Are real estate bubbles predictable?

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Since real estate is inherently cyclical, analyzing and predicting market cycles have always been critical topics for real estate investors, tenants and developers. The global financial crisis has increased interest among regulators and central bankers at both national and international levels. While industry players can’t really avoid future downturns, accurate expert analysis could limit their financial and social costs.

With first-hand appreciation for the devastating economic, social and political effects that result when a real estate market bursts, and with an intimate understanding of the long-lasting effects of commercial real estate crashes, it is very important to understand if there is  a way to institutionalize the methodology associated with predicting dramatic commercial real estate market downturns.

An early warning system prototype, conceived by the World Economic Forum’s Asset Price Dynamics Steering and Advisory Committees, was able to correctly describe recent market developments. The initiative delves into the mechanisms of asset pricing to learn how to detect when and why markets shift from fundamentals and how detrimental, irreversible consequences can be mitigated. Used in conjunction with other methods and analysis, such a system could increase overall market transparency and help prevent destabilizing effects of capital rushing into and out of property markets during periods of dramatic change or recession.

This initiative provides on the real estate ecosystem – the main players and their motives. But they are far more ambitious in providing an early warning system for commercial real estate crashes. Moreover, the intent is to build a system that can be scaled up to the global level and also applied to other asset classes, including the residential real estate sector. So, does the effort succeed?

The initiative shows that the risk of crashes in the commercial real estate prices can be linked to developments in a few macroeconomic indicators – inflation rates, bond yields, consumer confidence, employment –and to growth in the sector’s net operating income. There is thus no complex or secret ingredient needed to assess the risks of crashes: one only has to look out of the windscreen.

Within its first two years, the initiative developed a strong brand by engaging the key real estate ecosystem players: leading academic experts, central bankers and businesses from the real estate, investors and financial services industries. In the second project year, high-level multi-stakeholder discussions had been facilitated to further define asset ecosystems and describe how asset bubbles can be spotted early enough to be able to limit negative consequences. The focus was to help market players make more informed decisions. One work-stream focused on designing a prototype early warning system to flag markets that will undergo severe downturns; a second work stream focused on institutionalizing the team’s insights and learning through developing an educational curriculum showcased through a case study.

Behavioral decision-making is key to understanding asset price dynamics, asset cycles and the macroeconomic inter-dependencies. The most destructive cycles are those in which asset price leverage and credits are intertwined, causing the greatest systemic effects. Asset-pricing dynamics impact economies from the local to the global level. Policy-makers, industry leaders and academics are currently debating whether asset-pricing dynamics can, or should, be managed in the public interest.

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