California Dreamin’

Rational and Irrational Exuberance

in Property Markets
Bubbles and the Winner’s Curse
Snap, Crackle and Pop:
How to Win in a Bubble Economy

Randall Zisler
Managing Director and Chief Investment Officer

Griffin & Company, LLC

A Real Estate Investment Bank
Beverly Hills
 Outline
• What is a bubble?
• What causes bubbles?
• How can investors minimize the likelihood of
overpaying during a bubble—winner’s curse?
• What are the warning signs a bubble exists?
• How can investors profit during a bubble?
 “Thank You!” to Our Contributors

Heitman
A Real Estate Investment Management Firm

“Irrational Exuberance”
 Popular Bubble Definitions
• Irrational exuberance
• Speculative mania
• Self fulfilling
prophecy
• Vicious cycles
• Speculative orgy
• Markets out of line
• Analytic approach
 What is a Bubble?
• A psychological state of irrational exuberance
and investor enthusiasm
• Spreads like contagion
• A cascade of amplifying stories
• Price and volume increases
• Doubts about fundamentals crumble in the
face of investor envy
 Famous Bubbles

ƒJapanese stock market in the 1980’s

ƒPalm stock and the NASDAQ run-up
ƒU.S. real estate in the 1980’s
ƒStock market and DOT COM 1994 through 2000
ƒReal estate 2004 - ?
South Sea Bubble
1000
900
800
£ per fully paid share
700
600
500
400
300
200
100
0
1720.0 1720.5 1721.0
South Sea Bubble
 Tulipmania
One of the early experiments in
financial engineering
70

Price of Gouda tulip bulbs, Guilders

60

50

40

30

20

10

0
1634 1635 1636 1637
Teapot Dome Scandal
 Bubbles are easier to
detect with the benefit of
20/20 hindsight!
 What is Not a Bubble?
• A rapid price increase
• Relative prices can change due to
regulatory or tax changes, cartel-induced
oil price hikes
• Have fundamentals changed?
• Are expectations of future price increases
sustaining the market?
• Are these expectations creating anxieties?
• Is there sufficient confidence in diverse
expectations to generate trades
Housing and Apartments are the
Most Bubbly
 Single Family Homes and
Condominiums are Bubbly
• Disentangling bubbles from fundamentals is difficult.
• One comparable period of home price increases is
the period just following WW II.
• Smart money does not typically speculate in homes
• Real, quality-adjusted, housing prices have not
appreciated significantly over the decades.
• Stock and housing market booms have a two year
lagged correlation.
• Booms are contagious across asset classes.
 Bubbles—Macro Correlates
• Prices are significantly
above trend
• High prices in relation
to income—cap rates
have fallen rapidly
• High price volatility
• Trading volume is high
and rising
• Increase in frequency
of portfolio and mega
deals
 Bubbles-Micro Correlates

• Winner’s curse and participant irrationality

• More bidders increase probability of
overestimating the value of an asset
• Increased bid dispersion
• Bubbles do not typically crash if there is a lot of
market noise and investors are not
synchronized
• Many positive feedback channels, not all
evident to investors
 Positive Feedback
• Difficult to identify precipitating factors or
specify causality; feedback can last for
years
• Feedback occurs in response not to a
sudden price increase but a consistent
pattern of price increases
– Price-to-GDP-to-price
– Price-to-price
– Wealth-to-price
– Price-to-corporate earnings-to-price
Not all bubbles are bad!
 Stock Market Interlinkages
• Stock markets can play a significant stabilizing or
destabilizing role
• Where countries have different financial risk,
interlinkage reduces dispersion of asset prices.
• Where countries differ to asset payoff risk, linkage
can increase price dispersion—high prices are
higher and low prices are lower
• Financial liberalization, short-run inelastic supply of
assets, and absence of short sales.
• Central bank must make difficult choices: Stabilize
exchange rates? Consumer prices? or asset
prices?
 Agency Problems
• Intermediaries with agency problems buy
most real estate.
• Leverage accentuates the agency problem.
• Borrowers increase payoffs in good times
by shifting risk to lenders in bad times.
• In the aggregate, this risk shifting can bid
up prices.
• The riskier the asset, the more risk to be
shifted and the larger the bubble.
And now for some fun
technical stuff!
 Our Bubble Model 1

• Assumptions
– High trading costs
– Short sales not allowed or practically too costly
– Heterogeneous and asymmetric information
– Investors differ in assessment of fundamentals
– Inelastic supply of real estate assets
– Many risk neutral agents
 Our Bubble Model 2

• Preliminaries and predictions

– Coexistence of high prices, high trading volume, and high
volatility
– Asset prices may exceed fundamental value when agents
disagree or when short selling is not possible
– Agents disagree regarding probability distribution of
expected income
– Information signaled through noisy “indicators”; each class
of bidders has a special “indicator”
– Agents are overconfident in the accuracy of their indicators.
– Thus, there are different forecasts.
– The noisier the information, the more trades.
 Our Bubble Model 3

• The Bubble
– Asset owners have an option to sell the asset in the
future to agents in other bidding groups
– Determining the option value is an optimal stopping
problem
– Value of option (the “bubble”) is difference between
demand price and fundamental value
– Fluctuations in bubble value contributes to priced
volatility
– Bubble is consequence of divergence of opinions by
overestimation of informativeness of distinct indicators
 Our Bubble Model 4

• When to sell?
– The “critical amount”, K, is the amount by which the price
must exceed the agent’s valuation
– K determines turnover and sales volume
– K is zero when there are no trading costs, C
– Low C increases the size of the bubble and volatility
– As C increases, K increases and the expected profit from
each trade increases.
– Forecasts oscillate and information flows, thus
generating trades
– The greater the overconfidence of heterogeneous beliefs,
the greater is the size of the bubble
Let’s check the evidence!
 All REITs, average daily trading volume,
millions of dollars

1000
1500
2000
2500

0
500
1990

1992

1994

1996

1998
Volume
Predicted

2000

2002

2004
REIT Trading Volume is Up
NCREIF Cap Rates Have Fallen
11%

10%

9%
Cap Rates

8%

7%
Cap Rates - All Sold Props
6%
Current Value (Appraisal) Cap Rates
5%

4%
923 943 963 983 003 023 043
Year-Quarter
 Return standard deviation, m onthly, %

0.0
1.0
2.0
3.0
4.0
5.0
6.0
7.0
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
all stdev

1998
apt stdev

2000
2002
2004

Return moving average, monthly, %

-2.0
-1.5
-1.0
-0.5
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5

1972
1974
1976
1978
1980
1982
1984
REIT and Returns

1986
Total and Apartment

1988
1990
1992
1994
1996
all mov
apt mov

1998
2000
2002
2004
NCREIF Regional Cap Rates
12%
East West
11%
South Midwest
10%
Cap Rates

9%

8%

7%

6%

5%
91 93 95 97 99 01 03
Y e a r- Q ua rt e r
Total Private NCREIF Sales
700 25,000

600

Market Value (millions)

20,000
500 # of Properties
Properties

Market Value 15,000

400

300 10,000
200
5,000
100

0 0
78 82 86 90 94 98 02
Year
If you win the bid, are
you losing the game!
 Winner’s Curse—What is it?
• People often overestimate the precision of their
knowledge; Illusion of knowledge; experts’ estimates
will vary substantially
• Asymmetric bargaining and incomplete information
• Winning the bidding is a Pyrrhic victory
• Each player estimates the value of the asset.
• If bidders estimates are unbiased, then the highest
bidder almost certainly overestimates the value,
and, on average, overpays
• Perceptive, rationale bidders place a bid below their
estimate of value
• The greater the “winner’s curse”, the greater the
number of bidders, the uncertainty of the price of the
asset, and the dispersion between the highest and
lowest bid.
 Avoiding the Winner’s Curse
• Rationality is an assumption, not a demonstrated
fact!
• The “curse” is about cognitive illusion and systematic
error, especially in bubble economies
• Hubris hypothesis and takeovers
• Collusion (which is probably illegal) or sharing
knowledge with competitors to reduce their bids
• Bidding lower than one’s estimate of value, and being
prepared to lose more auctions and to avoid loses.
• Avoiding auctions and focusing on off-market
transactions.
Focus on California
 California Apartment and Total
Cap Rates and Trading Volume
10% $9.0 10% $9.0
CA apartment average cap rate
9% CA apartment volume, $ $8.0 9% $8.0

8% 8%
$7.0 $7.0

Total volum e sales, $ billions

Total volum e sales, $ billions
7% 7% CA office average cap rate
$6.0 $6.0

A verage cap rate, %

A verage cap rate, %

CA office volume, $
6% 6%
$5.0 $5.0
5% 5%
$4.0 $4.0
4% 4%
$3.0 $3.0
3% 3%

$2.0 $2.0
2% 2%

1% $1.0 1% $1.0

0% $0.0 0% $0.0
2001 2002 2003 2004 2005 2001 2002 2003 2004 2005

‘2005 Real Capital Analytics, Inc. All rights reserved. ‘2005 Real Capital Analytics, Inc. All rights reserved.
 U.S. Apartment and Total
Cap Rates and Trading Volume
10% $30.0 10% $30.0

9% 9%
$25.0 $25.0
8% 8%

Total volume sales, $ billions

Total volume sales, $ billions
7% 7%
$20.0 $20.0

Average cap rate, %

Average cap rate, %

US apartment average cap

6% 6%
rate

5% US apartment volume, $ $15.0 5% $15.0

4% 4%
$10.0 $10.0
3% 3%

2% 2%
$5.0 $5.0
US office average cap rate
1% 1%
US office volume, $
0% $0.0 0% $0.0
2001 2002 2003 2004 2005 2001 2002 2003 2004 2005

‘2005 Real Capital Analytics, Inc. All rights reserved. ‘2005 Real Capital Analytics, Inc. All rights reserved.
 Is Real Estate in a Bubble?

• Probably, we observe high prices, increased

volatility, high trading volume, and increased
dispersion of bids
• Maybe we are witnessing a massive institutional
portfolio shift toward real estate
• The bubble component varies by market, asset
type, and location
• Single family homes and apartments/condos are the
most bubbly
• How will the bubble break?
• What are the likely mechanisms of a burst bubble?
Will the bubble break?
 Profiting During Bubbles 1
• Brokers (paid based on trading volume):
– Punctured bubbles are Darwinian herd-thinners
– Agents benefit from volatility and heterogeneity
– Break up portfolio if assets have low correlation
– Otherwise, reap potential portfolio premium
– Research as “story telling” generates trades and
reinforces environment of heterogeneous views
 Profiting During Bubbles 2
• Agents (paid based on asset performance)
– Big question: Bubble or change in fundamentals?
– Answer suggests different strategies
– Avoid auctions
– Focus on non-bubble markets
– Build strengths that permit preemptive moves
– Specialize in controlling certain kinds of systematic risks
– Pursue economies of scale
– Pay for value-added research that is not a “sophisticated
front end” for the sales or marketing department
My beach has the BEST bubbles!