We are seeing much discussion surrounding the topic of excessive cash premiums for HDB flats, with buyers desperate to get into public housing market. The cash premiums, equivalent to Cash-over-Valuation (COV), has hit as high as the median at $24,000 in the fourth quarter of last year, based on the Housing Board (HDB) data. In a way of saying, if the valuation of the HDB unit is $400,000, the buyer may have to fork out around $24,000 more on top to purchase it.

As the ERA Asia Pacific associate director Eugene Lim is putting across in the Straits Time headline dated 23 Jan 2010: “Valuation is lower than actual resale prices because it is based on past prices. Currently, the market is on the upswing and is therefore forward-looking; this explains the disparity between valuations and sellers’ expectations in a hot market”. To me, this has somehow explained my concern over the vicious cycle being formed highlighted in my earlier article: Record breaking prices of HDB resale? Blame it on the valuation system.

With much of over optimism and unrealistic expectation towards the economy, real estate bubble can be easily formed. This could be explained by the demand & supply theory in Real Estate Economics.

The quantity of housing supply is from two sources: new constructed units from developers or HDB, and the existing stocks. The short term elasticity of housing supply is low, i.e. the responsiveness of the supply is slow towards the price change, since it takes time to construct new housing. Therefore we have been saying housing is lumpy in nature. However the long term elasticity of housing supply is high since there is incentive for developers to build more due to the high demand with good pricing. A bubble will burst when it comes a point that when the prices have risen a high while the housing supply releases far higher than the actual demand. When it happens, we will witness the housing pricing will suffer a free fall as we saw in the Asian crisis in 1998 compounded with a high interest rate.

Cash Premiums /Cash over Valuation behaves similar to the Price Earning (PE) of a stock unit in stock exchange. The higher you are willing to pay for the higher COV/PE implies the growth expectation you factor you. It implies the lower the dividend/rental yield you are able to get across the years. One thing different is that housing is much more complex in terms of its consumption and interesting characteristics that you might want to pay additional attention to it. Since the consumption of a single house means a lifetime commitment to most of us.