As an economist, I am often asked to explain why property prices keep increasing when there seems to be excess supply of apartments and office blocks, given that one sees so many of them being built.
This question is, of course, based on the assumption that excess supply of property really exists.
As is well known, it is a basic principle of economics that, in a market for a given good, when the quantity supplied of that good is larger than the quantity demanded of the same good, its market price would tend to fall. Conversely, when excess demand for a good exists, we expect its price to rise.
We see this happening mostly in perishable goods like vegetables, the prices of which fluctuate, decreasing when there is a good harvest and rising when there is a shortage. This principle also applies to non-perishable goods, including natural resources. In news reports, we often hear that an increase in the supply of oil by OPEC leads to a fall in price and vice versa.
However, are we so sure there is currently excess supply in the property market?
The answer to this question is “not necessarily so”. If the apartments and other forms of property that have been and are being built all over the Maltese islands are meant only as residences and business premises, then I would say that currently there is probably excess supply and this surplus is likely to increase with the Planning Authority’s ease of dishing out permits. But property does not only provide a roof over one’s head or space for business activity.
In Malta, developers as well as households may invest in construction because they consider this to be a rewarding investment, even if the property remains unoccupied. In this case, property can be considered to be a quasi ‘idle’ asset, that is, an asset that is not directly yielding a financial return.
There are other idle assets of this type: bank deposits with zero interest are a case in point. Even if there is no direct financial return on such deposits, one may consider depositing one’s money in a bank account for safety or for ease of settling payments.
In the case of property, the actual return of a vacant flat may even be negative as there are, for example, maintenance costs involved. In addition, unlike a bank deposit, property is an illiquid asset and cannot quickly and easily be exchanged for cash.
What are the attractions of holding property even if it remains unsold or unrented? I think one of the benefits is that the price of the land on which the property is built will not go down in the long term, as this is in short supply in Malta. Simply possessing a tract of land therefore may be considered as a safe investment for those who have money to invest or who can easily access loans.
In addition, it is likely that when property prices increase, developers are likely to speculatively invest more in property in line with the law of supply which states that increasing prices improve the prospects of profit and this motivates firms to expand production.
This all means that demand for property should not be measured simply by demand for residence or business spaces. This also means that what seems to be excess supply of property can in reality be apparent but not real.
There are many lessons to be learnt from the Irish and Spanish experiences and we had better learn them now- Lino Briguglio
However, at some point, a construction frenzy like ours could lead to a situation where supply exceeds demand for property for practical uses as well as investment. In such a case, property speculation could eventually lead to a bubble, followed by a collapse of the property market, with repercussions on the banking sector, as has happened in many other countries, notably Ireland and Spain.
In the case of Ireland, property prices increased rapidly during the early years of this century as a result of speculation, reaching a peak in 2006. Within four years, property prices had fallen by an average of 35 per cent compared with 2007, although at one extreme some apartments registered a price decrease of over 60 per cent.
This, in turn, resulted in a collapse of the Irish banking and construction sectors. Economists attribute this to unbridled speculation and weak financial oversight.
The Spanish case was somewhat different as the property bubble took longer to materialise, possibly starting in 1985 and accelerating between 1996 and 2008, after which year prices began to fall. By 2013, property prices had fallen by more than 30 per cent.
Again, here, property speculation played a major part in the disaster and, again, weak financial oversight was one of the causes.
There are many lessons to be learnt by Malta from the Irish and Spanish experiences and we had better learn them now, before it’s too late. Many operators in the construction sector probably have their own funds but bank finance is still often needed for this purpose.
The banks would seem to be happy lending money for construction, albeit while imposing what is known as a haircut, which is the difference between the market value of an asset and the amount of the loan. But this haircut may not be enough for banks to recover their loans if prices fall sharply and if borrowers go bankrupt.
In this article, I have confined my discussion to financial aspects associated with the construction boom, which, as explained, could deal a major blow to Malta’s construction and banking sectors. I have not touched on the environmental and social downsides of construction, which are added disadvantages of the speculative pursuit by many developers, issues that also need to be considered by our authorities.
The sector has received considerable government support in recent years. It is one thing for the government to encourage the construction sector to ensure the basic human right of housing, it is another to encourage it for speculation.
Lino Briguglio is professor of economics, University of Malta.