Sean Ellison is a senior economist with the Royal Institution of Chartered Surveyors. He discusses what a housing bubble is, and its symptoms. What is a housing bubble, and how do we know if we are heading towards one? A bubble in any asset class is characterised as a period when the asset’s price significantly deviates from the intrinsic value of that asset for a sustained period. Economist Charles Kindlebergercharacterised it as “a sharp rise in the price of an asset or a range of assets in a continuous process, with the initial rise generating expectations of further rises and attracting new buyers – generally speculators, interested in profits from trading in the asset rather than its use or earning capacity.” A bubble tends to imply that a decline in prices (crash) is likely to occur. Housing bubbles are characterised by a significant deviation from the long-run property price trend, but there are a few indicators to consider apart from prices. Transaction volumes can help indicate which stage of the property cycle we are seeing. Affordability and vacancy are key indications of market sustainability, while the loan-to-value ratio indicates how leveraged a market is, and is an indication of fragility. Historically, markets that have experienced a bubble in any asset class have seen a significant credit expansion in the lead up to the bubble followed by deleveraging when it collapses. Are bubbles destined to burst? Has the low interest rate environment distorted the real estate cycle? Bubbles themselves are difficult to spot before they collapse. Deviations from a long run trend could be transitory, as in the case of a bubble, or they may occur because of a structural change in the underlying asset or economy that permanently alters its value. Low interest rates have altered the real estate cycle, but in a nuanced manner depending on the market. Low rates likely helped stem the decline in home prices in the US. However in markets like Hong Kong, which imports US monetary policy and did not see the same collapse in real estate prices during the global financial crisis, it has likely created artificial demand. Is housing affordability a good indicator of how healthy the market is and what stage it is in? Price-to-income is the accepted methodology for determining housing affordability. The OECD calculates a price-to-income ratio across markets – allowing apples to be compared with apples, so to speak. Generally, this compares median after-tax income to house price levels in a constant currency (US$) – i.e. how many years would it take for the average person in this country or city to pay for a house. Price-to-rent – the ratio of home prices to annual rental rates – is another indicator. This takes rental yields as well as prices into account, and the data tends to be broken down by region. Is public or subsidised housing included in the measure of housing affordability? Public housing should be included as long as the incomes of the occupants are. However, some affordability indexes just focus on private housing. This highlights a drawback of affordability – it could be different for different segments of the market. Are income gaps factored into housing affordability measurements? The headline indicators do not do well to capture the stratification of wealth in countries places like Hong Kong. These measures are useful as a guide, but the data should be broken down to see if some segments of the market are tighter than others. Are other property market statistics useful as indicators of the risk of a housing bubble? Other property market statistics are fairly useful in signalling the risk of a bubble. Since the financial crisis of 2007-2008, leverage has been a key indicator of stability. If a market is highly leveraged its ability to withstand higher vacancy rates and lower rental yields is eroded. Although some leverage is essential to ensure market functionality, any increase in leverage tends to exacerbate market volatility.