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Spanish housing market bubble and bust explained

What to know a bit more about Spain’s housing bubble? Mihály Borsi, a Hungarian student at Corvinus University in Budapest, has written a thesis on real estate cycles using Spain as a case study. It’s slightly technical, but if you read this summary of his thesis you will have a better idea of the madness that took hold of the Spanish property market in the last decade.

Real Estate Cycles

A Study on the Spanish Housing Market
By Mihály Borsi

The Spanish housing market proved to be very cyclical over the past decades. The most recent boom raised enormous attention because of the magnitude of the increase in house prices; at the end of 2007, real estate prices were nearly 200% higher than 1997 levels. Since prices are driven by various forces, we can ask whether Spanish property price increases between 2000 and 2007 could be justified on rational economic grounds, or were they fuelled more by expectations of price appreciation in the future (i.e. a bubble)?

Figure 1 – Evolution of average housing prices in Spain (quarterly, left axis - Euros/m2,, right axis – 1996 Q1 = 100%)
Figure 1 – Evolution of average housing prices in Spain (quarterly, left axis - Euros/m2,, right axis – 1996 Q1 = 100%)

Those who challenge the existence of a property price bubble in Spain explain the situation with the interaction of such economic and structural factors like the country’s buoyant economic performance after entering the European Union, increasing real incomes, favourable lending conditions – including historically low interest rates and longer mortgage terms – and changing demographics. In contrast, arguments for a real estate bubble suggest that prices and thus, high construction activity, were stimulated by market participants’ expectations about future price appreciation that finally led to the inflation of an asset bubble. My Master’s Thesis demonstrates that the upward spiral of housing prices was both triggered by some unique economic and structural factors, and by speculative behaviour of the investors in Spain.

In order to understand the operation of the Spanish housing market, I first presented a coherent revision of the theme of real estate cycle theories that I expanded by a historical perspective. Empirical evidence affirms the theory that the development of bubbles in property cycles is a result of economic fundamentals combined with investors’ speculation based on future price expectations. Generally, rising property prices peak when the amount of houses offered on the supply side at a certain price level is not matched by demand for the same number of houses at that price level, and therefore the market does not clear. This is followed by a bust period, when prices fall until the market clears. When the bubble bursts, housing values plummet and construction activities are suspended or significantly reduced. The comprehensive analysis of the Spanish economy provides evidence for such movements in the country’s real estate market; housing stock in Spain increased by 31% between 1998 and 2007, while greater building activity corresponded to increasing demand and skyrocketing prices. According to the Ministry of Housing (Ministerio de Vivienda), 745,000 new homes were finished but less than 300,000 were sold in Spain in 2008, the year after the bubble burst. From this point of view, the Spanish real estate market was, in fact, overpriced.

I examined the underlying financial and structural peculiarities within the framework of a simple mathematical model based on the stock-flow approach developed by Denise DiPasquale and William Wheaton. The model allows us to observe the operation of a housing market and the various forces that determine prices and output. By emphasizing the importance of backward-looking expectations, it suggests that even a simple representation of lagged supply response to price changes, when combined with speculation, is sufficient to generate boom and bust cycles. Consequently, the model proved to be a suitable instrument in observing the unique processes that generated the housing boom in Spain. The most significant fundamental influences highlighted when investigating the Spanish case were the extraordinary rise in the number of households, the sharp decrease in interest rates on mortgage loans, and the prominent role of speculative investment in the housing market during the period in question.

Among the demographic factors that affected the Spanish housing market over the past several years, immigration trends and other cultural and sociological changes could be considered the most important. Mass immigration into Spain since the mid-nineties is the highest in Europe, accounting for 10% of the country’s current population. Even more, changes in the age structure and reduction in household size – converging to European Union trends – have altogether resulted in a significant increase in the number of households. Besides structural changes in the population, a notable increase in real disposable income – which can be linked to the favourable evolution of the labour market – has led to a long-term rise in living standards, easing the formation of new households in Spain. Higher employment rates and rising real disposable income boosted demand for housing, which drove prices up in recent years.

Figure 2 – New households and housing starts in Spain (units, quarterly)
Figure 2 – New households and housing starts in Spain (units, quarterly)

The interest rate on mortgage loans started to decrease already in the mid-1990s, accompanied by rising inflation that further reduced mortgage costs in real terms. Subsequently, extremely low mortgage rates boosted demand, and therefore, house price inflation as a result. Concerning some other financial factors that affected household borrowing behaviour, the debt service burden – the ratio of households’ debt payments to disposable income – fell to a large extent, and households were willing to accumulate more debt when expected house prices were on the rise. The liberalisation of the mortgage market also included more favourable terms on loans, such as extended mortgage lengths of up to 50 years, and increasing loan to house value ratios, sometimes reflecting a full 100% value of the house. Households’ ability to endure a heavier debt service burden fuelled the boom and deepened the bust of the housing cycle. Eventually, rising house prices increased speculation and pulled the investment component of demand for housing – thus mortgage debt – until the speed of increasing debt exceeded that of house prices.

Figure 3 – Mortgage debt (left axis, EUR 1000s) and mortgage interest rate (right axis, %) in Spain (quarterly)
Figure 3 – Mortgage debt (left axis, EUR 1000s) and mortgage interest rate (right axis, %) in Spain (quarterly)

In order to analyse the Spanish scenario I have modified some variables and parameters of the standard stock-flow model – in accordance with the actual Spanish developments – to demonstrate how the aforementioned shocks on the demand side contributed to rapidly increasing housing prices and exceptionally strong construction activity until reaching the turning point where the bubble burst, housing prices declined and construction ceased. The myopic approach that I integrated into the model illustrates how speculation on the part of domestic and foreign investors further exacerbated the boom and bust in Spain.

The conclusions of my qualitative analysis are simple yet powerful. Both economic and speculative forces in Spain contributed to a buoyant real estate market over the last decade. The real estate stock-flow was successful in pointing out that the immense population growth combined with extremely low mortgage interest rates, further deepened by speculative behaviour – based on backward-looking expectations – indeed, caused the formation of an asset price bubble in the Spanish real estate market. In addition, a trend of increasing domestic and foreign speculative investment in Spanish real estate could already be observed in the early 2000s. Since, by empirical evidence, there is a lag between demand and the response of supply in the construction industry, construction was still active when prices peaked. As a result, housing stock in Spain overshot its target by 2007, prices began to fall and the bubble burst.

While my approach to analysing the existence of a bubble in the Spanish housing market is clear, further exploration of some key considerations could give more insight on the reasons behind the development of property prices and construction activity in Spain. Most importantly, a subsequent analysis would intend to refine the stock-flow model by concentrating on econometric work to obtain better estimates of the parameters. Such improvements could provide a complete, quantitative reproduction of the Spanish real estate scenario and, form a basis for econometric forecasting to provide insight into making real estate decisions in the future.

The collapse that the Spanish real estate market is currently experiencing has wiped out both investments and families’ wealth, left many unemployed, and contributed to the broader economic downturn. There is no doubt about that governments, families, investors, and construction firms and others involved will try to avoid such a situation in the future. My conclusions could therefore, form the basis for a deeper analysis of what happened in Spain so that, going forward, better regulations are put in place, more sound business and investment decisions are made, and families are better able to protect their wealth.

+ Download complete thesis in pdf format (8mb)