Real estate bubbles are hard to predict

In the real estate market, the largest asset bubble in recent times was during the World Financial Crisis (WFC) of 2008.

Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, one by one, said author Charles Mackay.

There is a litany of research surrounding the formation of an asset bubble on how and if even possible to identify them. Tulip mania is considered to be the first recorded speculative bubble in history dating back to the 1600s during the Dutch Golden Age. It was popularised in the book Extraordinary Popular Delusions and Madness of Crowds published by Charles Mackay in 1841. He uses the tulip mania to highlight the point that crowds usually behave irrationally, leading to extraordinary price movements that cannot be justified by fundamentals. During the episode, prices for tulips increased 10-fold in 83 days before crashing to its original price.

Another famous example quoted in Mackay's account is that of the 'South Sea Bubble'. The South Sea company was a British joint-stock company founded in 1711 created as a public private partnership to reduce national debt. The company was also granted a monopoly to trade with South America. However, at that time, Britain was involved in the War of Spanish Succession, and any trade from that region was doubtful. However, once again the madness of crowds and irrational exuberance sent the stock price sky rocketing seven times in 210 days, eventually leading to its collapse. In 30 days since the peak, prices had reverted to its original flotation price.

In recent times, one of the most famous bubbles in the equity markets was the dotcom bubble in 2010. It was fuelled by cheap money, easy capital and pure speculation, causing the Nasdaq to rise by 165 per cent 24 months before the peak. In this case, investors overlooked fundamentals, causing valuations of dotcom companies to double or triple overnight, which eventually led to the bubble bursting and the Nasdaq falling 63 per cent in the subsequent 24 months.

In Dubai, the DFM index rallied 265 per cent (2012-2014), surpassing that of the dotcom bubble, before crashing 35 per cent. This was fuelled by a cornucopia of factors which included the 'euphoria effect' due to the win to host Expo 2020. The rally came to a halt in mid-2014, triggered by the crash of oil prices.

In hindsight 2020, both these events look obvious that a bubble formation was in the works and prices would eventually implode. They followed the stages laid out in the bubble cycle; stealth, awareness, mania and finally the blow off. However, the predictability of a bubble has been argued by Nobel Prize economist Eugene Fama that it is not possible. He does not believe that security prices exhibit price "bubbles," which he defines in his Nobel lecture as an "irrational strong price increase that implies a predictable strong decline". He calls the term "treacherous".

However, a recent paper published at Harvard University by Robin Greenwood disagrees with his notion that bubbles can't be predicted. The paper states that "although sharp price does not predict unusably low future returns, they do predict a heightened probability of a crash". It further states that if prices increase 150 per cent above market returns, there is an 80 per cent probability of a crash.

In the real estate market, the largest crash in recent times was during the World Financial Crisis (WFC) of 2008. A closer look into Dubai and California reveals that both cities rallied 50 per cent and 30 per cent respectively (24 months before their peak). During the WFC, the housing market in California crashed by 32 per cent whereas Dubai real estate assets declined by 29 per cent.

A look into the second run-up (2012-2014) of real estate prices in Dubai reveals that assets on a city-wide basis appreciated close to 50 per cent. However, unlike the WFC, markets have had a soft landing falling only 13 per cent in 24 months. We opine that this time around, there has been lower amount of speculator activity as long-term investors enter the market, along with stricter government regulations.

The writer is the head of IR and research at Global Capital Partners. Views expressed are his own and do not reflect the newspaper's policy.