The value of a tradeable and durable good can be broken down into two factors: the intrinsic value and the speculative value.
The intrinsic value is the value gained from the actual use of the good and it is little affected by market movements of demand and supply. It is the value of what the good is made up of or what it produces. In property this would be determined by the quality of the land, the cost to build and the potential rental earnings.
Speculative value is created from buying and selling. It is entirely based on the buyer’s expectations that the property will be worth more in the future and therefore it should be bought now. Enter the irrational realm of human emotion.
Some speculative buying may be based on sound reasoning. A buyer may hear of city plans to renovate or increase security in a community scheme and therefore buy early, expecting property prices there to rise. Note, however, that this is mostly intrinsic as the buyer can reasonably expect rent income to increase in the area as the quality of the product has increased.
But most speculative value is created by flock mentality and reactionary behaviour. It’s a game of making money off somebody else’s loss. Property prices may increase for many reasons: increases in intrinsic value, increases in wealth or an injection of money supply. Seeing that prices have risen, speculative buyers may expect further increases and thus buy early with the intention of selling at a higher price.
This demand boosts prices even further, prompting stronger belief that prices will rise and creating even more demand. The price of property soars without a change in the number of bricks and amount of mortar and the perceived value rises far higher than the intrinsic. At some point there must be a reversal.
Unlike gold, the danger of property is that it can be used as collateral for debt. It is not the intrinsic value the banks will take into account to grant you a loan but rather the perceived market value. So the system we have created has allowed us to borrow an amount higher than the intrinsic value of the good we are using as collateral, therefore linking our debt to the vulnerability of the market. This problem was one of the main causes of the 2008 financial recession that started in the US.
As soon as the property speculation bubble popped in 2008 and prices dropped, debts exceeded the value of assets, prompting widespread defaults on loans that ultimately crippled the banks.
Nobody benefits from a default.
Financial markets, and us as individuals, need to put more effort into basing decisions and debts on intrinsic values. We need to reduce the consequences of the crash of speculative bubbles.
Article reference: Paddocks Press: Volume 7, Issue 2, Page 3