Housing Bubbles: A Tale of Two Cities

Abstract

This study examines the impact of land tenure on housing bubbles. A housing bubble is defined as the portion of housing prices not justified by market fundamentals that determine the consumption demand for housing. While there are many factors that contribute to the formation of housing bubbles, we hypothesize that a housing bubble is likely to be bigger in a market with properties than in one with leasehold properties. This is because the value of the real redevelopment option embedded in a property is affected by changes market expectations to a much greater extent than its use value. Therefore a small change in market sentiment will affect the prices of housing units situated on land more than those on leasehold land. We use a state-space model to empirically estimate the sizes of housing bubbles in Taipei and Hong Kong since the 1980s. The land tenure in the former is freehold, while that in the latter is leasehold. We find that the average size of housing bubbles is larger in Taipei during the period of observation, which supports our hypothesis. The change in Hong Kong’s land policy after July 1997 has effectively turned its land tenure system from one of leasehold to almost freehold (i.e., the market expects that leasehold land will be automatically be renewed without payment of a premium upon the expiry of a lease). Our result shows that there has been an increase in the magnitude of housing bubbles in Hong Kong since 1997, which provides further empirical support to our hypothesis. The results also have important policy implications for developing markets where the land tenure systems are still evolving.