A couple of weeks ago, Philip Lane, the Governor of the Ireland’s Central Bank, suggested while appearing before an Oireachtas committee that Irish house prices could fall in coming years. The comments generated a lot of interest, given his role. In particular, he said that a combination of factors could combine to not only halt price rises but even bring down sale and rental prices. These factors, he suggested, were increased housing supply, including of student accommodation, higher interest rates, and potentially higher unemployment due to Brexit.
How much weight should we put on the Governor’s comments? Some thought the Governor even mentioning price falls means that he sees this as likely. Others, however, see in his remarks the typical economist’s way of seeing the world: many possible outcomes – one of which is falling prices – so why deny that?
To get a sense of just how much weight to put on the potential of housing prices – either sale or rental – falling in the coming years, it is important to understand the forces that push them up and down. In brief, there are five forces that affect average house prices, three of which also affect rents. The first three factors affect both sale and rental prices and are what you might term fundamentals, as they reflect the real economy. The first is household income. This captures both average income per worker and also the number of workers per household (i.e. unemployment).
When the Governor spoke of Brexit being a force for lower house prices, he was referring to this channel: that due to the British economy cutting itself off from its closest trading partners, the Irish economy – as its single closest trading partner – would be affected enough that incomes would fall and unemployment would rise.
The second factor, again a fundamental one affecting both sale and rental prices, is demographics. This is best measured as the number of persons per household. In Ireland, there has been a steady fall in the average household size over the past half-century, although one that has paused in recent years, due to a lack of housing.
But in big picture terms, it is hard to see how Ireland will do any other than slowly follow all its peers towards a smaller average household size. If over coming decades Ireland’s average household size falls from 2.75 people to something like 2.25 people, this creates a need to produce over 10,000 new homes – mostly urban apartments – each year.
The third and final fundamental is housing supply. This is best thought of in euro terms, rather than in number of dwellings, as a rural cottage and an urban apartment may have very different values.
But for simplicity, let’s think of housing supply as the number of dwellings. Construction is simply the addition to the stock of dwellings. Although it is important to remember that at least some construction merely offsets the obsolescence of other, older properties. In Ireland, a country with roughly 2 million dwellings, at least 10,000 – and perhaps as many as 15,000 – homes are likely to fall into disrepair each year.
Adding obsolescence on top of the various sources of demand, the country needs at least 40,000 and closer to 50,000 new homes a year. Granted, this is certainly less than the 80,000 or so new homes built at the peak of the Celtic Tiger. But it is more than twice the number of new homes started in 2017.
So for an over-supply to contribute to price falls, rather than a shortage contributing to price rises as has been the case since 2012, the building of new homes would need to more than double in the coming two years. And this itself is assuming that none of the backlog in unmet demand since 2012, either sale or rental, needs to be met for prices to fall.
Various commentators believe such an increase in housing construction is simply not possible, given capacity constraints in the sector. Where would all the new construction workers live, for example?
The final factor mentioned by the Governor is interest rates. And this brings up the difference between sale and rental segments. Unlike rental homes, owner-occupied homes are assets as well as consumer goods. Given the favourable tax treatment of the family home, it can be very profitable to concentrate your wealth into housing.
This potential for capital gain – or indeed capital loss – looms large in the minds of would-be buyers and sellers. In surveys over the last 15 years, those active in the Irish housing market have expected everything from 10% gains a year for the next five years to 10% falls per year.
This are huge numbers compared to the equivalent changes in interest rates over the same time. Mortgage interest rates have barely budged since 2008 and have been between 3% and 5%. This is not to say that mortgage rates are irrelevant. Far from it.
But mortgage rates are only one part of the ‘user cost’ of housing and have to be offset by potential capital gains. Since the 1980s, Ireland – and Dublin in particular – has been building far too few homes relative to the underlying need. This has created an expectation of capital gains that may prove tough to shift, even with the bubble and crash we’ve witnessed.
The fifth and final factor affecting housing prices is the one Professor Lane did not mention: credit conditions. This was the one that was most responsible for the bubble and subsequent crash in property prices in Ireland 1995-2012. Think of it as the typical deposit required by the first-time buyer.
The typical deposit fell from over 25% in 2000 to just 5% in 2006. But since the introduction of the Central Bank’s mortgage rules in 2015, this property price lever has largely been removed from the equation. Banks may have a greater appetite for lending now than in 2013 but the rules prevent them from repeating the mistakes of the past.
The Governor is right to highlight that property prices are not a one-way bet. However, looking into the detail of the Irish housing system, it is tough to argue – given the tight control the Central Bank itself has over credit conditions and the large gap between supply and demand, that prices will fall soon.
An edited version of this post was originally published in my column in the Sunday Independent.