real estate behaving like oil

Tel Aviv Apartment Prices

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What is the Relationship Between Oil and your Apartment?

Expanding the notion that the Tel Aviv Real Estate Market is behaving more and more like the Commodities Market.

What are Backwardation and Contango?

Backwardation takes place when the current price of an underlying asset is higher than the price trading in the Futures Market. Sometimes, the concept of backwardation is misinterpreted with an inverted futures curve. Backwardation can occur as a result of a higher demand for an asset currently than the contracts maturing in the future through the futures market. The primary cause of backwardation in the commodities’ futures market is a shortage of the commodity in the spot market.If you think of real estate as a commodity, I know it’s a bit of stretch, but let’s assume this is the case for a moment.

Backwardation is the normal state. Intuitively, if you were considering two identical apartments, the only difference being that one is ready now and the second is ready in 3 years, you’d pay more for the former. There are many practical reasons for the premium that you’d pay. But beyond that fact, there is the concept borrowed from the options theory, of the time value of money. This is a core principle of Finance. A sum of money in the hand has greater value than the same sum to be paid in the future. This is one of the factors that explain why apartments for delivery in 3 years should be cheaper than an apartment ready immediately.

Now in the case of real estate in Israel, a phenomenon is occurring as I pen these lines. The price of apartments in new projects to be delivered in 2 to 4 years have been catching up with the prices of apartments for immediate delivery. Again you probably can think of a million reasons why that would be. But let’s go back to the idea that apartments are a commodity. In financial terms, this movement is a flattening of the curve and could potentially shift into contango.

Contango describes an upward sloping curve where the prices for future delivery are higher than the spot price. Most commodities markets periodically shift between the two states and a barrel of oil for example can be more expensive for delivery in the future than delivery today. But what does it say about the prices of apartments. Why would one pay the same price (or more) for an apartment delivered in 3 years than today? Let’s break it down.

No supply. Short term supply is dramatically low. That is very true for apartments in Tel Aviv especially.
People discount the risk factors of a construction projects to 0.
The value of apartments is expected to rise in the future at a faster rate than expected inflation. Expected inflation is the main factor affecting the time value of money. As inflation goes up the value of money goes down.

So if we read this phenomenon, future apartment prices will go up by more than real rate of inflation, than locking in the purchase of a future apartment at today’s price would be the rational thing to do, much like a future contract in commodities.

There are caveats though:

This can only work if you have no exposure to the interest rate I.e. you buy all cash.
You have a lot of cash sitting idle.
The purchase price today of your future apartment is not indexed to inflation.

A reversal of the phenomenon can be very painful though. In a case where the market for future apartments slows down. That could happen if the stock options of the high tech employees fall out of the money. Or if the real interest rate increases dramatically. Or if there is a rapid increase of supply in the market for apartments.

All these factors have a lower likelihood of happening that the prices of both apartments and future apartments going up in the medium term. But that likelihood may go up nonetheless and that’s all it takes to see the future apartments prices take a nosedive.