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.
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.
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.
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.