Modeling property bubble dynamics in Greece, Ireland, Portugal and Spain

Greece, Ireland, Portugal and Spain have been in the spotlight of the recent economic crisis in Europe. With their economy strongly reliant on the construction industry, these countries have become widely exposed to the downturn in the property sector. This paper aims to examine residential property bubble dynamics in the period from 2003 to 2014 and investigate the role of financing conditions in the formation of these bubbles.

Building on the present value model in conjunction with the rational bubble assumption, the study applies the discounted cash flow (DCF) approach and applies weighted average cost of capital (WACC) to capture real estate bubble dynamics in the four countries. Reduced form vector autoregression models are used to examine the relationship between financing conditions and the bubble indicator.

The bubble indicator suggests that Spain and Ireland experienced a large rise in the bubble relative to moderate increases in Portugal and Greece in the period from 2003 up to the collapse in 2008. Our findings from the empirical analysis indicate that central bank policy shifts that impact interest rates and lending volumes on the domestic level have a significant and leading effect on the formation of residential property bubbles.

Only little research on real estate bubbles takes financial leverage into account. This paper bridges this gap by applying the WACC in the DCF model to identify real estate bubbles. While using a distinct bubble indicator, this analysis provides new insights into the linkage between financing conditions and real estate bubbles.