficult for them to get access to loan facilitate. However, with time, the economy will recover and this will in turn lead to expansion in credit and due to the procyclicality in the real estate, the house prices will start to rise again. Therefore, in generally, through the spillover effect, the real estate causes fluctuation to a numbers of macroeconomic factors including interest rate, employments and production hence contributing to economic instability.
- Procyclicality and the real estate bubble
Literature suggest existence of strong relation between procyclicality of real estate with real estate bubble and financial crisis as well. McCoy & Wachter (2017 found out that procyclicality of real estate lead to credit expansion which in turn lead to house bubbles/real estate bubble. Lambertini, Mendicino and Punzi (2011) also noted that real estate bubble is usually a precursor of financial crisis.
Real estate bubble is defined by Pavlov and Wachter (2011), as a sharp increase in the price of properties in a continuous process with initial rise generating expectation for further increase in prices, which attract new buyers’ mostly speculative buyers who are interested in making profit. This rise in property price is then followed by a reverse of expectation result to a sharp decline in house property. The relationship between procyclicality of real estate and real estate bubble and financial crisis is largely due to the fact the real estate is financed by debt. For instance, in the Europe, 80 percent of homeowners hold mortgage debt. Generally, procyclicality of the real estate, influence the availability of credit. As explained earlier, when the economic activities are on the rise, the GDP and employment level is also on the rise. Because of these prevailing positive economic conditions, lenders expand access to credit by reducing restriction to it access. As a result, more people qualifies for mortgages even though who are at higher risk of defaulting. The expansion of credit facilities and more so the mortgage lead to an increase in the demand for properties, which in turn lead to increase in house prices. Increase in house prices attract new buyers especially the speculative buyer who sole intention is to make profit in near future from the sale of the same property. This increase the prices of the house even further until the price become unsustainable. Once price become unsustainable, the economy start to slow down. This in turn led to loss of jobs. Newly unemployed mortgage holders, start experiencing difficulties paying their mortgage. As result, they default leading to foreclosure and eviction. Foreclosure increases the supply of houses in the market leading to a further decline in property price and value. It is at that point a real estate bubble, is said to have occurred.
Pavlov and Wachter, (2011) notes that real house bubble is usually temporary in nature but may last for years. However, as noted by Davidson, Levin, & Watcher (2013), real estate bubble usually have far-reaching impact on the financial sector which lead to financial crisis in most of the time. Pavlov and Wachter, (2011) notes that once real estate bubble occurs, banks experience huge amount of loan losses, which affect their solvency. A case in point in this case is the 2008 financial crisis that started in the united started. It started after a real estate bubble occurred which caused massive loss by the banks hence affecting their solvency and as result majority of them collapsed leading to the financial crisis.
- Conclusion
This paper has critically discussed the real estate procyclicality effects and the impacts it has on the macroeconomic. As clearly demonstrated in the paper, the procyclicality of the real estate, affect the lenders decision on whether to tighten credit or to expand credit. During times when economic activities are on the rise, the demand for house increases leading to higher prices. Normally, at that time lender chose to expand credit facilities since based on the loan-to value approach, the risk of defaulting is minimized. The hand, during economic downturn, house prices decrease, and lenders tighten credit facilities. The finding of the paper found out that procyclicality of the real estate therefore impact the economy in several ways. Through spillover effect, the production increase, employment rate improved, and interest rate decreases during the times when the house prices and demand are higher. However, when the demand of house decreases due to economic slowdown, there is loss of job, production is slashed and interest rate increases. The paper has also found a significant relationship between the real estate’s procyclicality and real-estate bubble and financial or credit crises. The procyclicality effect, real estate price increase when economical activities has raised. The house prices increase to point they become unstainable leading to sharp decline in house prices due to tighten credit, defaulters, foreclosures and loss of home equity. This in turn lead to devastating impact of banking sectors where most banks risk become solvency due to high leveraging