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Lu Ming: “The Spatio-temporal Pattern of Real Estate in China” — Economic Principles Determining Housing Prices

Summary of this issue

How to determine if there is a bubble in a market?

How much income will residents spend on housing-related products?

What's in this issue

Next, let's talk about the second part, how to understand prices in the real estate market.

When I was talking about the first part, I actually mentioned an important concept, which is the ratio of housing price to income. If people are more concerned about the real estate market, they have probably more or less thought about the question, that is, is there a serious bubble in the real estate market in China? If you read some articles in the media, including statements made by scholars or industry figures who specialize in price fluctuations in the real estate market, or even some international people concerned about price changes in the Chinese real estate market, you may often see this statement, that is, there may be a serious bubble problem in the Chinese real estate market.

How to determine if there is a bubble in a market? Maybe everyone will also go through the textbooks. The textbooks will tell us that to determine whether there is a bubble in a local real estate market, we use an indicator — the ratio of housing price to income.

So if housing prices are high, or the price-to-income ratio is relatively high, is that necessarily a bubble? To explain this issue clearly, we need to start with the basic mechanism for determining housing prices.

Let's first make a very simple assumption. Assuming that a product such as housing is actually not speculated on, that is, let's remove the investment function of real estate first, and let's assume that it only serves a residential function. In this case, when there is equilibrium in the market, an equation will definitely hold: housing prices multiplied by interest rates equals rent.

Why does this equation hold? Everyone thinks that if a house is just for living, then renting a house and buying a house should be the same thing. If this equation doesn't hold, for example, if the house price multiplied by the interest rate is less than the rent, what does that mean? The monthly payment for buying a house is equivalent to the housing price multiplied by the interest rate. If the price multiplied by the interest rate is less than the rent, this means that the cost of buying a house and living in it every month is less than the cost of renting this house, so you might as well buy a house. Conversely, if the price multiplied by the interest rate is greater than the rent, you might as well rent a house.

Therefore, the regulation mechanism in the real estate market will definitely make housing prices multiplied by interest rates eventually equal rent. Only then will there be an equilibrium in the market. In other words, buying a house and renting a house are the same for you. This is what we usually call a state where housing is not speculated.

Lu Ming: “The Spatio-temporal Pattern of Real Estate in China” — Economic Principles Determining Housing Prices -1

Next, I'm going to tell you another equation, which is the latter half of this equation: rent equals a times income. What does that mean? That is, how much money residents spend on housing-related expenses, including renting a house, including proper renovation and maintenance expenses. We generally count all of these expenses as a housing-related expense. This expense will account for a fixed proportion of residents' income, that is, a. This a actually reflects the importance you attach to this kind of product; in a more technical term, it is a preference.

You can think of it this way. If you don't have any demand for a product, for example, for a person who doesn't smoke, the cost spent on a product such as cigarettes accounts for 0 percent of his income. But if you like to smoke, the monthly expenses you spend on smoking will account for a higher share of your income. So in fact, the size of this coefficient represents the importance you attach to this kind of product.

On average, how much of their income will residents in countries around the world spend on housing-related products? Current affairs research tells us that this ratio is actually highly stable, about between 30% and 50%. Maybe everyone's income levels are different, or personal preferences are different, and this ratio will not be the same, but from a social perspective, this ratio is actually quite stable.

If everyone understands this, we can make some changes to this formula. How can we transform it? If you move the rent to the left, that is, divide the housing price by the rent equal to 1 divided by the interest rate, or move the interest rate to the right to get the housing price divided by income equal to a divided by the interest rate.

From a country's long-term perspective, interest rates are relatively stable. Although they fluctuate up and down according to the economic cycle, if you look at a longer period of time, it won't fluctuate much. For example, it won't rise to 20% or 50%, and it won't fall below 0%. It is probably 3%, 5%, for example, and may be as high as 8% during severe inflation, but its fluctuation is very small. In this case, everyone wants to know if 1 divided by the interest rate or a divided by the interest rate is a relatively stable constant value.

If you understand this, you know why we often say that housing prices are divided by rent, or that housing prices are divided by income. It should be at a reasonable level, so that it can be accepted by residents, simply because this formula was established.

This is why textbooks tell everyone that if the ratio of housing prices divided by rent or housing prices divided by income is particularly high, it means that high housing prices are not supported by long-term income growth, then this housing price is considered too high. This is what we usually use as a theoretical basis for judging whether housing prices are too high or whether there is a bubble.

But speaking of this, I'll just say that, because what I just mentioned is just a starting point, that is, to tell everyone that if we actually live in a house without being sold, when the house only has a residential function, we can use the ratio of housing price to income or the ratio of housing price to rent to determine whether the housing price is too high. But does the house really only have a residential function?

That is the content of this course, thank you all.

This issue's guests:

Lu Ming: “The Spatio-temporal Pattern of Real Estate in China” — Economic Principles Determining Housing Prices -2

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Lu Ming: “The Spatio-temporal Pattern of Real Estate in China” — Economic Principles Determining Housing Prices -3

        

Disclaimer: The above content does not constitute any act of financial product marketing, investment offer, or financial advice. Before making any investment decision, investors should consider the risk factors related to investment products based on their own circumstances and consult professional investment advisors where necessary.

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