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Bubble Logic | London Business School

From London to Dubai, soaring real estate prices are causing worries about an impending bubble. But how do you spot a bubble from a boom? Joao Cocco provides the logic.

For any asset, at least two types of value are relevant. The market value is the price at which investors can acquire the asset. In liquid asset markets, such as the markets for the shares of the largest companies or the markets for the foreign exchange of major currencies, this price can be readily observed from the sales transactions that take place. On the other hand, the fundamental value of an asset is the present discounted value of all the cash that the asset is expected to generate. In a bubble, asset prices become much higher than the asset fundamentals can justify. What makes the analysis particularly difficult is that fundamental values are not directly observable. Their calculation requires estimates of the cash that the asset will generate in the future and of the discount rate used to obtain the value today of the stream of future cash flows. This discount rate should reflect the risk of the cash flows that the asset is expected to generate.

For example, during the dot-com boom, the share price of many internet companies rose to levels that were difficult to justify based on the companies’ current and future cash-generating prospects. The same valuation concepts can be applied to real estate assets. The cash that a property is currently generating includes the rents received as a cash inflow and property maintenance, taxes, insurance and other expenses as a cash outflow. The difference between the two is the net operating income of the property. For some types of properties it is much easier to obtain data on rents than on property expenses, so the focus is usually on the former.

Is a given increase in real estate market prices a sign of a bubble in the making, or can it be explained by the asset fundamentals? It will be explained by fundamentals if the higher price is due to improved cash-generating abilities or to a decrease in the discount rate required to calculate the present discounted value of future cash flows.

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