The Future of Global Real Estate Investment: Back to Basics or Fundamentals

1. The Future of Global Real Estate Investment: Back to Basics or Fundamentals Professor Jarjisu Sa-Aadu Chester A. Phillips Professor of Finance and Real Estate & Associate Dean of Tippie School of Management University of Iowa

2. Outline of Presentation • Brief overview of the on-going economic and financial crises • The magnitude and duration of house price cycles • The link of house price cycle with overall business cycle • House prices and economic fundaments • The Great Moderation • Future prospects for real estate investments • China and Taiwan Free Trade Concept: The Economic Co-operation Framework Agreement (ECFA)

3. Current Sage: Don’t Worry be Happy; the Sky is not Falling “All that said, given the fundamental factors in place that should support the demand for housing, [we] believe the effect of the troubles in the subprime sector on the broader housing market will likely be limited, and [we] do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system” Ben Bernanke, May 17, 2007, Federal Reserve Bank of Chicago, 43rd Annual Conference on Bank Structure and Competition, Chicago, Illinois

4. Some Perspectives on Global House Price Boom-Bust and the Global Financial Crisis • The global house price boom that started in the late 1990s and burst in late 2006 is unique in its perspective • It was worldwide in nature and there appears to be no prior example of such dramatic boom occurring in so many countries (advanced and emerging) concurrently • It was preceded by “democratization of credit” and unprecedented borrowing by companies and households alike • Largest and most important financial institutions either declared bankruptcy or rescued financially • It defies explanation based on rational markets and economic fundamentals alone • Despite coordinated easing of monetary policy by governments, trillions of dollars in intervention by central banks and governments, and large fiscal stimulus packages, the crises appear not over

5. Exhibit 1: Origins of the Global Financial Crisis: The Rise and Fall of Risky Debt 1** 2 3 5 “Global Excess Liquidity & Yield Chasing” 4 House Price Boom 1997-98 Asian Financial Crisis 7 6 * * * Global Financial & Economic Crisis *** House Price Bust Source: Congressional Research Service

6. The Magnitude and Duration of House price Cycles • The house price boom started in the late 1990s and ended with a bust in 2006 was global in nature – See Exhibit 2 • Started in US and other industrialized countries but quickly spread to emerging economies • House prices started to fall in June 2006 in the US and spread around the globe – see Exhibits 3 & 4 • The boom-bust cycle is generally viewed as major catalyst for the global financial crisis

7. Exhibit 2: The Global Boom and Bust in House Prices (and deterioration and other credit markets)

8. Exhibit 3: The History of U.S. Housing Boom-Bust $199,000 (2006) $100,000 (1890) Note: Over the long run the distinctive feature of US house prices has been the cycles rather than the trend $66,000 (1920)

9. Exhibit 4: The Inevitable and Dramatic Decline in House Prices “The Faster they Rise the Harder they Fall” …… SUSTAINABLE (12) 3

10. The Magnitude and Duration of House Price Cycles: What Amplitude? • Exhibit 5 puts the recent run-up in house prices in perspective by comparing it with previous cycle • The rise in house prices from 1970- mid 1990s in 18 OECD economies lasted just over 5 years, and real house prices increased by +40% • The subsequent downturn lasted about 4.5 years and house prices fell about -20% • In contrast the recent rise in house price in the same 18 OECD countries lasted twice as much (10.25 years) and house prices rose by almost three times (or 114% real terms) – See Exhibit 5

11. Exhibit 5: The House Price Cycle (upturn and downturn from 18 advanced economies1) UP-TURN DOWN-TURN 1. The upturn in house prices in 18 advanced economies that started in the mid 19902 and continued for a decade eclipsed that of earlier cycles. The downturn began three years a go and it continues. The 18 countries are: Australia, Canada, Denmark, Finland, France, Germany, Ireland, Italy, Japan, Korea, Netherlands, New Zealand, Norway, Spain, Sweden, UK and USA 2. Real Prices from trough to peak 3. Real Prices from peak to trough Source: Prakash Loungani 2010 Housing Prices, Finance and Development

12. Record decline in annual rate of return of -19.1% in 2009Q1 Exhibit 6: Peak 2006Q4 Index value at peak 2006Q4 = 186.91 =-56.45 points Index value at trough 2009Q1=130.46 =+106.68 January 2000 Base index = 100 Index value at start of run-up in prices 1996Q1 = 80.23

14. Driving Forces Behind House Price Cycles: Why do house prices go through cycles? • The on-going downturn in house prices is nearing the past downturn in both duration and amplitude • It is likely the price declines will eclipse that of the past episode, because prices rose much more and sharply • So why do house prices go through cycles? • Long-run equilibrium relationship view • In the long run house prices, rent and income should move together • When prices and rent get outline with each other households will switch between owning and renting – See Exhibit 8 • Likewise in the long run house prices can not stray far away from peoples’ income (affordability problems) – see Exhibit 8

15. Exhibit 8: Evidence of Long-run Equilibrium Relationship in house prices With rents and income in the USA and UK Ratio of house prices to rent reverted to long-run average 4 times from 1970 -2000 Ratio of house prices to income hovered its long -run average fives times between 1970-2000 in UK

16. The Short Run View of House Price Cycles – drift from the fundamentals • In short run house prices do drift from the long run equilibrium (or the fundamentals) for various reasons • Strong demand momentum leads to increase in house prices, often not fully explained by the fundamentals • The Case of Ireland • Robust income growth between 1992-2006 • Population also grew after 1992 • House prices grew nearly 20% per year in the same period (10 times the previous decade) • Other factors: (1) Supply lag, (2) housing and financial markets – feedback effect, (3) psychological and social factors

17. Exhibit 9: The Rise in US House Prices and Fundamentals DID THE FUNDAMENTALS SUPPORT THE HUGE RUN-UP IN PRICES?

18. Exhibit 10: US House Price Boom and GDP Growth The Recent House price Boom Seemed Out of Step with Real Economic Activity

19. So Where are We in the House Price Cycle? • House prices in the US fell about 30% from 2007 to 2009 • They fell an average of 5% in real terms between 4th Q of 2007 and 3rd Q of 2009 in 18 OECD countries • HOW LONG CAN PRICES GO DOWN? • In most countries house prices are well above their levels at the beginning of upturn in early 2000 • In many countries house price to rent and income ratios are still above the long-run equilibrium relationship, suggested by theory • There is evidence that the increase in house prices between 2000-2006 cannot be fully explained by short-run driving forces or long-run relationships (behavior of the fundamentals) • Lastly, the current house price boom was strikingly out of step with business cycle or output growth • The above four points suggest more price correction ahead

20. Exhibit 11: How Much do House Prices Need to Fall? INCREASED AFFORDABILITY CHEAP

21. Exhibit 12: MORE PRICE CORRECTION NEEDED FOR THE FROTHEIST HOUSING MARKETS

22. Are we near the bottom of the House Price Cycles? • At this point the correction has not thus far eliminated the excess in house prices that occurred over 2000-2006 • Exhibit 11 shows how much the ratio of house price to rent and income in each of 18 OECD countries would have to fall to bring it down to its long-run equilibrium • Hence the conclusion is that global housing markets have not bottom out yet • However on both ratios the USA appears to be in much better situation than most OECD countries • But real estate investment (housing) like politics, is always local

23. The Rise of China’s Property Markets • The boom in property markets continues unabated (See Exhibit 13) • 1.87 billion square meters of living space under construction as of 1st quarter 2010 • Bank have expanded mortgage lending • About 10% of China’s GDP is now in real estate • House prices in 70 Chinese cities rose roughly 13% year to April 2010 • Total sales value of homes (72.4m squares meters) in April 2010 was about US$56.3 billion • Mortgage borrowing is increasing (See Exhibit 14) • Attempting to slow the party • Restriction of housing speculation • Raising down-payment • Raising interest mortgage rates • Limitation of number of house purchase in Beijing

24. Exhibit 13: The Downturn in Chinese Housing Appears Over

25. Exhibit 14: Mortgage Utilization is Growing in China ( mortgage ratio to GDP is still low, 15.3% compared to 79% for USA)

26. The Great Moderation • One of the most remarkable features of past two decades or so was the substantial decline in macroeconomic volatility • The volatility of quarterly growth in real GDP and quarterly inflation have in most industrialized countries have declined since mid 1980s, with the exception of Japan • This twin growth and stability has been dubbed the Great Moderation • The global prosperity (rise in output, house prices and wealth), have all occurred during this period • Going forward the future prospects of real estate investment (all investments) may hinge on the repeat of this phenomenon

27. What Caused the Great Moderation? • Three classes of explanations have been proposed • Structural changes in the economy • Technological innovations • Improved management of inventory (supply chain) • Financial markets innovations • Increased openness to trade & international capital flows • Improved performance of macroeconomic policies • Monetary policy • Plain Good Luck • Economic shocks to countries became small and infrequent

28. Exhibit 15: The Quarterly Variability of US Output Growth Rate 1966 to 2010

29. Exhibit 16: Quarterly Variability of US Inflation 1966 to 2010

30. Future Investment Prospects: Some Key Factors to Consider • 1. Great Moderation: Is it due to (a) Structural Changes, (b) Good Monetary Policy, or (c) Pure good luck will hold • 2. The level debt • 3. Wealth Effect • 4. Trade and oil surpluses • 5. The health of banks • 6. Demographic Changes

31. The Debt Hangover • The rise in debt levels accompanied the Great Moderation • Debt increased at all levels: consumers, households, companies, banks, whole countries (national debt) • In 10 matured economies private and public sector debt rose from average 20% of GDP in 1995 to 300% in 2008 (see Exhibit 17) • In general the Asian countries (China, India, Korea, Taiwan) are less indebted. • China and oil exporters built huge current-account surplus which was lent to current-account deficit western countries to buy more of their goods

32. Exhibit 17: The Debtor Nations and Creditor Nations

33. Exhibit 18: Significant Foreign Ownership of US Debt Obligations

34. Exhibit 19 : Banks with Biggest Profits and Banks with Biggest Losses

35. The Economic Cooperation Framework Agreement (ECFA) between China and Taiwan • What is the objective of ECPA? • Promote and normalize economic relationship between China and Taiwan • Internationalization of Taiwan’s economic relationship • Initial steps – early harvest • Elimination of trade tariffs on 539 export items from Taiwan by China worth US$13.8 billion • Elimination of trade tariffs by Taiwan on 267 China export items to Taiwan worth an estimated US$2.9 billion

36. Exhibit 20: Taiwan’s Trade with China

37. Perceived Impact of ECPA on Real Estate Investment • Capital flow from China into Taiwan and vice versa • Reduction in cost of capital • Investment in tourism-related real estate • Hotels and Motels • Restaurants • Retail Shops • Increased ability of Taiwanese banks to participate in Chinese service sectors including banking • Participation infrastructure developments by Taiwanese companies

38. The Investment Clock Cycle for Real Estate The investment clock or the economist clock was first published in London in 1937 It is based on well known phenomenon that major business cycles occur roughly every decade It depicts the movement of markets within this longer-term cycle It is suppose to assist with timing major market moves As shown in Exhibit 20 the progression of economic cycle through time with 12 o’clock representing the boom down to 6 o’clock repression the depth of recession (bust) Real estate investment is at its most dangerous phase in terms of liquidity when the cycle enters the credit squeeze mode

39. Exhibit 21: The Investment (or Business) Cycle Clock for Real Estate – Where do you think we are on the cycle clock?