Ronan Lyons | Personal Website
Ronan Lyons | Personal Website

Are we nearly there yet? Finding the new floor for property prices

Yesterday saw the launch of the latest Daft.ie Report on house prices, with a commentary by Constantin Gurdgiev. To my mind, there were three main headlines:

  • Asking prices fell by an average of 5% across the country in the second three months of the year, the largest quarterly fall in a year and a half.
  • The 50% fall from the peak threshold has been passed, in some parts of the country – Dublin prices were on average 51% lower in June 2011 than at the peak four years ago.
  • The €200,000 threshold has been passed – the national average asking prices in June was €196,000, compared to €366,000 at the peak. Looking at Dept of the Environment data, this suggests that house prices are at levels last seen in the first half of 2001.

Given that we’re in the territory of 50%+ falls, and given that prices are back below €200,000 on average, it is an appropriate time to ask: how far further will house prices fall? This is important question for two competing reasons. Firstly, falling accommodation costs are good for Ireland’s competitiveness, and good for those who have not yet bought. However, falling property prices mean greater negative equity, which drags down economic growth for us all by affecting household spending.

In this post, I’d like to look at three different ways of calculating what an “equilibrium price” for the average house in Ireland might be: firstly, adjusting the house price for inflation, secondly by comparing house prices to household income, and thirdly by comparing house prices to rents. By doing that, we can not only say something about how far house prices will fall, but also how long it might take, given the typical quarterly fall in house prices over the past few years.

“Real house prices”: stripping out inflation

The most basic metric of house prices is to compare the average house price to the general price level. Why should this work? Well, the experience of other countries tells us that we should not expect house prices to increase significantly faster than the general rate of inflation. For example, real house prices in the USA – i.e. adjusting for inflation – over the past fifty years have increased at a rate of just 0.4% per year. A longer running series – for the Heerengracht in Amsterdam – suggests that over almost four centuries, house prices adjusted for inflation increased by just 0.1% per annum, albeit with significant booms and busts.

Unsurprisingly, when Irish property prices are adjusted for inflation, we find much the same relationship here until the boom. The average house price in the middle of 1995 was (in today’s euro) €115,000, exactly what it was in the middle of 1978. And that represents the high watermark of pre-bubble prices: the average between 1975 and 1995 was €105,000. The graph below shows how real house prices have fared since 1995 and where they stand now: even at €200,000, they would still be overvalued by almost 50% if this rule held true.

Real house prices in Ireland
House prices in Ireland, adjusted for inflation, 1975-2011

Sustainable growth: adding in income

But while attractive in terms of its simplicity, that’s not an economically sensible approach. Household incomes have changed significantly over the past generation and ultimately a mortgage lender cares about your long-term income prospects, not the past average price. Real household income increased from €30,000 (in current terms) in the 1990-1995 period to about €50,000 by 2007, as there were more full-time jobs per household and each job earned more in real terms.

Suppose 1995 marks the start of potential over-valuation of Irish property, as the graph above suggests. Figures on incomes only go back to 1988, but for the 1988-1995 period, the typical house price-to-income ratio was a pretty steady 3.6. Applying that ratio to household income since then, we can calculate a measure for “equilibrium house prices” that reflects the fact that the number of people working can change as can the real wage they earn. This is shown in the second graph below, and the equilibrium price suggested by this measure rose from €120,000 in 1995 to €175,000 at the peak and now stands at €150,000, about 25% below the current price.

Real property prices and incomes in Ireland
House prices in Ireland adjusted for inflation and incomes, 1975-2011

Fundamental value: comparing house prices to rents

I’ve talked on a number of occasions about what I regard as the single most important relationship in the property market, the one between rents and house prices. When rents are stable, then house prices should adjust in such a way that the annual rental income (explicit if you’re a landlord, implicit if you’re an owner-occupier and thus saving by not paying an equivalent rent) represents what would be regarded a “very healthy savings rate” on a deposit account: something like 6%.

This is an important extra step over the incomes approach as rising incomes will be reflected in rising rents, while changes in the financing environment will be reflected in what a “health savings rate” looks like: that may have been 12% in the early 1990s but now might be 6%, now that Ireland is in the low interest environment of the Eurozone.

Figures on rents are even harder to get than figures in household income and I’ve only been able to get numbers back to 1996. Nonetheless, over the period 1996-2002, the average yield was about three quarters of a percentage point above the average mortgage interest rate, which was 6%. By coincidence, 6% is the ballpark long-run rate of interest that I think will prevail in Ireland over the coming generation. Thus, we can use that 6.75% yield – and figures on rents up to this year – to calculate an alternative equilibrium house price from 1996 on.

Property prices compared to rents and incomes in Ireland
House prices in Ireland adjusted for inflation, incomes and rents, 1975-2011

This is shown in the third graph above. While it varies more than the income metric, we can see that it starts and ends very close to the income metric. In particular, it also suggests that the typical house price in Ireland now should be of the order of €150,000, or a fall of 60% from the peak. There are no certainties in this world: these numbers change if you change your beliefs about what income ratio or yield should apply, or if you have a different outlook about income or about rents. But the fact that both metrics suggest that house prices in real terms should currently be about 50% above their pre-1995 level, adjusting for inflation, is noteworthy – particular given that prices are still about double their pre-1995 level.

Are we nearly there yet?

So the graph above suggests that Ireland’s property market adjustment is about three quarters complete. How much longer will all this uncertainty and falling prices take? Clearly, that’s not just unknown, it’s unknowable right now. All prospective sellers and buyers could in theory read this post today and go off and make sure their ask or offer at 60% below the peak tomorrow. Would that solve things? Probably not without an easing of credit conditions, as would-be buyers find it very difficult to get credit at the moment.

It’s also very unlikely that all sellers and buyers will do this. It’s much more likely that what has happened over the past four years – quarter on quarter falls of about 4% – will continue. If that happened, the average house price would reach €150,000 in early 2013.

One of the important features of the housing market, though, is that Dublin and its surrounding counties have seen significantly larger falls from the peak than the Western seaboard, up to 55% in Dublin city centre. Not only that, the Dublin market also looks healthiest when looking at current time-to-sell and the stock sitting on the market. If 4% quarter on quarter falls continue, Dublin city centre would reach the bottoming out level of 60% below the peak in the first quarter of 2012, while those areas that have seen 50% falls so far would reach that in the final quarter of 2012.

Elsewhere, prices are about 40% below the peak and have been falling at about 3% per quarter. If that were to continue, these areas would reach the house prices suggested in the graph above in the third quarter of 2014.

PS. This hopefully gives some meat to the bones of the predictions accredited to me in NAMA Wine Lake’s convenient table of property market calls.

  • Treasa ,

    I’d be interested, if you have the data, Ronan, in a graph of property value rises in Dublin plotted against property value rises outside Dublin with a corresponding graph of values on the way down.

    Obviously I am bitter and twisted in my memories but I recall being told by the wannabe experts that Dublin would not be so badly affected by the property crash because of location and demand, something which I always doubted because property prices had risen disproportionately in the Dublin area.

    It looks, at present, that I was correct that Dublin would be badly affected – and today it certainly seems to have suffered more of a correction. I wonder if the disparity in correction between Dublin and the country as a whole was also matched on the way up.

    • Des Doris ,

      Hi Ronan,
      thanks for a very interesting piece.
      As a matter of interest is the data on “time to sell” available anywhere?
      All the best
      Des

      • Clare ,

        Excellent work – an interesting & compelling analysis.

        • Ronan Lyons ,

          Hi Des,
          We do monitor the “typical time to sell” of properties coming off the daft.ie site. For Dublin, it’s currently about 4 months, while at the other end, in Connacht-Ulster it’s about 12 months. Both of those mark a small improvement on the time to sell a year ago. I should do a post looking just at time to sell – thanks for the suggestion.

          @Treasa
          I remember that too – the idea that being inside the M50 insulated you from any property market risk. I also think the PTSB index does show that Dublin rose more over the decade to 2007. That is a different question, though, to whether it will fall more from peak to trough, as in addition to demand factors (where are the jobs?) you also have supply factors (where were the excess homes built?). In terms of proportional oversupply, the Upper Shannon was by far the worst area of the country, while the five cities were the least affected.
          I also think that the prices that matter most are relative prices. So if Dublin falls back to €300,000, other parts of the country (particularly but not exclusively those where people commute to Dublin) will be scaled relative to that. Currently the average price in Limerick city is higher than in Dublin city centre. While some of that is explained by average property sizes, that doesn’t sound sustainable in the long run to me.

          Thanks for both comments,

          Ronan.

          • Dreaded_Estate ,

            Excellent analysis as always Ronan.

            The 25% additional falls indicated by the rent and income measures are to return the current prices to the long run average.

            Isn’t it usually the case in bursting bubbles prices generally over shoot the long term average on the way down.
            Given the lack of credit and oversupply in many segments of the market I think this could be very for Ireland.
            This could push out of the potential bottom by as much as 12 months and the total drop from current prices by 10% to 25% imo.

            On the Dublin prices vs the rest of the country the CSO published this for 2007 (a little out of date given the collapse we have had but the relative levels should hopefully still be relevant)
            “Mean Annual Earnings by Area of Residence, Sex, Year and Statistic”

            State – €35,607
            Dublin – €39,487

            That would indicate a 10% premium for Dublin incomes over the national average. Do you think we should a similar premium for Dublin houses Ronan?

            • Mark ,

              Ronan,

              Interesting analysis but I feel you’ve left out one huge factor – the effect joining the Euro had on mortgage rates in Ireland. You mention 1995 as a possible start of over-valuation of Irish property however, it’s interesting to note that from 1975 to 1995 the average mortgage rate in Ireland was 11.55% whilst since 1995 they’ve plummeted and have averaged less than 5%.
              If nothing else changed, would you not expect that fall in mortgage rates to result in an increase in real house prices?

              Looking at your graph of real house prices, and assuming this were a suitable indicator of under or over valued prices, we can see that house prices appear under valued around 1975, a time when interest rates were 12%-13%, i.e. above 20 year average of 11.55%. House prices then increased in real terms up until 1978 by which time mortgage rates had fallen to approx. 9.5%. As mortgage rates once again began to increase, up to 16.25% by 1981 and 1982, real house prices tumble and only recover as mortgage rates once again fall, 9.25% by 1988.

              By 1995 mortgage rates were approx 8.0%, falling to 5% by 1999 when we joined the Euro. Given how much we can see real house price move in the 70s and 80s when interest rates changed, can you really compare real prices over the 1975-1995 period with post 95 prices without adjusting for our joining of the Euro and subsequent effect on mortgage rates?
              How much, if any, of the increase in real prices in the late 90s / early 2000’s do you think is down to us joining a lower interest rate environment as opposed to the bubble?
              At 11.55% a 100k mortgage over 20 years costs over 1,000 p.m to repay but at 5% this falls to approx 650 p.m. and that doesn’t even factor in the increasing mortgage terms now available. Would you not expect the house price to income ratio of 3.6 you mention to increase as the cost of repaying that multiple tumbles?

              You mention the trend in real house prices in the US and Amsterdam but did they ever experience a significant shift in their interest rate environment similar to that experienced by Ireland when it joined the Euro?

              • Dreaded_Estate ,

                @Mark
                Long term German interest rates would have followed a similar pattern to Irish rates but at a lower level.

                http://www.windsurf-schmidt.de/hypzins1.htm

                So while we have experienced a large drop in mortgage rates since joing the € so have lots of other countries and very few experienced the type of property bubble Ireland did.

                Global interest rates are record lows the UK 0.5% rate is still the lowest in 300 years. So the only way it up from here

                • Ronan (a different one!) ,

                  “falling property prices mean greater negative equity, which drags down economic growth for us all by affecting household spending.”

                  I dont see how being put further into negative equity would effect household spending. The mortgage does not change – the householder might feel a bit gloomier because their property is not worth as much as they are paying, but if they are not considering selling in the short term – how does the extra negative equity affect hosuehold spending?

                  • Rick ,

                    Hi Ronan,

                    Great article. I wonder though if perhaps you should give more weight to supply/demand when considering when house prices will stop falling.

                    The census figures last week showed the population of Dublin had increased from 2006, with the vacancy rate of accommodation decreasing. You can see from the Homebond statistics that there are virtually zero new housing starts. I would have thought these factors may correlate to create, dare I say it, a supply shortage and hence a price increase in the short term (at least in Dublin).

                    I know from my own experience of trying to buy a house over the last year that houses are selling (we were actually gazumped (gasp!) in January). I know apartments are a different story. Be interested to hear your thoughts.

                    • John Mack ,

                      A truly useful look at reality, in contrast to oratory.

                      What about the coming austerities/ How will the shrinkage of Irish wealth affect this analysis?

                      To track any correlation between the fall in house prices and austerity, I wonder if you could do this every year or every two years. Of course there may be a point where foreign individuals or corporations start buying up Irish properties, making he property prices increase again.

                      • Paul Mara ,

                        Hi Ronan

                        Thanks for another very interesting blog article.

                        I wonder about what you say on the first graph where you mention “they would still be overvalued by almost 50% if this rule held true”. I wonder do you mean “they would still be overvalued by almost 100% if this rule held true”?

                        About the price ratio, I was wondering how you feel about wages in future years? Do you think the price ratio will remain roughly where it is and/or possible go up? As we are in difficult times, would it not seem more likey for wages to go down and so affect the price ratio graph?

                        With the rent graph, I though the purple line was interesting. It seemed to be going down and then seemed to flatline. Do you think that average rents have now reached their bottom? Could some other factor be affecting it? I’m not sure where you got the rent figures but I remember reading somewhere that government rent supports might affect 50% of rental properties. Do you think that factor could be affecting the rental line in the graph? Could government supports be creating an artifical bottom on rental prices given that the other lines all seem to be trending downwards?

                        Thanks again

                        Paul

                        • Dan ,

                          @Ronan
                          The only place I could fault your projection, is that it’s missing one key constant: lending.

                          Currently 4 in 5 mortgage applications are being refused. With Ireland on track to owe something like 1/4 of a trillion by the time the lines in your second graph meet in the third quarter of 2014, it’s highly probable that this won’t have improved , saying nothing of default.
                          There has been huge capital deposit flight, and the customer deposit flight is underway, thanks in no small part to the FG private sector pension levy.
                          I expect another tranche of bank recapitalization by 2014 and lending has to keep shrinking until it’s sustainable from customer deposits.

                          But lack of lending is not something you can really measure ex ante, to be fair (or mass mortgage default).
                          So I would simply say, your graph is best case scenario.

                          @Mark,
                          I disagree with the interest rate being cited PTSB are already @ 10% on 10 year, with an LTV of x<50%
                          ECB rates may sit @ 6%, but in order to make a profit/repay the ECB, Irish institutions will be along the lines of 10% minimum.
                          That ECB rate is meaningless unless you have a tracker.

                          • Mark ,

                            @ Dreaded Estate

                            I’m not saying that the reduction in interest rates could explain all the real increases in house prices, there was obviously a massive unsustainable bubble, but reductions in mortgage rates must explain part of the increases. I’m wondering if anyone can quantify how much of the increases could be attributed to the mortgage rate reductions and how much purely bubble.

                            In relation to Germany – The cost of reunification to date is estimated to have cost the German tax payer €1,600bn, unemployment has soared, industrial output in East Germany has virtually disappeared, tens of thousands of properties have been knocked as cities in the East have become deserted. The German economy stagnated for over a decade hence their need to keep interest rates so low when they joined the Euro. Authorities thought Berlin would double in size and started a massive building project but it was only last year that the population exceeded that of 1989 leaving thousands of empty apartments in a city with over 1/3 of the population on welfare. Taking all that into account, are movements in German property prices over the past 20 years to use as an example? I don’t know but I suspect not.

                            @ Dan
                            AIB variable rates are currently 3.5%. I don’t expect them to stay there, I’d expect a long term rate of 5.0%-5.5% to be more likely. I really can’t see ECB rates rising another 4% any times soon, maybe another 1%-1.5% over the next 2 years.

                            My point is that if you believe that 3.6 was an appropriate mortgage to income multiple to use between 1988 and 1995 when interest rates averaged 9.75%, what is appropriate when interest rates are likely to average 5%-5.5%.
                            At 9.75% somebody on the average wage borrowing 3.6 times earnings would be spending approx. 40% of their disposable income on mortgage repayments.
                            At 5.0% you could borrow approx. 5.7 times your earnings before your repayments took up 40% of disposable income.
                            (this ignores reductions in taxes, widening of bands etc since 1988).
                            So which is more appropriate to use, the mortgage to income multiple or the % disposable income spent on mortgage repayments?

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                              • vincenzo ,

                                Hi Mark

                                I have the impression that you are missing the point that what counts is the real interest rate not the nominal one.If you are paying an interest of 15% on your mortgage but your salary goes up every year due to inflation, in real terms you are not really paying 15% interest on your mortgage. So a comparison with a mortgage of 5% and zero inflation does not really make sense. The point I want to drive home and that is supported by 60 years of data for the whole UK market is that interest rates do not affect the relationship between house prices and salaries.Hope this helps

                                • Taipeir ,

                                  No mention of mortgage rate changes, rates are near historical low now. It’s my impression, excuse me if I am wrong, that house prices are correlated with both easy access to credit AND cheap money i.e. low interest rates.

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                                    • Laura ,

                                      Ronan, I think you missed out on 3 factors (though rightly you pick up on where the jobs are and where the services are).

                                      1. Prices rose in Dublin before anywhere else. I recall spending 6 months working in Wexford in 1997, and a townhouse could be had for IR30k. Even then, in Dublin there was little to be had under 100k and trophy properties in Dublin 6 were meeting the 1 million mark. This didn’t really happen in the rest of the country until 99-2001

                                      2. Dublin has no holiday homes and less MacMansions (i.e. jumbo properties). Very remote areas have often got a disproportionate level of MacMansions of both residential and holiday home variety which would inflate local averages. One exception to this is the cut of land between the M50, the M1 and the N2 – you will find a large number of MacMansions in that chunk of north county Dublin with attached jumbo price tags.

                                      Its actually something worth doing a study on in its own right.

                                      3. I don’t think incomes are a primary factor in rent determination – they were more so in the late 90s. Two strong factors is social housing demand and SWA rent allowance subsidies. It is worth pointing out that rents declined marginally around 2002-2003 despite rising incomes as a result of the impact of a series of caps and restrictions imposed on Rent Allowance applications.
                                      (You could argue that without the additional cuts in rent allowance rates in the last 2 years, rents would have actually risen).

                                      • fravo ,

                                        Great article Ronan — just saw it via the link on IrishEconomy.

                                        The “equilibrium rental yield” approach makes great economic sense. But surely a home owner gets two benefits: (a) rental payments avoided and (b) appreciation of (equilibrium) house prices.

                                        So if we expect house prices and rents to grow in line with incomes (say 1% real plus 2% inflation) then isn’t a house a good deal at 3% yield when (nominal) interest rates are 6%?

                                        You might also want to adjust for the difference between gross and net rents (the home owner gets the gross benefit of rent avoided, but also has to pick up the costs the landlord would otherwise have paid – so he needs a net yield of 3%). If these are say 1/3 of rents we are left with an equilibrium gross rental yield of 4.5%.

                                        Daft’s Q1 Rental report showed yields already above that level in much of the country …

                                        • Sporthog ,

                                          Another very interesting article from your good self. However I have a question.

                                          If house prices keep falling, at what point will it be uneconomic to build a new house?

                                          I realise that a number of factors are at play, however will a point be reached where it is cheaper to buy a second hand house than building a new house from scratch.

                                          After all energy costs + taxes have increased, it must be more expensive now to produce cement + blocks + bricks than in 2006.

                                          I believe the insurance industry has different bands Euro/ square foot plus some other factors such as No of bedrooms, and location in calculating a estimate of what a house is worth. Does not take into account the land or services connection.

                                          I suspect the market will overcorrect itself with regard to property prices. After all if a house costs 130K to build, but is selling for 90K second hand, is that sustainable?

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                                                        • niall ,

                                                          It makese sense for the average house price to reverse all the gains from when Ireland joined the €. i.e €120k and borrowing costs became dangerously low. I can not envisage a scenario where you do not have overshoot on the way down versus the expected value discussed in this piece. Ireland has €150bn of mortgages (including securitizations). The number of houses in the country is 1.4mn. so on that basis 1.4mn * €120k = €168bn of housing stock. I don’t think we will see a situtation where the housing stock is bottoms at a value greather than the mortgage debt by the time this is all done. even though we all acknowledge how that debt is distributed by area and demographic. i.e younger people leveraged up. Of course that does mean we could see debt destruction. Which the bank balance sheets can not handle without outright nationalisations and further bailout.

                                                          • Casaprivati.net ,

                                                            In Italy situation is similar, but not hard like in Irish market. We think just in this period have touch the bottom, but is not certainty. Big city like Milan and Rome decreased not very much, conversely the interland and little village in real terms fallen very much.

                                                            House seller’s confidence is negative for the future. Let’s see what happen, always with trust!

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