Monday, April 10, 2017

Why loose lending and foreign buying can have large effects on property prices

Key Points
In asset trading markets prices are set through buyer competition
It takes only one extra buyer to bid up the price at an auction, whether they end up winning it or not

Price changes snowball
This month, extra buyers bid up the price. Then next month, they bid prices up from the new higher price that was established last month

Impact on asset trading markets
These two phenomena are why prices in all asset trading markets (where people buy and sell, like most houses and shares), change so much and so often compared to prices of consumer good (that consumers only buy, like most groceries and household items)

Conclusion
Any policy that brings more buyers into the housing market can have large effects on prices (and the same in reverse if you take those buyers away)

Extra buyer effects
In NSW last year, 11% of home buyers were foreigners. But is 11% a big number? What sort of effect on price could that much foreign buying have?

What we know for sure is that 11% of buyers does not mean that the presence of foreign buyers has made prices 11% higher. The price effect could be lower, or far higher. I suspect higher.

One trick to understanding the price effect of additional buyers in the housing market is to understand that potential buyers can affect prices without ever buying a home. It doesn’t matter if the extra buyers are foreigners, or investors funded by loose lending. In all cases, not only do the extra buyers who end up buying a home affect prices, but so to do other new buyers who didn’t end up buying.

Consider a home auction scenario. The highest bidder wins by exceeding the second highest bid by a tiny amount. But it may well be the case that this one person was willing to bid much higher to buy the property, but didn't have to.

Let's say for simplicity that the winning bidder was willing to pay $1.2 million (it is a Sydney house after all), and the second highest bidder (the under-bidder) was willing to pay $1 million. In this case, the winning bidder need only bid a little over $1 million to win the auction and set the price.

What happens if another buyer shows up at the auction and is willing to pay $1.1 million. They will take up the bidding after the previous under-bidder stops. Pushing the price to $1.1 million by bidding against the person willing to pay $1.2 million. The eventual result will be the same person wins the auction and buys the home, but the bidding process with the extra potential buyer sets the price at $1.1 million, or 10% higher.

What this small example demonstrates is that in a market like housing, additional buyers can influence the price even if they never actually buy anything!

My reasoning therefore suggests the price effect of the presence of extra buyers at the margin can have a large effects on prices relative to how many homes they actually buy. This is actually likely to be exacerbated in an asset market like property, as small rises in prices ‘reset’ expectations for future buyers about what the price should be next week, or next month. So any small price effect at each auction with an extra buyer in attendance, setting a slightly higher price, is cumulative across the market and over time. These effects are why asset markets can be so volatile and cyclical.

One implication of this is that a sudden reduction in the presence of investors or foreign buyers in the Australia residential property market is likely to have a large negative effect on prices.

Demonstration with auction simulation
To get a feel of the potential size of the price effects from a new group of buyers such as foreign investors, who end up buying 11% of properties, I do the following auction simulations. In these simulations, the new buyers have exactly the same distribution of willingness to pay of homes as local do. The price effect comes from both additional under-bidding and addition winning of bids.

In the ‘before foreign buyers’ case I draw 89 people out of a statistical distribution of willingness to pay. I use 89 people for the auction so that in the ‘after foreign buyers’ case I use 100, and the new people win the bid 11% of the time on average. The bidders are drawn from a normal distribution with mean of $1 million and standard deviation of $150,000 to represent the likely willingness to pay in the Sydney housing market.

I then play an auction with the 89 people, where the price paid is the second highest bid based on the slightly different willingness to pay of each person. The mean winning bid is $1.305 million. It is higher than the mean willingness to pay because the mean potential buyer almost never wins, as they are outbid by the people higher in the distribution of willingness to pay.

The ‘after foreign buyers’ case simply adds 11 extra people to the auction, so that there are 100 people, all drawn from the same distribution of willingness to pay. Here, the mean winning bid is $1.313 million.

That’s 0.6% higher.

That’s not much. In fact, that’s somewhat in keeping with analysis on the price effect of foreign buyers by Treasury. Their analysis looked at price difference between suburbs with high levels of foreign buyers and low levels, to conclude that the price effect of their presence is small. Others have argued similarly.

The cumulative effects
But this is not the end of the story.

There is a problem with my method, and with the method used by the Treasury. Treasury’s analysis assumes that the price effect caused by additional buyers in one area is fully independent of the way prices are set in neighbouring areas. This is unlikely to be true. In my analysis, I assume that the price effect at one auction has no bearing on the willingness to pay of all potential buyers at future auctions. Again, probably not true.

In reality, the prices that are set this week, or month, inform how much every buyer will be willing to pay next week, or next month. After all, where does the willingness to pay come from if not informed by previous prices and how they are changing?

So to get an understanding the total cumulative impact of this larger buyer pool we can take the 0.6% price effect at each auction and compound it to reflect the higher prices becoming incorporated in the willingness to pay of all buyers. There is no clear and correct way to do this, but two options that jump out are to compound weekly (people update their willingness to pay after last week’s auctions), or monthly (the update based on new price information once a month).

If we compound weekly, we get a cumulative price effect of 34.9% over a year. If we compound monthly, it is 7.1%.

What we see is that small effects at the margin matter if they are cumulative, and certainly the effect of more buyers in the property market will have such a cumulative feedback effect on prices.

It is important to note however, that these numbers just demonstrate what could be happening. They are not true of correct, unless by chance my simulation is a perfect reflection of reality. They simply demonstrate the mechanism by which a new pool of buyers who buy 11% of properties can effect prices.

What is definitely not happening is that 11% foreign buying means prices are 11% higher. They probably are higher, but we have no idea by how much. This simulation just shows the sort of range of price effects if 11% of buyers were foreign and they were willing to pay exactly the same as local buyers.

There is also a case where foreign buyers have a different distribution of willingness to pay. Because some foreign buyers may receive benefits from purchasing that are external to the property, like in some cases permanent residency, they may on average be willing to pay more than each local buyer.

If I extend the same simulation account for foreign buyers being willing to pay just 1% more, then the cumulative price effects could be in the range of 14% to 75%. Obviously the higher the difference in the willingness to pay, the much larger effect on prices!

So what?
Unfortunately we can’t say a lot about the real price effect from additional buyers in the housing market, be they foreign buyers or investors. But what we can say is that
  • The share of foreign buying doesn’t really help understand the price effects very much 
  • Additional buyers will increase the price of properties they do not buy through under-bidding 
  • Small price effects from additional buyers are cumulative if all buyers incorporate the new market price into their future willingness to pay 
  • If foreign buyers have a higher willingness to pay for other reasons, the price effect will be much larger 

6 comments:

  1. Some good insights here. A seemingly small number of xtra buyers at the margin can really make a big difference and I think that's not intuitive for the layperson.

    As for the modelling though, I wonder if a regression of different markets by foreign buyer share might be more informative. What share of foreign buyers are there in Adelaide and Hobart, for example, compared to Melbourne and Sydney and does their presence retain any explanatory power when you chuck in, say, a variable for rental vacancies and one for interest rates.

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    1. Sure. We can do that, but that relies still on the independence of prices between capital cities (I think they are far more independent, and this would be a useful identifying assumption).

      Unfortunately the selection of controls would be important, because the price effects from extra buyers are not independent of buying vs selling choices of others in the market. Meaning that when new buyers enter to increase prices, those price increases encourage more buyers to enter (investors, etc) and fewer sellers (why sell when my asset it rising in value so fast!).

      You could just look at the difference in price growth between Syd and Melb, and say, Hobart, if you like. The raw difference would be the sum of all those interacting buyer effects anyway.

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  2. That's some well written and understandable of an phenomenon an economics dabbler/newb like myself had never thought of. Well done.

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  3. So are there any benefits to having foreign investors (non-permanent residents) buy property except higher prices for sellers?

    What do other OECD countries do?

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    1. Good question. A variety of complex things. Let me do some research and write a post about that!

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  4. Hmm, this article is very interesting for me, cuz a few days ago I was looking for an australia interest rate through the Internet, I just have to write a research paper about it. I think that a huge amount of people may this info in future.

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