The bill outlining how NAMA will work has just been published. I’m not a financial expert, so I leave it to those who understand these things far better to argue about the finer points of detail. I am happy, though, to make a contribution on the whole topic of “haircuts” and property values, namely what value NAMA will put on the ‘impaired assets’ that the Irish taxpayer will own, in what Ruari Quinn describes as the world’s largest real estate company.
NAMA’s mechanism allows for two channels to inform the prices NAMA will pay for the assets it comes to own: current market value and long-term ‘economic value’, as outlined by Karl Whelan on the Irish Economy blog. Key to all of this will be the yield, or ratio of house prices to rents, that NAMA chooses as its benchmark.
Current market value
On current market value, the market is muddy and I don’t think those involved in compiling the PTSB/ESRI index would argue that their measure is currently capturing in a timely fashion the full extent of falls in house prices.
As evidence, one need only look at the relative year-on-year changes in asking and closing prices. The PTSB index has been stuck at in or around -10% year-on-year since the start of 2008. By that measure, the fall in house prices has been slow and steady over the past 18 months. At the same time, falls in asking prices have accelerated sharply, from about -10% in Q3 2008 to almost -20% in year on year terms by Q2 2009.
The paradoxical result is that, by established measures, closing prices seem to have fallen less from the peak than asking prices. This is despite the widespread perception that asking prices are still above closing prices, i.e. if someone posts a ad for a property asking for €300,000, they’re likely to get a good deal less than that. So, even regardless of the future trend in house prices, those working in or for NAMA should not just use those stats they’re comfortable with, they need to have a broader look at the market to work out current value.
Longer term economic value
On longer term economic value, NAMA needs to be cold and calculating. While owner-occupiers are naturally sentimental to some extent about the value of the house, NAMA will be an investor on behalf of the Irish taxpayer. A lot of the properties NAMA is taking over will be unoccupied or even unfinished. As NAMA is an investor, this takes us back to yields. Which takes us back to rents. Which are falling, due to more properties available to let at the moment than ever.
The chart below shows recommended “haircuts” that NAMA should offer based on two sets of figures. The first, along the horizontal axis, is the fall in rents from their 2008 peak (they’ve already fallen 17% so hence the axis starts at 20%). The second is the yield, or ongoing return, the market gives on property, and is closely related to the house price-rent ratio. It’s also closely related to the cost of borrowing, and the graph below gives five different scenarios, from a very low yield of 4% to a significantly higher yield of 6%, closer to a yield, as the NAMA legislation says, “consistent with reasonable expectations having regard to the long-term historical average”.
The smallest “haircut” NAMA should offer, in the optimistic scenario that rents only fall 20% from the peak and a 4% yield satisfies investors, is 37%. This is significantly more than the 20% often discussed in public debate, although Brian Lenihan’s comments this morning suggest that NAMA is perhaps already thinking of the necessary 40%+ cuts. If rents were to fall by as much again as they’ve fallen in the last 15 months, i.e. a fall of about 33%, even just a 4% yield would mean a haircut of 47.5%. Working off a yield of 6%, on the other hand, would mean a discount from peak prices of 65%.
As the graph shows, the further rents fall, the closer the shave. If NAMA expects rents to halve, certainly a possibility given the trebling of properties available to let since 2007, restoring a 6% yield – last seen in Ireland in 1998 and briefly in early 2002 – would mean NAMA should offer just 26% of the peak price.
House prices when I retire
NAMA may also have one eye half-cocked to future returns and far-flung property prices. For that reason, I decided to have a look at house prices around the time I retire. Now, I had thought I’d be retiring in 2045, although I’m prepared to push that back to 2050 at this point, as I don’t think the “whole work for 40 years, retire for 20” model is really that sustainable any more. But I digress…
The chart below shows a possible trajectory for house prices between 2014 and 2050, assuming NAMA acts as a some sort of trough price-setter, a reasonable assumption given its size in the market. The black line shows peak prices in 2007. The other lines are for each of the yield scenarios and show growth at 3% per annum, a figure chosen with deference to both the ECB 2% price stability goal and a steady-state 1% real growth in house prices.
It is immediately clear that the yield that NAMA chooses has a significant effect on the future trajectory of house prices, as it determines the start-point of any renewed growth in house prices and thus the annual increase in house prices. When would we see 2007 prices again? That depends on the yield. In this scenario, a 4% yield, a very risky choice for NAMA, would see peak prices return in 2035. A much safer choice for NAMA, a 6% yield, would see peak prices return in 2049.
That of course is hugely dependent on the steady-state growth rate in property prices. Suppose growth were to average 2.5% instead, on the face of it not a large difference in growth rate. In that case, a 6% yield scenario would mean that house prices would still be 13% lower than 2007 peak prices in 2050, as I settle down, “grandchildren on my knee” as Paul McCartney would say, to retire.