Week 1 Property and capital Markets

o How stakeholders of property markets can play a role in the funding system to
property markets, under financialization?

o To investigate the financialization of property markets – the system of flow of funds

to property markets

o To evaluate property related stakeholders and financial intermediaries in the

property investment market

o To understand the overseas funding system of NZ

Conceptual model for consumption, interest rate and property markets

This cycle demonstrates a relationship between interest rates and the property market.
How much we consume will determine the amount we save. (saving vs spending) (consumer
behavior vs choices).
1) Expected temporal consumption determines the interest rate: An increase in
aggregate spending increases demand for money/credit, which increases interest
rates. OR a decrease in consumption (aggregate spending) will decrease demand for
money/ credit which decreases interest rates.
2) Interest rate affects property price through property buyers purchasing power/ or
ability of borrowing. Higher (lower) interest rates determine the cost of borrowing.
If interest rates are higher, people are incentivized to save more money and earn
interest, resulting in a decrease in spending/consumption. If interest rates are lower,
it is an incentive for people to borrow as they want to spend and invest, as they can
borrow at a lower interest rate.
3) Property price, especially for residential properties, leads to housing affordability:
Interest rates affect property markets as a low interest rate (has increased spending
and borrowing) resulting in increased pressure on property prices. (NOTE: other
factors also determine housing affordability). As the prices for properties are now
higher, the amount of deposit required to purchase property is also higher. On the
other hand, when the interest rate is high – people are saving more/spending less
 and are also less inclined to borrow due to the higher costs of borrowing. As a result,
there is less pressure on the housing market (due to higher costs of borrowing)
which decreases property prices and therefore, a lower amount of deposit is
required upon borrowing.
4) Household’s dispensable income for consumption is affected by property price and
housing affordability. Depending on whether you rent or buy a house and the
housing affordability will affect your dispensable income (which is the income left
after taking into consideration rental, or payments towards your mortgage/
amortization.
5) Households’ dispensable income over time influence the temporal consumption;
then it in turn will affect the interest rate in this temporal cycle. The cycle repeats –
as the amount of money you have left over for food, travelling and other lifestyle
expenses will determine how much you spend.

Stakeholders of relevance in the property market

 Households, owners & investors
 Developers & Professionals
 Government

System of flow of funds

Investors distribute capital in property markets (capital markets) through financial products

Capital markets are critical to the effective functioning of a modern economy.

Capital markets channel savings and investment between suppliers of capital, such as retail
investors and institutional investors, to users of capital like business, governments, and
individuals. They do this by selling financial products like equity and debt securities.
They do this by selling financial products like stocks and debt securities. Stocks are
ownerships shares in an organization. Debt securities, such as bonds, are interest bearing
IOUS. Capital markets include primary markets and secondary markets. In primary markets,
new stock and bond issues are directly allocated to institutions, businesses, or individual
investors. Whereas, in the secondary markets, existing securities are traded in organized
and often regulated markets such as NYSE. Capital markets are concentrated in financial
centres such as NY, London and Hongkong. Because capital markets move money from
people who have It, to organizations that need it for productive uses, they are critical to the
effective functioning of a modern economy. E.g. TV tech is a start up company who is
looking for investors to fund their new product, a combination TV & Watch device. Alice, a
venture capitalist, believes this new company will be a great success and decides to buy 20%
of the startup directly from founders. This transaction, because it lacks a regulated market,
would take place in the primary market. If TV tech then goes public and is listed in an
exchange like the NYSE or the NASDAQ, then buying and selling shared of TV tech from its
original investors would take place in the secondary market.

Difference between market – based and bank – based financial systems

Market Based System Bank – Based system
Dominant role: primary securities market Dominant role : Banks
Banks make profit from fee-based services Banks make profit from interest e.g. Japan,
e.g. US and UK NZ and Germany
Pro: reduce inefficiencies. This is because Pro: can form long run relationship
banks can compete with each other by between banks and companies
 providing services
Con: dropped incentive for individuals to Con: Banks may collude with firm managers
acquire information. Discrepancies of – causing inefficiencies.
information between principals and agents,
which can cause crises if the information
does not reflect risk vs profit.
Financial intermediaries facilitate investors to get risk adjusted return. Certain level of
return which is compensation for the level of risk taken.

REIT – real estate investment trust is a trust entity as it has a pool of properties, which
collect rental from the tenants and distribute it to the trust holder. Most REITS are publicly
traded on stock exchange.
Listed property funds is also a pool of properties listed on stock exchange to be publicly
traded. These are different to REITS as they have different regulations.

Real estate funds can be syndicates and can be traded in the public market but like private
equity funds, they do not have to be listed on the stock exchange.

Asset backed securities is using certain assets backed up securities.

Read relevant chapters to understand the three types of investment mechanisms.

New Zealand overseas funding system

NZ bank borrows USD for a fixed term from the international capital market and then they
pay a floating interest rate which is relatively low.
Then they utilize the financial product called SWAP (which is a currency and an interest rate
swap) to swap USD with NZD and meanwhile swap the low floating interest rate payment
with a fixed nz interest rate payment, because the interest rate on the floating NZ dollars is
low which allows them to land domestic borrowers at a low interest rates for the funds they
have obtained.

1) New Zealand bank raises US dollars in the international capital market paying
floating interest rate
2) NZ bank swap raised US dollars in exchange for NZ dollars through interest rate
SWAPs and currency SWAPs (SWAP is one type of financial product).
 3) Then banks are able to provide local borrowers with cheap NZ dollars, gaining a
profit from the profit margin of interest rates.

Week 2 – Property Ownership and Investment Vehicles.

Distinguishing the features of three main property related investment vehicles

Real Estate Property Syndicates Commercial

Investment Trusts & & Unlisted Funds Mortgage Backed
Listed Property Securities (CMBS)
Trusts
Underlying Assets Properties Properties Loans

Source of revenue Mainly from renting Mainly from renting Interest payments
of investors who out property space, out property space from borrowers who
invest in securities overall increase in & strategic are also property
value management buyers

REITS/ LPT’s
The function that creates value is property. So when you rent out property and collect rent,
that income is passed onto investors. So there are two types of income the investor can
earn (income in the form of rental + value appreciation of the asset).

Real estate investment trust is a company that owns and operates income producing real
estate. Individuals can purchase stock in these companies – and so the income produced
from rental collection is distributed to shareholders in the form of dividends. REITS will
produce reliable income (through diversification of assets in their portfolio which minimizes
risk and increases return) combined with long term value appreciation through stock price
increases (share value)

Listed REITS are professionally managed and publicly traded companies that manage their
business with a goal of maximizing shareholder value. That means positioning their
properties to attract tenants and earn rental income and managing their property portfolios
and buying and selling assets to build value throughout long term real estate cycles.

LPT is basically the value of the asset which is managed by the listed property trust. The
company is the business structure that exists to deliver a trust.

LPTs solely exist to increase value of their portfolio and increase wealth of their investors.
They trade shares which you can buy and sell through trading accounts, brokers etc but
instead they focus on property.

CMBS – are loans on properties. When you’re invested in CMBS the source of revenue is the
interest that the borrowers are paying to the financial organisation which you’re invested in.

E.g. so when an investor is repaying their mortgage, then you as the person who has
invested in CMBS will get a portion of it. Rather than taking advantage of the increase in the
value from the property itself.

 Companies who invest in real estate

 Listed or unlisted entities
 Typically sector specific (industrial, office, retail ) e.g. goodman is industrial, Kiwi
property is diversified. Some are sector specific as they have a lot of IP, relationships
etc in one sector.
 Investment no different from buying shares
 Dividends and share value appreciation
 Huge scale investments
 Heavily regulated
 Success of the investment based on the performance of the fund
 Growth is slow, losses can be quick – this is reflected by COVID-19 as businesses had
issues of rental arrears, confidence decrease in investors, open market value
decreased as the investors in the open market are not willing to pay as much.
 Hugely diverse spread of assets
 Generally, risk averse
 Net tangible asset
 Liquidity is good – you can sell the ownership of an investment in a listed property
fund.

NET TANGIBLE ASSET - for e.g. goodman's NTA in the graph on the left is $1.73 but the share price is
over $2 so there is a 18.6% premium. This suggests that this means there is confidence in the
industry. they are expecting the value of the share to appreciate overtime.
Goodman might put out what their develop pipeline may look like - so their marketing etc can
influence the premium. Because the new development might increase their value etc. so this is AN
EXPECTATION that the share price will increase.

Property Syndicates and funds

Property syndicate – property is also the underlying asset. There is a narrower pool of
properties, and the income source is still rent. But the income is also dependent on the
strategic management of the property. Performance of the properties in the syndicate will
differ/alter the return an investor can expect.

 Pooling of funds to purchase property and share rental returns

 Each investor owns proportionate share of asset/s
 Investors share in success/failure of the specific investment
 Ongoing returns (distributions) to investors.
 Generally smaller value than LPT’s
 Long term – e.g. 5,10,15 years
 Have higher returns than LPT’s because there is less investors.
 Liquidity issue – as the process for selling is much longer in comparison to an LPT.

The pool of funds is a significantly amount of money. The syndicate wants to give an
investor the opportunity to take part in an investment opportunity that they wouldn’t be
able to in their personal capacity. So like-minded investors collect funds and buy big assets.
Depending on how much money each investor wanted to invest in each syndicate then that
investor owns a proportion of share of their assets directly based in how much money they
have put in.

Syndicators are goodman, argosy, precinct etc who charge fees for administrating
themselves. Their job is to raise capital. If an investor is a part of a syndicate – then straight
away the individual investment is worth slightly less because you must pay fees for
collecting the capital (fees the syndicator is charging) and fees for strategic management.

All the investors share the success and failures. For example, just having one bunnings is not
as diversified as owning a plot with supermarket, car parks, other little shops etc. if a
syndicator decides to sell an asset at an appreciated price then you can get higher returns
based on the proportion but they don’t like selling because they want to get paid. So they
line up purchasing another property with similar property to maintain the returns to the
investor.

Risks
 Syndicator – you need to do your due diligence because u need to know what type
of property e.g. bunnings warehouse etc. because this influences their ability to
extract value out of the property, as this translates to your earnings so you should
look at their track record.
 Diversification is key to minimize risk. If there is no diversification performance of
the asset (based on how well the tenant is doing and their rental) will directly cut out
your returns. Have to assess whether tenants can meet their rental obligations.
 Tenants
  Building condition – if capex is high then it will decrease your returns.
 Liquidity
 Global factors – e.g. financial criss, pandemic etc u cannot mitigate externalities

CMBS

Important function to housing market: banks can sell off loans.

People can access more funds, rolled into the bank
Sustainability in the mortgage market
Ability to give more liquidity and accessibility of funds to bank

CMBS is an investment through purchasing of a loan.

Initially you a have a pool of loans in the banks. The investors then pay the bank on a regular
basis (these payments consist of interest and principal)
There is a secondary mortgage market where players in the market will buy loans from the
bank, they set up a series of securities called tranches which are created backed by the pool
of mortgaged. This is just a big pool of loans broken down to separate loans which hold
different values.

AAA – high priority repayment – less risky loans with a lower yield. Then you have AA, and
so on.

So where does the money come from – when all property owners with loans pay their bank
their repayments – the money goals into the pool. The function of the mortgage-backed
security lender is to then pay on that money to the individual investors who have chosen a
tranch.

This is not too different from putting your money in a bank, but the difference is that you
can pick and choose the risk criteria based on the set of information available to you.

CMBS plays an important function in the housing market because selling from the banks to a
secondary mortgage market, allows them to access more funds. THE BANK can create a
bigger pool of loans, so when they sell off loans, they money is rolled back into the bank –
the primary lender who can then loan out money to property investors. This is a function of
sustainability in the mortgage market.

When the accessibility of funds became tighter, CMBS began.

The risk begins from when investment in property begins and throughout the process, the
money is passed over to the investors (which is less)

GFC caused a big issue as companies like Freddie Mac will allow the banks to keep lending
money to the market. BUT WHEN PEOPLE TAKING PRIMARY LOANS ARE NOT ABLE TO MEET
THEIR PAYMENTS – it becomes a problem as the risk again, begins from there.

Modern Performance of REITS/LPTS

  Rely on all typical indicators of financial stability (population, unemployment,
mortgage rates)
 More recently benefitted from higher occupancy rates, and rising rents
 Interest rates low, investors seeking investment returns.

Green line outperforms the blue as in the past 20 years LPT’s have been higher – proving
them to be sustainable investments. More recently, there is a higher occupancy rates and
higher rents. So as management and agency functions, valuations improve then this
improves the functionality.

Currently there is an attempt to gradually increase interest rates to encourage more saving
and less spending.

Property Is a vehicle for investment – so appreciating the role of finance within property
organizations is critical to understanding their function and motivation

Week 3 Property Market Drivers and cycles

The context and characteristics of the new economy – motivated by the three ‘tions’
Information, communication, and digitalization.

Information Is crucial – making investment/ purchase decisions in property will require you
to evaluate and analyze all information – allowing you to make an informed decision.
Example, when you buy a house you look at listings, neighborhoods, agents, recent sales
etc.

Communication between market players e.g. agents, buyers, investors etc. is important.
Through digitalization the information on social media is filtered and personalized based on
the individuals’ preferences. Communication is key for investors, government decisions,
property owners and developers.
Digitalization - everything is transmitted or communicated through the internet. When we
check real estate websites you can see virtual videos, drone shots etc. All of this is an
example of digitalization which has resulted in an increase in efficiency.

Advancement in technology – blockchain application which can overcome challenges in

commercial property transactions and leasing processes.
E.g. property maintenance data can be stored in blockchain.
 Efficient property searches due to fragmented listings data
 Time – consuming, paper driven, predominantly offline due – diligence process
 Complexity in managing ongoing lease agreements, property operations, and cash
flows.
 Absence of real – time rich data affects management’s decision-making capability.

Exploring changes in the financial industry and their impact to investors and market
players in the property market.

Changes in the financial industry

 Innovative ways of capital flowing from capital markets to property markets. REITS,
CMBS are all vehicles which connect the capital markets to property markets.
 Institutional investor is a company which invests money on behalf of other people
 Global competition among institutional and individual investors
 Eroded geographical boundaries

Impacts on buyers/ sellers and investors

 A variety of financial products in relation to properties – securities, derivatives
 High risk under high financial leverage in the new economy.
 Pumping money into the market is not a long-term solution towards energizing
economies.

Leverage and frequency of extreme events in property markets

The proportions of loans in comparison to the total asset value.
Low Geared: means that the proportion of loans in the aggregate market is quite low in
comparison to the values of the physical asset in the property market. When you have a low
geared economy – there is less or rate risks/ spikes.
- You have a lower percentage of loan in the economy in comparison to the asset
value.
- In general the market performance is more stable in the economy in low geared/
and even in the case of unexpected events so investors can expect less fluctuation in
a low geared economy.

In a highly geared economy (high percentage of loan in the economy in comparison to the
asset value so there is more risk and more fluctuations for investors e.g. GFC and Covid.
- There is higher volatility in the market/ more fluctuation in the market performance
in high gear – there are way more spikes.
- In 2007 (GFC) the economies were highly geared due to lose credit.
- When the OCR decreased to 0.25% at the start of covid there was an increase in govt
(fiscal) spending to energize the economy. This shows that the monetary policies
combined with govt spending can support the economy to go through the
downturns.

The focus is shifting to fiscal policy rather than monetary.

Discuss the three main factors contributing to property value in the new economy
(read pages 112-116 of Tiwari and white)

Economic globalization
Commercial activity is organizing around the network of gateway cities like London, NY,
Tokyo etc

Sustainability
Energy performance certificates, for e.g, Europe, Australia; developers, owners and
investors are realizing low risk and more value for energy and water saving technology-
based properties.

Innovation and preferences

Innovation becomes important for growth In developed nations – technological and
business innovation.
Internet sustains demand for second homes in resort locations.
Technology allows more efficient use of commercial space.

To understand the formation of the property market cycle

 The sides of the chart shows what
has happened in the general
economy – e.g. economy upturn,
credit expansion etc.

Middle row is about the effects on

the property market

Economic upturn and credit

expansion happen at the same
time

During the economic downturn –

there are rising interest rates.

Recession – credit squeeze

Economic side and credit side come together to the property side.
THIS SHOWS HOW THE FINANCIAL MARKET AND ECONOMY ARE RELATED TO THE PROPERTY
MARKET.

Property market drivers

 Net migration
 Population growth vs building supply
 Labour market
 Interest rates
 Credit control
 Legislation impact
 Sales volumes
 Fear of missing out and catch up.
The increasing rate of housing credit generally slows down during and after global financial
crises.

Week 4 – Property Market crises Bubbles

Economic Bubble can be defined as a trade in high volumes at prices that are considerably
at variance with intrinsic value. OR a trade in assets with inflated values

Economic bubble, also referred to as Speculative/ market/price and financial bubble.

This just means that properties are traded at higher prices in comparison to what their
intrinsic value is. E.g. the floor area of your property, your property characteristics and
features etc will affect the intrinsic value.

A trade In assets with inflated values – where the price is actually traded at a much higher
value than its intrinsic value.

Bubble reflects – that the price as observed in the market, deviates (so its higher than the
intrinsic value). So we can say that this property is traded with an inflated price.

Property values keep going up and a bubble can appear in the market where things are
traded. A bubble is classified as when the house prices are three times income, that’s a huge
problem.
In NZ, the 2016 average income was $52,468 where the NZ house value is 622,309.
Auckland house prices are 10 times more than the annual income. This increased the
household mortgage debt.

HOWEVER, signs of bubble don’t mean there is always one – things like migration, low
unemployment will also affect house prices.
Problem for ‘intrinsic value’ of properties is that the market is not actually efficient for all
types of assets. If the market was efficient then all the past prices of assets could be used to
reflect the future prices of assets.
- If everyone observed and predicted the same price of assets (both buyers and sellers
agreed at a price) there is no incentive for a buyer to buy or a seller to sell because
both parties believe that there is only one price. So subjectivity has to be considered.

Properties are physical assets so every property has a unique feature about it – so these are
the factors you assess when you want to purchase a property e.g. REITS, CMBS is all one
type of financial product.
Everyone has different financial capabilities to afford houses, other personal preferences etc
which can also affect the price of the property. This causes a further challenge in obtaining
an intrinsic value of property.

Sometimes It may be hard to get intrinsic values due to a lack of comparable. Real estate
agents can pay for databases to view all of these. However, nowadays we see more
transactions, but it is still difficult to see the historical trading price.
- High cost of information. – in order to get an accurate assessment and cost.

Key problem for developers and investors

Investors and developers in the property market view the current situation as a trend but
not actually the fact that that Is a part of a cycle, which will go over its time into another
stage of the cycle. (only see one part of the picture). It wont always be an upswing
AND BECAUSE SOME DEVELOPERS AND INVESTORS FAIL to see that – it causes an
overreaction and overvaluation during upturns.
And when there is a downturn – then you can see undervaluation.
So overactions in an upturn and underreactions in a downturn will cause a shift in property
prices form its intrinsic value – implying that market players CAN FORM BUBBLING EFFECTS.

Three categories of bubbles

Growing bubbles - Reasonable return to agents (market players)
 Deviations from the fundamental value
 Grow rate of bubble component
 Agents expect to reap “reasonable” return based on the bubble component
 E.g. in the market the property price is likely to be deviated from the fundamental
value if market players believe they can make returns or profits during the process-
this rational can push the bubble.

Fads – Social or psychological forces

 Mean reverting deviation from intrinsic value
 Caused by social (peer effect) or psychological forces (fear of loss)
 Social media and networks have so much influence on daily actions – which
influences peoples beliefs on the price of certain assets - meaning social and
psychological sources pay a substantial role.

Information bubbles – differences in agents (market players) beliefs

 Differences in agents’ beliefs
 In how the economy works (asymmetric information)
 Our behaviour and attitudes or market players (households, developers, investors
etc)
 Our personality shapes our choices – because these affect our choices
 Asymmetric information – the information about how the economy is performing
will reach different players at different times. This combined with fads (different
preferences, beliefs) can affect our views. Everyone can have different views on the
same property.

In a booming market when the market players are buying properties – we see an observed
correlated price movement over time. This increases in return expectation will become a
part of forming a bubble in the market.
Higher volatility because of a highly geared economy – causing bubbles
When there is more money available in the banking sector, they want to lend more money
through low interest rates, encouraging loans. From the borrowers and home buyers
perspective – this will encourage them to take up more loans, given they can afford the
deposit
 Increasing % of credit facilities to collateral - then the bank can use this collateral as
security to their lending contract, so collateral is basically when you default in paying
your monthly payments - they can take the property. When the value of the loan is
high in comparison to the collaterised asset value.
 Cumulative non-performing loans means the borrowers who cannot repay their
loans – this happens due to the economy, sector specific reasons, business, job or
personal reasons. Then this leads to a lose credit cycle – and more problems will
reflect in the crises.
 WHEN WE HAVE CRISES THEN IT SIGNALS THE BUBBLES TO EMERGE.
 Credit squeeze – higher interest rate

Notes on video – 2007 financial crisis.

 When the interest rates decreases – people without income, jobs and assets begain
pursuing their dream of buying homes. So easy credit and increasing home prices
made investments in high yielding subprime mortgages.
 The fed continued slashing interest rates all the way to 1% in 2003 (lowest in 45
years).
 Bankers repackages these loans into collateralized debt obligations and sold them to
investors.
 The FEC reduced net capital requirements at 5 large investment banks freeing them
to leverage their initial investments to 30 or 40 times.
 When interest rates started rising – sub prime borrowers could not afford the higher
rates and started defaulting.
 Subprime lenders filed for bankruptcy in 2007.
 Financial firms and hedge funds owned more than 1 trillion dollars in securities
which were backed by failing subprime mortgages.
 Problems spread beyond the US central banks
 All of this persisted – then the national economic stabilization act of 2008 was
introduced which created $700 billion of distressed assets including mortgage
backed securities. Other governments followed similarly.
Properties influenced financial crises through banking and financial sectors.
 Properties – collaterals (drop in prices)
 Financial sector – loans on properties exploded (weakened banking system)
 Business cycles – amplified effect from the financial sector (business cycle busts)
 Crises.

Basically non-performing loans – effect overall performance because the banking sector has
non-performing loans, affecting the economy. Banks increase interest rates (tighter credits)
and companies cannot borrow as easily, resulting in a decrease in the financial capacity to
expand – increasing unemployment rates and resulting in an overall crisis.

Week 5 – 6 Reading – Dealing with real estate booms

Policy efforts should focus on booms that are financed through credit and when leveraged
institutions are directly involved, the following busts tend to be more costly.

The state of knowledge on real estate markets and linkages to the economy
 Cycles are a common feature of real estate markets e.g. delays in demand and
supply responses given time to build and the physical constrains on the supply side
(limited land supply and zoning restrictions put additional limits on new
construction).
 The average real house price index where prices increase in 1970s then mid 1980’s
and then early 2000s, with the last upturn being much larger and longer than the
first two. Economists suggest that the longer and higher prices go up, the more they
will come down. the average upturn during the past cycles is a sample of OECD
countries last 20 quarters where prices have risen by 48% while downturn lasted 18
 quarters and prices fell by 23%. In the present cycle, the upturn was 38 quarters as
prices increased by 126% - with the downturn being 20% in the last 20 quarters.

Housing cycles are closely interrelated with credit and business cycles (credit and housing
are slightly more linked than the business cycles).
 Housing cycles lead credit and business cycles over the long run, reflecting housing’s
feature as an asset whose value is ultimately driven by “fundamentals” in the long
run.

Important to note that there are differences across countries in general patterns. Legal and
institutional structures of housing finance systems, degree of government intervention, and
supply responsiveness are crucial elements which determine the characteristics of housing
cycles and the degree of spill over to the rest of the economy e.g. LTV ratios etc which have
bearings on the strength of wealth effects on consumption that may emerge as a result of a
surge in house prices. Similarly, housing credit provision by government -owned and govt
sponsored entities, rent controls, social housing initiatives, tax treatment of housing, etc
may introduce a wedge between rents and house prices with implications for housing
tenure choice and economic activity.
 Geographical conditions as well as urban planning policies can amplify cycles and
affect how cyclical movements in house prices and construction activity spill over to
other parts of the economy.
 Lack of information and reliable data is a major issue which restricts the in-depth
analysis of real estate market.

The case for policy action on real estate booms

Leverage and the link to crises.

Macroeconomic perspective – what matters is not the boom but how it is funded.
Booms are more costly when they are financed through credit and leveraged institutions are
directly involved.
 Balance sheet of borrowers (and lenders) deteriorate sharply when asset prices fall.
When banks are involved, this leads to a credit crunch with negative consequences
for real economic activity. In contrast booms funded with limited credit and bank
involvement tend to deflate without major economic disruptions. For example, the
burst of the dot-com bubble was followed by a mild recession, reflecting the minor
role played by leverage and bank credit in funding the boom
 Home and commercial property transactions in advanced economies involve
borrowing. Banks and other levered players are actively involved in the financing.
Homeowners allowed leverage ratios to be magnitude higher than any other
investment activity as a typical mortgaged loan carries a LTV of 71% on average
across a global sample of countries. Whereas the stock market participation hardly
any individuals rely on borrowed funds. If they are they it’s a small marginal amount
is allowed.
  In 2007 the severity of the crisis across countries was initially triggered by the US
market, but the extent of impact experienced by each country was dependent on the
real estate booms of their own.
 A “bad” real estate boom -bust is caused by the rapid increase in leverage and
exposure of households and financial intermediaries – which results in a decline for
the financial sector and a drop in the economic activity.

Wealth and supply side effects

 Real estate is the most important in storage of wealth in the economy as individuals
hold majority of their wealth in homes rather than equities.
 In advanced economies – house price cycles tend to lead credit and business cycles.
This means that fluctuations in the house prices create ripples in the economy
through their impact on residential investment, consumption, and credit while the
reverse is not as prominent – IMPLYING THAT THE HOUSE SECTOR IS THE SOURCE OF
STOCKS. Recessions which coincide with a house price bust tend to be longer and
deeper.

Illiquidity, opacity, and network effects

 Delays in supply response to demand shocks and the slow pace of price discovery
due to the opaque and infrequent trades as well as illiquidity owning to high
transaction costs.
 Homeowners in financial distress have diminished incentives to main their properties
 The double role of real estate as investment and consumption good may reduce
mobility and increase structural unemployment, as households in negative equity
may be reluctant or unable to sell and take advantage of job opportunities
elsewhere, weakening the positive association between employment growth and
mobility.

Policy options
 The main risks from real estate boom-bust cycles come from increased leverage in
both the real estate and financial sectors – so policies, wherever possible aim at
containing these risks rather than price increases.
So policies should
1) Preventing real estate booms and the associated leverage build-up together
2) Increasing the resilience of the financial system to a real estate bust
Monetary Policy
 Increase in policy rate makes borrowing more expensive and reduces the demand
for loans – higher interest payments lower affordability and shrink the number of
borrowers that qualify for a loan of a certain amount.
 So monetary tightening reduces leverage in the financial sector (alleviating financial
consequences of a busy even if does not stop the boom).
 A reduction in the risk of a real estate boom busy cycle may come at the cost of a
larger output gap and associated higher unemployment rate (possibly inflation
 below the target range). But these are not relevant when a boom occurs in context
of a general macroeconomic heating
 Another concern is that the expected return on real estate can be much higher than
what can be affected by a marginal change In the policy rate. At a 5 year horizon – a
100 basis point hike in the policy rate would reduce house price appreciation by only
1 % compared to a historical average of 5% increase per year and would lead to a
decline in GDP growth of 0.3 percentage points.

Fiscal Tools
 Variety of fiscal measured (transaction taxes, property taxes, deductibility of interest
payments) bears on the decision to invest in real estate.
 These fiscal tools could be adjusted cyclically to influence house price volatility, while
preserving the favourable treatment of home ownership on average over the cycle.
 Taxation is not the main driver of house price developments during the housing
boom as it was observed that real house prices increased significantly in some
countries with tax systems highly favourable to housing as well as countries with
relatively unfavourable tax rules.
 In most countries, tax policy is separated from monetary and financial regulation
policies, making it extremely hard to implement changes in tax policies as a part of a
cyclical response with financial stability as the main objective. RATHER government
would reduce property or transaction taxes to attract residents during good times.
 If homebuyers, consider than to be an acceptable cost for an investment with high
returns and consumption value (so the ability of cyclical transactions taxes to contain
exuberant behaviour won’t work as well)
 Cyclical transaction tax might make it hard to evaluate a property, and may also
affect the mobility of households, with potential implications for the labour market.

Macroprudential Regulation
 Macroprudential measures such as higher capital requirements or limits on various
aspects of mortgage credit could be designed to target narrow objectives and tackle
the risks associated with real estate booms more directly and at a lower cost than
with monetary or fiscal policy.
1) Capital requirements or risk weights that change with the real estate cycle
2) Dynamic provisioning (the practise of increasing banks loan loss provisions during
the upswing phase of the cycle
3) Cyclical tightening/ easing of eligibility criteria for real estate loans through LTV or
debt to income rations
These tools may be able to achieve both the objectives of reducing the likelihood and/or
magnitude of a real estate boom (by imposing measured to limit household leverage),
and strengthen the financial system against the effects of a real estate bust.

 This effectiveness of this tool cannot be judged solely as it has only been used with a
combination of macroeconomic policy and direct interventions to the supply side.

Higher capital requirements / risk weights

  Capital regulations has a procyclical effect on the supply of credit. During upswings,
better fundamentals reduce the riskiness of a given loan portfolio

Flow of funds – direct and indirect

There are two ways individuals can invest in property – direct (100% equity) or indirectly
through primary securities market (bonds, CMBS etc).

In relation to the banking sector -

Aggregate consumption increases mean the demand for property increases. However, the
barriers of entry to the property market and the high value – hence the high deposit make it
more feasible for individuals to access the property. – resulting in demand for credit/loans.
The increase the demand for leverage – which leads to credit expansion.
As a result, there is an increased pressure on property prices. As the prices for properties
are now higher, the amount of deposit required to purchase property is also higher.

There is a supply of housing shortages as cheaper cost of borrowing has further increased
demand, putting pressure on the housing market. In general, there is higher leverage in the
economy, increasing risk.

In NZ, other factors affect the high/ housing unaffordability such as net migration etc…

 Economic upturn – increase in aggregate consumption

 People want to enter the property market. Can do this directly or indirectly
 Talk about both ^
 The high values and barriers make it more feasible to use the banking sector as an
intermediary to fund
 Increase in demand for credit– as people want to consume/enter the property
market as cost of borrowing is cheaper. Adds pressure onto property prices
 Causing economic bubbles – inflated prices as….
 More leverage in the economy – higher risk etc

WEEK 5-6
You will be able to critic ally evaluate optional policies as stated in the reading in section
“policy options”

The housing market is strongly interrelated with the financial and business cycles. (More so
financial). Financial market share cycles and the global house price index cycles follow a very
similar cycle. The housing market will affect the entire economy – as property serves as
collateral e.g. the decrease in house prices will decrease the value of the house – negatively
affecting the lenders collateral. There is a strong connection between housing markets,
financial markets, and economies. This is demonstrated by the global financial crises –
where lose credit and increase in aggregate leverage in the economy resulted in more
defaults. As a result, there was a decline in the housing markets which further exaggerated
the worsening effect on the financial sector, overall impacting the economy. (gearing can
exaggerate the fluctuation in cyclical patterns).

The aim of policy makers is to ensure sustainability in the housing market by meeting the
needs of households, owners, buyers and occupants, making it critical for policy makers to
evaluate the outcome of different policies.

The two optional policies are Macroeconomic and Regulatory Policy.

Macroeconomic policy includes
Monetary Measures
 Interest rates (OCR) – limit on LVR or LTV.
 Reserve requirements
Fiscal measures
( is about the governments potential involvement into investments and allocations of
capital resources across different pockets and sectors in the market). – its about the
money supplied into the capital or other markets – reallocation through the taxation
system – with governments direct involvement with different sectors. E.g. governments
direct investment in a project e.g. infrastructure or allocation of capital resources across
different market sectors.
 Taxation system on property transactions, capital gains or market value
 Abolition of tax-deductible mortgage interest

Monetary Measures – OCR

- RBNZ’s purpose is to operate monetary policy to maintain price stability.
- Promote the maintenance of sound and efficient financial system
- Meet the currency needs of the public

The OCR is set 7 times a year and is a powerful signal of the bank users to increase or
decrease the cost of money (interest rates) to ultimately influence how much people are
borrowing for their houses, credit cards (spending), cars etc. Interest rates will determine
the proportion people save, spend and borrow. This influenced CPI (consumer price index)
and the level of activity in the economy. Their main goal is to keep prices stable – as if the
economy overheats then higher interest rates can discourage spending and encourage
saving to keep a lif on inflation. If the economy Is too slow then the lower interest rates can
encourage borrowing > investment which injects more money flows into the economy –
increasing overall economic activity. For example, if interest rates are low then households
will be less inclined to save resulting in an increase in spending. As spending increases,
businesses/ suppliers face an increase in confidence resulting in an increase in investment,
increasing pressure to produce more goods and services – this increase in pressure for
production results in the cost/prices leading to inflation. This cycle repeats itself every time
the OCR is set. The OCR determined by the bank will influence interest rates charged by the
bank – as they use that OCR as a base and add a premium. A buyers decision to borrow or
save will depend on the current rates and future expectations.
Decreasing/ Low interest rates in NZ decreases the demand for NZ dollars – (a lower NZ
dollar means we pay more for the goods and services we import) this raises the price of
imports but exports become cheaper which increases business for Nz exporting businesses.

Regulatory Policy - is about putting constrains on property related loans

1) Capital requirements for property loans
2) Limits on mortgage credit growth
3) Limits on LTV
4) Limits on debt-to-income ratio

House prices appreciate in line with loan to value ratio (positive correlation) Example the
Maximum loan to value ratio allowed will determine the house prices. The more you
allow to be borrowed – the more the house prices will increase.

ZHI’s tables
There is a causal effect of monetary (OCR) policies on housing affordability
There is relatively less correlation between impact of credit policies on housing affordability.
There is correlation between the impact of Monetary policy on housing affordability when
there are unexpected fluctuations of exchange rates.

This means
Market players (house buyers and sellers) in the New Zealand housing markets, respond
faster to the change in the OCR than towards the intervene on “housing credit” as
influenced by loan restriction
 Monetary policy has been effective, in comparison to credit policy, about its
impact on housing affordability
 Monetary policy has continuous impact on housing affordability till at least 2 years
after the change of the OCR
 These results are consistently found when the unexpected exchange rate of NZ
against USD is taken or not considered.

HOWEVER – ECONOMISTS recommend a combined adoption of fiscal and monetary policy

– so monetary policy is not the only way to deal with crises. E.g. after the GFC there was a
gradual increase in loan constraints as more constrains were introduced to home loans –
and maximum loan to value ratios in the market.

Singapore Case
As a response to the housing crises – the government built 51,000 apartments rehousing
400,000 people in 5 years – solving the housing shortage. Today they have built more than
1,000,000 as government housing is not targeted for the poor but for the mases. The pries
are 20-30% cheaper than the private market. However, there are some limitations of a time
lag as you have to apply and order the apartment and wait several years for it to be built.
Along with issues of social control.
However, the main goal was to solve housing affordability and it has. This issue goes beyond
just the property market, but is also correlated to quality of life, well-being, health and
other social aspects.
Guidance on policy for housing


Depending on the situation – different housing policies are effective. If the boom is
concentrated in a few locations or segments then you use tailored macroprudential tools
to target specific vulnerabilities.Macroprudential policies aim to mitigate risk from the
financial sector. They are financial policies aimed to ensure sustainability of the financial
system as a whole to prevent substantial disruptions in credit and other vital financial
services necessary for stable economic growth. Risks include the economic bubbles where
the price of assets (houses) increase far beyond their intrinsic value, ecessive risk taken by
banks and excessive corporate or household debt. Macroprudential policies are setting
mortgage lending conditions, LTV ratios. E.g. placing a limit on the amount house buyers
can borrow comdpared with the cost of a house or their income. But if there is signs of
overheating in other sectors then you tighten monetary policy which may complement
with macroprudential rules. Basically monetary policy will affect the entire economy.

Section 4 Policy Options

The main risks from real estate boom – bust cycles come from increased leverage in both
the real world (housing sector) and financial sector. The two main policy objectives are to
prevent real estate booms associated with leverage build up altogether and 2) to increase
the resilience of the financial system to a real bust. A policy maker has to take into
consideration the potential impact, side effects and practical issues. For example, some
policies have little room for cyclical implementation and would be in place for a long term.

Pros and cons of policy options to deal with real eatate booms
Macroeconomic Policy
Monetary Policy
Interest Rates & Reserve Requirements responding to property prices and / or real estate
loan growth
 Potential Impact: Potential to prevent booms, less so to stop on that Is already in
progress
 Side Effects: inflict damage to economic activity and welfare
 Identifying ‘doomed’ booms and reacting in time; constraints imposed by monetary
regime.

Fiscal Measures
Transaction/ Capital gains taxes to real estate cycles
 Potential Impact: automatically demapen the boom phase
 Side effects: impair already slow price discovery process
 Practical issues: Incentive to avoid misreporting, barter, folding the tax into
mortgage amount.
Property Taxes charged on the market value
 Potential Impact: limit price increase and volatility
 Practical issues: little room for cyclical implementation
Abolition of mortgage interest deductibility
 Potential Impact: reduce incentives for household leverage and house price
appreciation
 Side effect: inflict damage on the real estate sector by taking away a sectoral
advantage
 Practical issue: little room for cyclical implementation
 Regulatory Policy

Macro- prudential measures

Differentiated capital requirements for real estate loans
Higher risk weights on real estate loans
 Potential impact : increase cost of real estate borrowing while building buffer to
cope with the downturn
 Side effect: costs associated with potential credit rationing
  Practical issues: may get too complicated to enforce, especially in a cyclical context;
effectivensss is also limited when capital rations are already high
Dyamic provisioning for loans collateralized by real estate
 Potential Impact : increase cost of real estate borrowing while building buffer to
cope with the downturn
 Side effect: earnings management
 Issues: data requirements and calibration

Limits on mortgage credit growth

 Potential Impact: Could limit household leverage and price appreciation
 Side effect: Loss of benefit from financial deepdning
 Issues: Move lending outside regulatory periphery

Limits on exposure to real estate sector

 Potential Impact: could limit leverage and price appreciation as well as sensitivity of
abnks to certain shocls
 Side effect: costs associated with limiting benefits from specialisation
 Issues: shift lending to newcomers from whom exposure limits do not yet bind or
outside the regulatory periphery.

Limits on loan to value ratio & Limits on debt to income ratio

 Potential impact: limit household leverage and house price appreciation while
decreasing probability of default
 Costs associated with potential credit rationing
 Calibration is difficult, circumvention is easy.

Monetary Policy
An increase In the policy rates increasing the cost of borring, reducing demand for loans.
There is decrease in the qualified number of borrowers for a certain amount as
unaffordability increases, reducing demand for loans. Monetary policies will reduce leverage
in the financial sector and alleviate the financial conseuqnences of a bust even If It does not
stop the boom. However, changes in the OCR effects the entire economy, increasing the
output hap and the associated higher unemployment rate. So this policy may negatively
impact the entire economy – if the boom is only related to the real estate sector.
Secondly, during a boom the the expected return on real estate is much higher than what
can be affected by a marginal change in the OCR. Example a 5 year horizon, 100 basis point
hike in policy rate would reduce house appreciation by only 1% , compared to a hisotiral
average of 5% increase per year WHILE leading to a decline in GDP growth of 0.3 percantage
points. Additionally, the structure of the mortgage markets matters – if the mortgage rates
depend primarily on long term rates, the effectiness of monetary policy will depend on the
relationship between long and short term rates.

IN CONCLUSION – moneaty policy is a tool which will stop the boom BUT AT A VERY HIGH
COST as to have a substantial effect on real estate prices and credit it will significantly
decrease output and increase inflation.
 Fiscal Tools
Fiscal measures such as transaction taxes, property taxes, and deductiility of interest
payments will bear on the decision to invest in real estate. Some of these measures can be
cyclically adjusted to influence house price voltatility, while preserving the fabourable
treatement of home ownership on average over the cycle.

If the NPV of all future taxes are capitslized in property, adjusting taxes countercyclically
around the same expexted mean would not affect the prices. (evidence of the relationship
between these fiscal measures and residential property and real estate cycles is
inconslusive. Example, in the recent global house price boom, prices increased significantly
in some countries with favrourable tax systems (sweden) as well as countries with
unfavourable tax systems such as (france). So taxation was not the main driver of house
price developments. Additionally, technical and policitcal economy issues will also affect the
implementation of cycically adjusted fiscal measures. In most countries, it is hard to
implement changes in tax policies as a part of a cyclical response with financial stability as
the main objective. IF home buyers consider the taxes to be an acceptable cost for an
investment with high returns and consumption value – this fiscal measure will not be
efffective. Other incentives during a boom phase to “ride the bubble” may increase efforts
to misreport propety values or fold the tax into the overall mortgage amount. Lastly, with
tax measures it becomes harder to evaluate a property.

Macroprudential Policies
In theory, macroprudential measures such as higher capital requirements or limits on
various aspects of mortgage credit could be designed to target narrow objectives such as
household or bank leverage and tackle the risks associated with real estate booms more
directly or at a lower cost than within the monetary or fiscal policy. They may be easier to
find a way around as they can target a specific type of contrscts or group of agents. But
these measures may lead to liability structures that are more difficult to resolve/negotiate in
busts and may be more difficult to implement as they would be considered as an
unnecessary intrusion into the functioning of markets. All the aforementioned policies, can
reduce the likelihood and/or magnitude of a real estate booms e.g. by imposing measures to
limit household leverage. And also strengthen the financial system against the effects of a
real estate busts e.g. urging banks to save in good times for raint days.

However, only some countries have used these macroprudential tools and have only used
them in conjunction with macroeconomic policy and direct interventions to the supply side
of housing markets (e.g. singapore), making it harder to look at the effectiveness of these
tools.

Macroprudential Policy – Higher capital requirement/ risk weights

- Capital regulations (how much liquid the bank has)
Capital regulation has a procyclical effect on the supply of credit. During an upturn, it
reduces the riskiness of a given loan portfolio, improving a bank’s capital adequacy ratio and
its ability to expand its assets. However, in a downturn, procyclical capital requirements can
help reduce the bias. Furthermore, by forcing banks to hold more capital in good times, it
would help buffer for future losses.
Most countries, do not take collateral values into consideration or reflect the heterogeneity
among loans backed by real estate, other than commercial residential distinction. Risk
weights for property loans are fixed (50% for residential mortgages and 100% for for
commercial property loans). SO mortgage loans with predictability different default
probabilities (for instance because of different LTV ratios or exposure to different aggregate
shocks) are often bundled in the same risk category and no adjustment is made overtime to
account for the real estate cycle. Capital requirements or risk weights linked to real estate
price dynamics could help limit the conseuqneces of boom- bust cycles. By enforcing banks
to hold more cpaitla against real estate loans during booms, these measures can build a
buffer against the loans during booms. By increasing the cost of credit, they may reduce
demand and contain real estate prices themselves. (risk weights can be fine tuned to target
regional booms).

However, more risk weights (or capital requirements) carries the danger of pushing lenders
in the direction of riskier loans. SO implementing procyclical risk weights for real eate loans
should be accompanies by the implementation of a finer cross – sectional risk classification
as well. An increase in the cost of bank credit, procyclical risk weights may be circumbented
through the recourcse to non bank intermediaries, foreign banks, and off balance sheet
activities. These measures lose effectiveness when actual bank capital ratios are well in
access of regulatory minima (happens during booms). While improving resilience of the
banking system to busts, tighter requirements are unlikely to have a major effect on credit
availibility and prices. Finally, in countries with tighter capital requirements produced some
results of controlling the growth of particular groups of loans, real estate price appreciation
and overall credit growth still remained strong.

Dynamic Provisioning
Similar to capital erquirements, dynamic provisioning forces banks to build an extra buffer
of provisions by helping cope with the potential losses that come when the cycle turns.
Provisions to increase in a boom to prepare for a downturn or decrease in a downturn to
prepare for a boom. Provisioning recognises the loss on a loan, ahead of time. An amount
that the banks set aside from their profits or income in a particular quarter for non
performing assets.

However, it is unliekly to cause a major increase in the cost of credit, and thus stop a boom.
One benefit in comparison to capital requirements is that it would not be subject to a
minima, so it can be used when capital rations maintained by banks are already high.
Provisioning for property loans could be made a specific function of house price dynamics.
In periods of booming prices, banks would be forced to increase provisioning, which they
would be allowed to wind down during bursts. In the case of risk weights, provisioning
requirements could depend on the geographical allocation of the banks real estate portfolio.
This measure is targeted at protecting the bank system from the consequences of a bust
rather than having a signficant impact on credit and containing other vulnerabilities, such as
increases in debt and leverage in the household sector. Practicla issues such as calibration of
rules with rather demanding data requirements and earnings management should be
adjusted to fit the country. Application to domestic banks might hurt their competitiveness
and shift lending to banks abroad
THESE MEASURES are effective in strengthening a banking system against the effects of a
bust, but do little to stop the boom itself. Example In Spain, the Bank of spain reuqired
banks to set aside 10% of the NOI, yet the household leverage still grew by 62%. When the
cycle bust in 2007, total accumulated provisions covered 1.3% of the consolidated assets, in
addition to the 5.8% covered by capital and reserves. But as the financial sector, housing
cycle and economy is related – MACROPRUDENTAL POLICIES CAN BE IMPLEMENTED TO
SLIGHTLY STRENGTHEN THE BANKS POSITIONING, and dampen the flow on effects on the
economy.

Limits on LTV and debt to income ratios

Limit on LTV can help prevent the buildup of vulnerabilities on the borrower side The lower
the leverage, the greater the drop in prices needed to put a borrower into negative equity,
reducing defaults if a bust happens as more borrowers unable to keep up with their
mortgages will be able to sell their houses and in the case of a default,lenders will be able to
obtain higher recovery ratios.

DTI limits will rein in the purchase power of individuals, reducing pressure on real estate
prices. They will be effective in containing speculative demand, reduce vulnerabiltiies as
borrowers will have an “affordability buffer’ and will be more residlient to a decline in their
income and temporary unemployment.

The narrow target nature of these measures may increase political economy obstacles, since
the groups impacted by the limits tend to be those more in need of credit (poor and young).
Unlike with the more “macro” measures, the consequences of these limites are immediate
and transparent. They will ential cost in terms of diminished interteporal consumption
smoothie and lower investment efficiency.

These ARE effective MEASURES – maximum LTV limits are positive related to house price
appreciation between 2000 and 2007. Approx 10% increase in maximum LTV is associated
with a 13% increase in nominal house prices. However, the impact on year to year changes
is smaller, since prices tend to start increase again.

Conclusion
Macroprudential measures seem to be the best option to achieve the objective of curbing
real estate prices and leverage because they attack the problem at the source, adapt to
specific circumstances in different locations at different times, and give the added benefit of
increasing the resilience of the banking system

Ultimately, policy recommendations depend on the charactertics of the real estate boom in
question. If property prices are out of sync with income and rent, and leverage Is
increasingly rapidly, taking action is advisable. When deicising which policy option to
choose, policymakers should adopt a wider view of the economy and complement targeted
measured with broader macroeconomy tightening If the boom is a part of general
overheating in the economy.
A more proactive use of macroprudential tools – raises of the question of who should be in
control of these levers. With monetary policy – the question is whether the central bank
should be charged with boththe price and financial stability.

Trade off emerges between policy creditability/accountability and the efficienes stemming
from coordination. When the former is important, then separate agencies are preferable.
When the later prevails, then a centralized solution would dominate.

Week 1 - Reading
Real estate Finance in the new economy
Capital markets
Capital markets are markets where people, companies and governments with more funds
than they need transfer funds to the people, companies or governments who have a
shortage of funds. The two major capital markets are for stocks and bonds. Companies issue
securities on the capital markets to raise capital for productive uses. Investors (savers,
people, companies and governments) with surplus funds (savings) invest in these securities
in anticipation of cash flows in the future. The ROLE OF CAPITAL MARKETS IS TO promote
economic efficiency by channelling money from those who do not have an immediate use
for it and those who do. The physical places where stocks, bonds and other deivatives are
bought, sold and traded are called stock exchanges. Stock exchanges play a very important
role in capital transer, as they provide the regulation of company listings, a price – forming
mechaism, the supervision of tradiging, the authorisation of members, the settlement of
transactions and the publication of trade data and price e.g. the New york stock exchange.

Multinational companies seek a listing on several foreign stock exchanges to attract wider
investor intereests or because local exchanges were small for the ambitions of the company.
They conduct their operations and businesses in local currency, and to hedge against
currency risk, they often prefer to raise capital from local markets In local currency by listing
on local stock exchanges. One of the consequences of this has been the expansion in
primary issues and secondary market trading in non- domestic equities. Even though foreign
listings compliance with foreign accounting and listing regulations, they are willing to bear
the risk because of the advantages associated with accessing larger capital markets.
International capital market is a number of closely integrated markets which conduct any
transaction with an international dimension.

Flow of funds to to Property and innovations

Domestic or foreign economic agents such as households, firms and government with
surplus financial resources in present time can invest in those domestic or foregin
opportunities that require these resources to carry out economic activities and earn risk –
adjusted return on their investment In the future. These economic agents could invest
directly in those opportunities such as housing, office buildings etc for their own use
purposes) or channelise their savings into various opportunitiies through primary capital
markets or through secondary financial sectors such as banks, pension funds and insurance
companies for investment in income generating properties.
The purpose of the financial system and financing mechamisms is ot reduce impediments
and create opportunities for the flow of funds from investors to investment opportunities.

Property Investors and intermediaries

Four major types of investors: institutional investors, unregulated investors, households and
proprietors and corporations. Motives for investment in property differ for different
investors.
i) The growth (savings objective, which implies a relatively long time horizon with
no immediate or likely intermediate need to use the cash being invested, and
ii) The income (current cash flow) objective, which implies that the investor has
short term and ongoing cash requirements from his investments.

Risk is an important factor for the decision to invest in real estate as future investment
performance may vary over time which is not predictable.

Time horizon for which the investor wants to stay invested in is a factor.

Liquidity, that is the ease with which the asset could be bought or sold at full value without
much affecting the price of the asset is another factor.

Minimum size of investment required also determines the willingness and ability of an
investor to invest in property.

So as investor space is hetergenous, an elaborate investment system with a number of

intermediaties and mechanisms through which funds flow to property has emerged.

Investment Mechanisms

Private Investment mechanisms

Debt – debt and equity form a major share of investment flow in the property. The finance
for development is short term and takes the form of a loan or an overdraft faciltity. During
construction, there is no cash flow to repay the debt, the repayment plan is a bullet
payment of accumulated interest and principal at the time of when the project
development ends.

REIT – the fund sponsor for a Real estate equity fund is usually an affiliate of a developer or
professional investment organisation. Investors provide most or all of the investment and
have responsibility for management of partnership assets.

Innovations in public investment vechicles for investment in property asset class.

ABS (asset backed securities) or CMBS (commercial mortgage – backed securities (CMBS) ,
REITS and property derivaties. ABS and CMBS are debt vehicles, REITS are equity investment
vehicles.
ABS or CMBS – offers bonds or commercial paper to the capital markets. Cash flows fom a
single or a pool of propery assets (such as rental income or loan repayments) is used to pay
the coupon and capital redemption payment on the bonds or commerc ial paper.

By securitising loans (CMBS) or rental income and value streams (ABS), the exposure to
specific risk associated with property reduces. For lenders, the securitised loan portfolio
moves off their balance sheet, thereby improvving their capital adequacy and solvency
ratios. For firms, ABS ALLOWS THEM TO RIASE CAPITAL secured on value and income stream
of their property assets while retaining ownership. ISSUING ABS OR CMBS on public markets
allows firms and lenders to tap into a new source of capital.

For firms – ABS is a cheaper source of borrowing as the cost of these borrowing could
further reduce as in case of tenanted properties, the rating of the bond depends on the
tenant convenants rather than the rating of the firm issuing securities.

Advantages for investors – they are able to gain exposure to market that faces huge enrty
barriers and high transaction costs. Investments in securities allows them to benefit from
liquid and marketable nature of this asset. Moreover, since the underlying asset is a pool of
loans or a pool of properties, the specific risk to an investor reduces. The transaction,
monitoring and management costs for an investor are lower than those associated with
investing in direct property.

ABS or CMBS recues the flexibility for the issuer in managing their securities portfoloo – as
there are costs associated with arrangement, underqriting, rating and credit enhancement
of a bond or commercial paper.

Asset backed securisitation offers further potential for innovation – underlying of any lease
there are three sources of cash flows – base rent, possibility of a rental uplift at a time of
rent review, and cash flows which arise from the fact that property hs a residual value at the
end of the lease which is still more speculative investment but would appeal to certain
investors.

REITS: tax efficient vehicles for equity investment in property. These allow for subdivision of
ownership or developments.
If markets are efficient, then there are no opportunities for any abnormal gains. Innovative
mechanisms serve to rebalance the risk and return in any transaction or help in addressing
sources of inefficiences In the market, should they exist. These investment instrtuments
have been able to overcome the limitations of property asset clss (namely, lumpy
investment, inelastic supply in the space market, infrequent transactions, huge transaction
costs, infromation asymmentry, a somewhat rigid valuation system that does not allow
innovations in lease terms, huge specific risk associated with investment in direct property
that lead to inefficienes in the market and create opportuities for investors and property
companies and strike a balance between risk and return for investors with relatively lower
cost funding for property companies compared to the traditional secured debt and equity
needs to be examined.

ABS
Mechanism which is secured by income or value of the underlying portfolio of property
assets, can
i) Reduce the cost of borrowing for the company issuing these securities compared
to secured debt because the rating of securities is on the strength of the tenants
occupying the property and not the corporate owning the assets
ii) Increase the leverage on property assets than the LTV that lenders would offer
iii) Allow investors to diversify into property without the need for taking full
ownership of the property
iv) Offer better returns than an equivalent – rated corporate bond
v) Limit the exposure to single asset or borrower for an investor

Clear advantage of securitisation is that it permits the risk to be spread over a range of
investors and the revaltly low cost of each security permits the investors to take exposure to
a portfolio of property assets. The barriers are removed – and investors can gain exposure
to the property market. Required rate of return is lower as as they do not face property
specific risk – putting downward pressure on interest rates on ABS.