With Taiwan's real-estate market booming, construction-industry insiders often appear on television, arguing that "compared to Hong Kong and Japan, housing isn't expensive here." Predicting that real-estate prices will continue to rise, they urge consumers to "hurry up and buy." Are housing costs high or not? Opinions vary. Of course, every property is different. It is hard to compare homes that vary in terms of location, age, and quality. And what baseline should be used to judge whether real-estate prices are expensive or cheap? That's also key.

Figure 2: Residence prices and rents in Taipei City, 1973-2008

In considering whether housing is expensive, economists often focus on price-to-income ratios, i.e. the median price of a home divided by median household income.

However, just looking at price-to-income ratios doesn't necessarily paint an accurate picture; one must also consider interest rates and the amount of down payment required. To stimulate economic recovery, nations aim to keep interest rates low. If they simultaneously want to rein in rising real-estate prices, they typically adopt another measure: they lower the percentage of a home's value that a buyer is allowed to mortgage. For instance, Hong Kong raised the down-payment percentage required for buying homes priced at HK$20 million or more to 40%, and the Korean government lowered the maximum loan-to-value ratio on mortgages in the Seoul area to 50%. Here in Taiwan, the Central Bank on June 24 without warning raised interest rates across the board by 0.125 percentage points and slapped controls on lending to parties buying property for investment purposes. The move was clearly intended as a warning to the market.

The price-to-income ratio may not always predict the rise or fall of home prices, but it is a good measure of affordability for an average household. Consequently, it is sometimes described as the "home buyers' hardship index." Internationally, a general rule of thumb is that a reasonable price-to-income ratio should not exceed 5.1. That is to say that if a family didn't eat or drink or spend money on anything but their home, it would take no more than 5.1 years of their income to pay for it.

According to a survey of residential housing demand trends published by the Ministry of the Interior's Construction and Planning Agency, the price-to-income ratio in Taiwan's five largest metropolitan areas over the past few years has typically ranged from 6.0 to 7.0. For the last half of 2009 the figure stood at 7.08. But in Taipei City and County the ratio rose substantially-to 9.06 in the last half of 2009. It is estimated that residents of the silk-stocking Da'an District would have to put up 14.6 years of income to buy a home there.

The following graph clearly shows that the price-to-income ratio in Taipei City began to rise rapidly in 2006-2007, and it now stands as high as it has since the housing bubble that peaked in 1990.

As everyone knows, household expendable income has shown sluggish growth in recent years and even declined 1.1% in 2008. In comparison, the average advance sale price for a home being built in Taipei City has risen 50% over the last three years, so that real-estate prices seem increasingly decoupled from basic economic realities. Apart from being put off by the high price of housing, the public also feels ill at ease when looking at the real-estate market, wondering: "When is the bubble going to burst?"

Figure 1: Housing price to income ratio for Taipei City, 1973-2008

According to textbook notions of supply and demand, when personal income does not keep pace with the cost of housing, there ought to be little room for further price increases. And in reality, apart from Taipei City and County, the price of housing in other areas of Taiwan has been relatively stable. In that case, what is pushing Taipei's real estate ever higher? Who is buying those ever-dearer homes?

In truth, the fact that incomes in Taiwan have been stagnant does not mean that other capital hasn't been entering the market. We can observe several factors to explain why a lot of capital that had been invested around the world has been brought back to Taiwan.

In 2006, as a result of insufficient demand and rising labor costs in mainland China, many Taiwan companies that had set up there began moving back to Taiwan and bringing capital with them. After the US financial crisis in 2008, more speculative capital that had been invested abroad returned to Taiwan, seeking safer investment targets. Then in 2009 the United States strengthened efforts to audit tax returns, and in 2010 Taiwan started to tax overseas income. These moves also encouraged a return flow of capital. What's more, relations across the Taiwan Strait have been improving, and the expectation that the two sides will sign an economic cooperation framework agreement has led many investors to regard the Taipei real-estate market as a place with a lot of potential.

Another reason that Taiwan real estate is prone to rise and not fall is a special tax system: Taiwan uses "assessed present value" rather than real market value to levy real-estate taxes. With assessed present value trailing real market value (land typically accounts for about 20-30% of housing prices), investment in real estate has become an important way for the affluent to protect their wealth and reduce their tax burden. With today's low interest rates, land and residences are viewed as a safe harbor for idle capital.

These forces have combined to bring a lot of investment money (as opposed to money for purchasing one's own residence) to the market. This can be observed through several phenomena. Figure 2 shows trends in the ratio of home prices to rents in Taipei City. In 2006-2007 the ratio broke 600 months (meaning that the price of a residence is higher than the rent that one would collect on it for 600 months or 50 years). With such a high ratio, being a landlord becomes an unprofitable endeavor.

There is a logical explanation for the phenomenon: Many buying residences as investments and intending eventually to sell for a profit end up renting out those flats in the interim to help cover their interest payments. When these investors grow in number, it creates both greater demand in the market for purchasing homes (pushing real estate prices higher) and greater supply in the market for renting homes (pushing rents lower). The divergence between home prices and rents is often cited as evidence of a real-estate bubble.

As long as investment costs are low (with small down payments and low interest rates) and expected benefits are high (with high rates of appreciation and residences that are easy to unload), speculators will boldly "chase the rising wave." Whether housing prices are high or low is beside the point. What's more, investors tend to herd together and pursue a few hot investment targets. That creates room for further increases and profits, and pushes residences in the best areas to continue to rise.

The housing market in Greater Taipei is dominated by investors and rich buyers for whom money is no object. Average middle-class residents can only look on in disappointment from the sidelines.

In other words, the continual rise in real estate prices doesn't bother investors. To the contrary, they regard it as an opportunity for making profits-so long as they're not caught holding the bag when the bubble bursts!

When a real-estate bubble forms, those wishing to buy homes as their own residences start grumbling about affordability, and when it bursts, it can hit the financial system and the whole economy hard. Japan's "lost decade" and the current US financial crisis are two excellent cases in point. According to UN estimates, the amount of money borrowed in mortgages should never exceed 40% of a nation's GDP. Taiwan is approaching that figure. When second mortgages for renovations are added, the total already exceeds 45%. There is growing risk connected with buying real estate here. Both the government and citizens should take prudent defensive measures!