Household finance complaint

This issue of the Canadian Journal of Administrative Sciences (CJAS) comprises five papers on real estate finance in Canada. To my knowledge, this is the first time that an academic journal has devoted an entire issue to Canadian real estate matters. I extend my thanks to Professor Abolhassan Jalilvand, former editor of this journal, for encouraging me to undertake the guest editor's duties and privileges for this special issue; Professors Iraj Fooladi and Philip Rosson, the current editors, for their exemplary cooperation; the authors and referees for their contributions and invaluable feedback and comments, respectively; and the Institute of Mathematical Finance in Montreal for its financial contribution towards the publication of the special issue.

Each paper studies a different aspect of the Canadian real estate markets. Hence, the special issue offers a diverse picture; it is my hope that such diversity can stimulate further research. From my short editorial experience, it seems to me that real estate research with a Canadian focus needs a big boost. It lags considerably behind that in the United States. In fact, limited Canadian research output, published sparsely and mostly in the U.S. academic journals, was one of the main reasons behind my request to CJAS for this special issue. There is indeed a lot to do. I invite all interested parties (researchers, universities, research centres, and funding agencies) to put more of their intellectual efforts and resources into research on real estate matters in Canada. Real estate constitutes a good portion of the national wealth, is an engine of the macroeconomic activity, and is also the major component of most individuals' personal portfolio, so efforts to uncover knowledge pertaining to the Canadian real estate markets are not trivial.

A Synthesis of Papers in this Issue

The first paper, by Tsur Somerville, examines financing of development projects and aims to fill the research gap on mortgage lending between the residential market and the development projects. It focuses on two hypotheses that have implications for efficiency in the Canadian credit markets. The first is whether small-scale local lenders establish "relationship" lending with smaller borrowers (developers), smaller projects, and more atypical projects. Or, alternatively, do small local banks fill a market niche ignored by larger lenders due to their desire to achieve economies of scale by focusing on loans that are easily processed? The second considers whether capital flows efficiently from one region to another, given the risk and required return relationship.

One of the basic lessons drawn from the research on capital markets is that capital should flow to projects that offer a sufficient risk-adjusted expected return. However, this lesson does not state who may be supplying the capital where it is demanded. It is assumed that anyone with sufficient capital and a willingness to earn the risk-- adjusted expected return on the project would be a good candidate for supplying the capital. Somerville's evidence (and other evidence from especially the banking literature) on this issue suggests that large lenders shy away from lending to smaller projects or borrowers. So, this leads potentially to a gap in the supply of capital even though the borrower is willing to offer to the lender a properly risk-adjusted expected return on the project. Somerville's results show that this gap creates opportunities for small-scale lenders, such as credit unions, which probably have informational advantage in producing more and better information about the local market conditions and especially about the borrowers' risk profiles.

Somerville's second inquiry provides a response to developers in British Columbia (BC) who, according to the author, complained in the early 1990s that Central Canada-based lenders did not lend to viable projects in BC because Ontario and Quebec real estate markets were in poor shape. Such a complaint hints at inefficiencies in the flow of capital. Somerville examines whether the lending volume and market share in Vancouver of lenders based outside BC rose when the relative condition of their home real estate markets worsened.1 His results indicate that "lenders neither behaved myopically nor dramatically altered their risk or loss aversion in response to downturns in the home office housing market." Thus, his results offer evidence that lending patterns follow relative market conditions in the target market and that capital flows efficiently within a firm to areas of greater demand.

When we combine Somerville's results for his first and second questions, we see that the BC lending market for small-scale projects and marginal borrowers is dominated mostly by small and BC-based lenders, while large lenders with a national reach offer lending to large projects and relatively large borrowers in BC. So, the question arises: Since large-scale lenders originate mostly from Central Canada and since small-scale BC-based lenders are survivors and, consequently, efficient intermediaries, why do large banks not establish a stronger presence in BC? Or, alternatively, are the capital projects in BC not large enough for large lenders to engage in more active local lending in BC?

Certainly, a second and much broader question follows from Somerville's important work and results: Will the locally-defined informational advantage of smallscale lenders survive the ongoing process of standardization of information as a commodity and of much higher and broader access to it? I believe these are important follow-up questions for further research.

"What is the value of my property?" is a commonly asked question by homeowners. The answer is important not only for a homeowner's personal portfolio of assets, but also for the homeowner and tax authorities to agree on a fair estimate of the amount of property taxes. Recent advances in constructing real estate price indices have been quite useful in offering estimates of percentage changes in property values in a locality over a period of time. These estimates facilitate property valuation and can be the basis of derivative securities, offering the homeowners some financial tools to hedge against the risk of sharp value declines in their properties (see Shiller, 1998).

The second paper, by Marion Steele, offers evidence that the quality-adjusted price of properties that sell may be quite different from the quality-adjusted price of all properties. She points out that the difference is apt to be especially marked during downturns and that hedonic-- based price indexes using transactions data tend to smooth price changes in the housing stock. For example, transactions prices understate price reductions and this smoothing is potentially important because it could result in over-optimistic appraisals by mortgage lenders during the early quarters of downturns, a too-slow response of banks and other lenders to market change, and understatement of the risk of housing assets and the risk inherent in wealth portfolio of the average household.

Steele studies the market crash of 1991 in Canada. Her results show that in the early 1990s transaction prices, as indicated by the Multiple Listing Service average prices, were a poor indicator of the true or appraisal-- relevant prices close to the market's turning point. She concludes that hedonic and repeat sales indexes, based on transactions data, must be treated with care, and that the impact of downturns in house prices on household wealth and portfolio risk may have been understated. These results also have implications for property appraisals based on transaction prices of comparable properties, even though Steele does not address the issue directly. The question of "Does using transaction prices of comparable properties lead to an understatement of true value of an appraised property?" seems to be a good candidate for future investigation.

Certainly, constructing local real estate price indexes has been one of the most exciting research developments since the early 1990s and lent itself to a lot of practical valuation applications, new product developments in mortgage insurance and derivative securities, and empirical tests of various property markets' informational efficiency. While there has been some work in constructing price indexes for some Canadian localities, I believe that the research output is limited. More can be done in this area.