Today I had an opinion piece published in the Irish Times on the importance of getting NAMA’s core assumptions right. The text is below and, don’t say I don’t give blog readers something extra, a graph that explains the true logic behind 10%-in-10-years. Hopefully, it’s of worth, despite NAMA fatigue having set in.
A week on from NAMA’s unveiling, and there has been a lot of commentary about how reasonable NAMA’s core assumption is, i.e. that property prices need only increase 10% in the next 10 years. On the face of it, it is a reasonable assumption and below what many would expect to be trend growth in property prices, which – over a 10 year period with no significant bubble or bust – could be closer to 25%, just ahead of inflation. However, it is an assumption that fundamentally relies on three other assumptions to come good, assumptions that need to be teased out, particularly if the taxpayer is expected to foot the bill.
NAMA’s three key assumptions
The first key assumption that NAMA’s 10%-in-10-years argument makes is the market has bottomed out already, and not only that but that is has bottomed out where the Minister says it has, i.e. an average fall of 47% from the peak. The second key assumption that NAMA makes is that yields are high, relative to European and historical averages. The third key assumption is that any yield correction will come from properties rising in value, rather than rents falling.
The importance of getting the fall right
The Minister for Finance has stated that the best estimate of the fall from the peak so far for NAMA’s properties is 47% on average. Before even going into the details of NAMA’s loan book, it is vital that the importance of this well understood.
The 10%-in-10-years assumption is actually an assumption that says: after overshooting on the way down, the property market will rebound and plateau at 39% below its value at the peak. This would of course have been a very different soundbite, but it is actually what the Minister is saying. It means, for example, that if the true fall from peak-to-trough in NAMA’s loan book turns out to be, say, 60%, the Minister expects the market to rebound by 50% in the next ten years.
The important thing to note here is that small percentage differences on the way down turn into huge differences on the way back up. If the fall is slightly bigger then 47% on average, say 55%, this means we need a 36% increase in the next decade, not a 10% one. A pessimistic scenario, where we witness a 70% fall from peak to trough, requires property values to double in ten years for NAMA to break even. The exact relationship between falls on the way down and on the way up is shown in the graph below.
The importance of getting the yield right
The Minister for Finance has stated that yields on Irish property are high relative to historical and European averages. To assess this statement, it’s worth knowing a little more about NAMA’s loan book.
A first point to make here is that the general public have not been given enough information. For example, of €88bn in loans, we simply don’t know what is collateral for about one third of the loan book: these are described only as “associated loans”. Ultimately, we know they are property-related, but we don’t know what kind of property. It is entirely possible that they significantly increase the loan-to-value of NAMA’s book – making the whole project riskier again.
We do know a little bit about the almost €60bn in land and development. For example, €21bn is in Irish land, while a further €16bn is in Irish developments. The €16bn in developments itself breaks down between commercial and residential projects. An exact breakdown between the two is given for only Anglo-Irish Bank. It suggests a 50-50 split between commercial and residential, indicating that about €8.4bn of NAMA’s loan book is in Irish residential construction projects at least partially underway, while €8bn is in commercial projects underway.
Amazingly, it is only this latter segment of the market, commercial, worth about €8bn at the peak, that is the subject of any form of yield analysis. And even then, the NAMA documentation only looks at yields on commercial property for one location (Dublin). It compares Dublin yields with its long-term average and with a range of other European cities, finding that yields in August 2009 were slightly higher than both.
In residential property, however, yields are significantly below historical averages, at 3.3% on average. The NAMA document itself takes 6% as closer to a ‘normal yield’. If residential and commercial are roughly half and half, the yield for development projects in Ireland is substantially below the 6% taken as a healthy target, not above.
The importance of getting the correction right
Lastly, the Minister for Finance has stated that because yields are above where they should be, this means that property values will increase from current levels towards some ‘long-term economic value’.
There are two ways a yield can decrease, rising property values or falling rents, and there is one very strong argument as to why the correction may come via falling rents. That argument is oversupply, a legacy feature of Ireland’s property market since the boom. We can see this already in residential lettings, where rents have fallen a quarter from the peak already. The adjustment may be slower in commercial property, where the ban in downward rent reviews means that the market has to find other ways of lowering rents, such as rent-free periods, but that doesn’t mean it won’t come.
Looking again at long-term economic value
Let’s say, for the moment, that NAMA’s calculations on commercial property are right: a 47% fall on average and above average yields. Let’s even leave aside for the moment Irish land and all foreign projects, leaving the focus on Irish residential and commercial markets. According to ESRI and daft.ie, the average fall in house prices in Ireland so far has been no more than 35%. Suppose oversupply in commercial and residential segments of the property market leads to a 20% fall in rents over the coming couple of years. If yields converge to 6%, this suggests a long-term economic value of €44bn, not €54bn.
It is genuinely amazing that NAMA’s entire estimation of long-term value hinges on rents holding constant, despite evidence to the contrary, in a subset (Dublin) of a subset (commercial projects) of a subset (projects underway) of a subset (Ireland) of the total loan book, perhaps about 5% of the loan book in total. Is that good enough?
A range of genuine alternatives to the NAMA proposal have been proposed, for example Dermot Desmond’s idea for an extended and modified guarantee, outlined in this paper last week. If, though, the Government honestly believes that NAMA does offer the best way of fixing Ireland’s financial system, it needs to get the fall, the yield and the correction right. On all three, the analysis presented by the Government so far seems at best lacking in detail and at worst fundamentally flawed.