Tuesday, January 10, 2006
Real Estate Capital Growth
An economic insight on why real estate capital values may slow down but never stop accumulating.
It is an undisputed fact that market economies, in Capitalism, are moved by the supply and demand for goods and services. Whereas it is natural and obvious to explain and justify demand as a direct and proximate result of the need for goods and services, it is not quite equally so natural and obvious to explain and justify why such goods and services should be available for us to grab in the first place. Demand has to do with the way the intricate thread and connectivity of neurons in the human mind work – or don't work. And since out of six billions or so humans there are six billions or so different minds, it follows that demand is a very subjective variable indeed. Supply, on the other hand, is in direct function and the proximate result of only one economic element: capital growth.
The basis for the real estate market is the demand by households, businesses, governments and institutions for space and shelter to conduct activities. Consequently, as demand changes in direct function of human activities and economic and demographic variables, conditions within the real estate market change. The demand for space, shelter and support for human activities is not for the land itself but, rather, for the use of the land – that is for the services provided by the land. Land that is useful has a value to the user. This value is the real motivating force for the operation of the real estate market.
More specifically, the value of land represents the amount a potential user is willing to pay in exchange for the right to use the land. From another perspective, it is the amount that the holder of the right to grant permission for the use of the land will receive in exchange for granting this right to another party. When there is no exchange, the holder receives value through his own use of the land. For example, a homeowner does not have to pay rent to live on the land. As the benefits from using land may be received long into the future, the value of an interest in land will be the dollar amount invested today that is justified by the anticipated benefits, given risk and current investment conditions. In general, any interest in land that has a value through use will also have a capital value. Value through use of land is possibly the only one precept - in the long and twisted line of thinking and rationalization of the human mind – that is common and shared by Marxism, Socialism, Fascism and Capitalism. The unreconcilable differences among these social doctrines, however, lie in the practical economic applications of the value through use of land as it relates to totalitarian regimes. On the other hand, value through use of land was absent during pre-industrial Mercantilism, as trade, tariffs and monopolies were given precedence over investment, free market and monetarism.
Housing supply is produced using land, labor, and various inputs such as electricity and building materials. The quantity of new supply is determined by the cost of these inputs, the price of the existing stock of houses, and the technology of production. In Economics, the price elasticity of supply measures the responsiveness of the quantity supplied of a good to its price. This responsiveness is measured as the percentage change in supply that occurs in response to a percentage change in price. As real estate is a fixed and durable commodity and the land underneath is practically indestructible, real estate markets are modeled as a stock-over-flow market. About 98 percent of supply consists of the stock of existing houses, while about 2 percent consists of the flow of new development. The stock of real estate supply in any period is determined by the existing stock in the previous period, the rate of deterioration of the existing stock, the rate of renovation of the existing stock, and the flow of new development in the current period.
Essentially, the production of real estate output depends on the accumulation of capital. This is so because the propensity to invest in production (construction of new inventories) depends a lot on expectations of furure profitability and on the present perceptions of market risk. If production stops being perceived as profitable, or if the present perception of market risk increases sharply, capital will exit more and more from the sphere of real estate production. What drives the accumulation process, therefore, is the perpetual search for more surplus-value, that is the amount of the increase in the value of capital upon investment, i.e. the yield regardless of source or form. This requires a constant supply of a labor force which can conserve and add value to inputs and capital assets, and thus create a higher value. The rationale behind this is that labor adds value by satisfying demand through production, since when people acquire income they tend to invest it, and the more people that acquire income the more people that tend to invest it. Therefore, there is a correlation between capital and unemployment in real estate or, if you will, between income and labor. An increase in levels of consumption sets forth an increase in prices caused by a corresponding increase in demand, in itself generated by a commensurate increase in the income-employment factor. It follows, therefore, that growth is derived by the equilibrium of capital and investment with labor and employment. And since, furthermore, production is in direct function of consumer spending which increases as unemployment falls, it follows that capital accumulation inreases as employment rises and capital accumulation decreases as employment falls.
As capital accumulation in real estate is driven by surplus value as explained above, and because of the fact that it is not possible for employment to ever reach a ‘zero value’ in any economy (otherwise there is no economy), real estate capital growth will never stop accumulating and, therefore, demand for real estate outputs will always be there – even in the worst possible market. Real estate, therefore, is unique in this respect and quite unlike other markets that are not anchored on the relationship between capital and labor. These other markets are far more speculative in nature, in that future capital accumulation is fueled only by present capital consumption. As one thing undercuts the other, therefore, these speculative markets are more unstable, unsafe and prone to crash. What happened to the stock market on Black Monday - October 19, 1987 - when it lost twenty-two percent in value in eight hours is primary proof of it.
Real Estate Chronicle