Subprime Mortgage Crisis and the Globalization of Real Estate
Subprime Mortgage Crisis and the Globalization of Real Estate

When Dow Jones hit a record 14,000 for the first time on July 19th 2007 and then dropped to below 13,000 by August 15th, 2007, investors around the world knew a crisis was brewing. The U.S. housing bubble, categorized by historically low interest rates, incorrect S&P ratings, and a housing frenzy, had burst.

Understanding how globalization affects the real estate industry may help shed some light on how it has becomes so vital for the economic well-being of societies around the world. In this analysis, we will examine the subprime mortgage crisis as well as other trends in the real estate industry, such as the impact of real estate investment trusts (REITs), demographics, offshoring, and government policy.

Background
In today’s globalized world, the finance industry and markets around the world are highly integrated. If a company, bank, government, or any institution wants to raise funds, debt (i.e. bonds) is issued and then rated by an agency on the institution’s ability to pay back the debt. Credit rating agencies, such as Standard & Poor (S&P), are responsible for rating debt obligations. In an ideal situation, the S&P rating gives a close to accurate picture for investors who want to make a decision on how much risk they are willing to have when making a purchase.

To decrease risk, securitization has evolved. Securitization is the packaging of loans, such as car, home, and credit loans. To attract more investors, securitization pools assets with varying degrees of risk. There are many foreign investors in U.S. securities and securitization is taking place in markets around the world. Securitization leads to a diffusion of high and low risk investments and, in the case of real estate, it makes investments more liquid (easier to trade). Securitization increases the pool of investors who can finance the loans. In real estate, it also increases the suppliers, since non-banking companies have started to issue mortgages.1

Mortgage-backed securities are integrated into different types of investment vehicles, such as collateral debt obligations (CDOs), which were developed in the 1980’s and became popular in the 1990’s. CDOs acquire a variety of securities, including asset-backed securities and mortgage-backed securities, then sell the rights to the cash-flow from these entities and the associated risk. These rights are divided into tranches (tiers), depending on their length of the loan (short or long) and its risk. Now people around the world are investing in real estate by buying CDOs and other investments which incorporate mortgage-backed securities. Whenever there is volatility in a major market, such as the current crisis in the U.S., many around the world will be impacted.

Subprime Mortgage Crisis
Sub-prime loans were given to people with bad credit history who were not able to qualify for traditional loans. In addition, people who qualified for traditional loans, took out variable rate loans because at the time the interest rates were low and they could afford the monthly fees. During the housing frenzy, S&P gave high ratings to subprime loans, which were part of CDO inventories, despite the fact that these loans were high risk. Investors and institutions around the world bought the CDOs. with an incorrect risk assumption. The CDOs were incorporated into major hedge funds managed by Goldman Sachs, Merrill and Lynch, Citigroup, and others. Mortgage lending institutions did not scrutinize loans, as investors bought all types of loans, even those for subprime mortgages because of the high S&P ratings and the high rate of return.2

When the interest rates increased, many people defaulted on their loans and home foreclosures skyrocketed. One out of every 100 homes loans in Michigan foreclosed last quarter.3 Subprime lenders were hit hard when the rates increased. The number two subprime lender in the U.S., New Century Financial Corporation, declared bankruptcy.4

In addition, when the subprime mortgage crisis hit, no one knew the value of the CDOs and so Wall Street firms were unable to sell them. Hence, the U.S. Federal Reserve Bank, European central banks, Japanese central bank, and central banks from Australia and Canada injected more than $240 billion dollars to bail out investors of the risky loans.

The U.S. Congress has begun investigating the subprime mortgage crisis and bills addressing predatory lending, where potential homeowners are steered toward more costly loans, are being drafted in both the House and Senate.

Aftershocks from the crisis will continue, some retirees will lose their pensions, which were invested in these funds, many real estate professionals will lost their jobs as companies downsize to survive the crisis, and some homeowners will lose their homes.

Real Estate Investment Trusts
Another international investment tool that has profoundly effected the real estate industry has been the creation of real estate investment trusts (REIT). A REIT is a designation that allows corporations to invest in real estate, such as apartment buildings, office complexes, and shopping malls, while paying reduced or limited corporate income tax on those investments. These corporations must then distribute at least 90 percent of their income, as dividends, to their shareholders.

REITs were originally developed in Australia in 1971 and are now available all over the world, such as in Bulgaria as of 2003, in Germany as of June 2007, in Hong Kong as of 2005, in Japan as of 2001 and elsewhere.5 REITS decrease risk through diversification and make real estate a more liquid investment as owners can buy and sell shares, similar to mutual funds.

While financial instruments, such as REITs and securitization, are crucial to understanding the real estate industry and the current subprime mortgage crisis, other global factors impact the field as well.

Demographics
According to the Urban Land Institute, World Cities Forum and Columbia Business School study, “Global Demographics and Their Real Estate Investment Implications,”6 trends in global demographics affect the demand side of real estate in the long-term. Drivers of demand include population, labor force (current and future), and personal and national incomes. If the population is growing and the middle class is increasing, demand for new real estate increases and the opposite holds true as well.

Today’s world population is 6.5 billion people and it is projected to reach 9.5 billion in 2050, with the growth occurring mainly in the developing world. Half of the global increase is expected to take place in India, China, Pakistan, Bangladesh, Nigeria, and the United States. In Europe and Japan, the average age in the population will become older since the birth rates are low. The numbers of residents will not grow there either since immigration is low in these countries as well. Whereas in the U.S., Australia, Canada, and the United Kingdom, migration will help maintain the average age of their citizens and will keep the population expanding.7

The global labor force is expected to grow by almost 50 percent, however, there will be not enough workers in Europe or Japan, given the low immigration and birth rates.8 Multinational companies will take into account labor force growth when deciding where to buy real estate and build new offices. In countries where there is a shrinking population, there will be no need to build new homes, schools, businesses, etc. In some parts of Europe, “replacement demand” is already taking place, meaning demand only results when old buildings are demolished, natural disasters or fire harm buildings, or buildings reach functional obsolescence.9

Offshoring
Compounding the effects of demographic changes is the growing trend of offshoring and outsourcing. As foreign companies relocate to emerging economies, such as India and China, the real estate industry changes on both sides of the divide. In China and India, and in other emerging economies, cities are exploding with new tenants and real estate prices are skyrocketing.

The top 10 global office markets by occupancy costs for 2000 were: 1) London, 2) Tokyo, 3) San Jose, 4) San Francisco, 5) Zurich, 6) Paris, 7) Hong Kong, 8) New York, 9) Moscow and 10) Stockholm. In 2005, the list includes: 1) London-West End, 2) Tokyo, 3) London-City, 4) Hong Kong, 5) Moscow, 6) Mumbai, 7) Paris, 8) Dublin, 9) Dubai, and 10) New Delhi.10 The 2000 list includes three U.S. cities, while none are featured in the 2005 list, reflecting that there are new potential global economic centers. There were no Indian cities in 2000, but there were two in 2005.

As companies increasingly move their subsidiaries and departments overseas, real estate in the home countries will be affected. For example, a 2004 study commissioned by Pollina Corporate Real Estate in Chicago, noted a loss of 53 million square feet of space and a resulting loss of approximately $1.2 billion in rent occurs every year the US, due to offshoring and outsourcing.11

Government Policies
While market forces are certainly influencing supply and demand factors for the real estate industry, government policy can be quite important in setting the overall investment climate in a country and subsequently the real estate industry.

For example, in February 2005, the Indian government enacted legislation that decreased restrictions on foreign direct investment (FDI) in real estate. This led 15 of the world’s largest real estate firms to open offices there, including Morgan Stanley and Blackstone. Traditionally, India did not allow Indian banks or pension funds to invest in Indian real estate and those seeking to buy a home had to pay nearly the entire purchase in cash. The interest rates were very high as well.12 Despite the legislation passed by the Indian government, the real estate industry in India still faces huge problems with poor infrastructure–often office complexes have been built before the roads to them.

Other factors affecting whether companies set up shop are a country’s taxes. In an online British Property tax portal, the site assesses potential markets for international investors based on rent tax, wealth tax, capital gains tax, and inheritance tax. For example, it notes that non-resident property owners in Bulgaria will face 15 percent withholding tax on rental with deductions for mortgage interest, no wealth tax, 15 percent capital gains tax on any increase in the value of the property, and no inheritance tax. The firm notes though that some property interests cannot be owned by foreigners, but only through a local Bulgarian company and that a Company tax of 15 percent will interact with the capital gains tax, making the running cost not worth the investment.13 Similar evaluations on the site are made for United Kingdom citizens interested in investing in real estate in France, Italy, Spain, the U.S., and other countries.

Looking Ahead
After the dot.com boom, was the housing boom and after the dot.com bust was the housing bust. People will always seek to invest in markets that have the potential for growth and high returns. Risk is inevitable when it comes to investments. Real estate will always attract investors because the potential rewards are quite high.

The developments within the financial aspect of the real estate industry, leading to increased liquidity and diversification should be positive in the long run, as markets tend to corrects themselves if they has gone too far in one direction.

The trends of economic growth in the developing world, shifting demographics, and subsequent offshoring and outsourcing will change the industry. The paradox of real estate in a globalized world is that location matters when it comes to buying a home or storefront or setting up a factory. Yet people telecommute to jobs half-way around the world or run businesses over the Internet from their living rooms, making location nearly obsolete. 


1 Lowenstein, Roger. “Subprime Time.” New York Times. September 2nd, 2007. http://www.nytimes.com/2007/09/02/magazine/02wwln-lede-t.html
2 Ibid.
3 “Rate of Home Foreclosures Hits Record.” New York Times. September 7, 2007. http://www.nytimes.com/2007/09/07/business/07mortgage.html
4 Ibid.
5 Real Estate Investment Trusts. Wickipedia. http://en.wikipedia.org/wiki/Real_estate_investment_trust
6 Lachman, M. Leanne. “Global Demographics and Their Real Estate Investment Implications. Issue Paper Series. Urban Land Institute. 2006.
7 Ibid
8 Ibid
9.Ibid
10 Bardham, Ashok and Kroll, Cynthia. Globalization and Real Estate: Issues, Implications, Opportunities. Fisher Center for Real Estate and Urban Economics. University of California, Berkeley, Spring 2007.
11 “Offshore outsourcing slams U.S. real estate corporate industry, study says” Shared Expertise Forums.
12 Bhandari, Raj and Tim Morris. Globalization of real estate flows. Global Executive Forum, University of Colorado at Denver. Winter 2005-2006.
13 Feingold, Daniel. “International Property Tax Essentials.” Property Tax Portal. http://www.property-tax-portal.co.uk/international_property_tax_essentials.shtml

* Picture Source: http://www.flickr.com/photos/joelogon/2278162133/

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