Ronan Lyons | Personal Website
Ronan Lyons | Personal Website

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Nasty Nick and Decent Dave: how do you measure a problem like rental inflation?

Late last year, new measures were announced to try to limit rent increases, primarily to give tenants – and the Government – some breathing space while issues inhibiting the supply of new homes are addressed. On the face of it, the measures were straightforward: in any area where rental inflation is above 7% for a year and a half, rent increases are now capped at 4% per annum.

There was a bit of a kerfuffle in the first few days, when there was confusion about the formula used to define 4% per annum. And there continues to be political football played with which areas were to be granted ‘Rent Pressure Zone’ status immediately.

Of course, when something becomes legislation, nothing is ever straightforward. What does “area” mean, for example? In everyday conversation, it is fine to talk about Dublin rents increasing by a certain fraction and to include Bray and Greystones in that definition of Dublin, but it an entirely different thing if the law has designated Dublin a rent pressure zone but not Wicklow.

Even if we were clear on what each area meant, things remain less than ideal. What if the Galway market is starved of apartments but has enough family homes? Rental inflation for apartments in Galway could be well above 7% but for houses it might be close to zero. Can rent pressure zones distinguish between the two markets in the same location?

But whatever about these technical worries, there are two more fundamental problems that threaten to undermine the system of Rent Pressure Zones just as it gets underway. The first is that it effectively attempts to control the price of apples while measuring the price of oranges. The motivation for this measure is to protect sitting tenants. However, rent inflation is benchmarked not against rents paid within leases, i.e. by sitting tenants. The RTB measures rents and rent inflation by looking at rents paid by new tenants. These are completely different beasts.

Secondly, what makes this policy such a substantial change from previous policy around rent control is the fact that it applies across tenancies as well as within tenancies. It has been standard, for more than a decade, that while landlords are limited in their ability to increase rents for sitting tenants, when those tenants move on, the rent can effectively ‘reset’ to the market level. This new system shatters that link.

The end result of both these features is best described by the parable of Nasty Nick and Decent Dave. Nick and Dave both own adjoining semi-detached properties as investments and rented them out in 2010 for €1,000 per month. Dave, being a decent bloke, has gone easy on his tenant – a family with young children – and only increased the rent twice in the following six years. The family now pay €1,200 a month for their home.

Meanwhile, Nick, being a different sort of character altogether, has increased the rent as often as the law allowed. The family living there in 2010 are long gone, priced out and living somewhere further out but more affordable. In their stead are four young professionals, who collectively pay €1,700 a month for the house.

Nick’s property, having been on the market a few times since 2010, is what is used to measure rent inflation. Dave’s should enter the calculations for cost of living – after all, his tenants are people too – but the way rents are measured in Ireland currently, the stable rent he offers is not reflected at all in the headline measures.

And the worse the situation gets on the open market, the more tenants in situations like Dave’s are going to stay in their home and enjoy their below-market rent under the radar. This means that, while it may have been the case 15 years ago that the typical rented property changed hands every 12-18 months, many renters are now staying put for 3-5 years. In other words, the more measured inflation in rents goes higher, the greater the pressure to stay put – exacerbating the problem with measured inflation.

It gets worse. Suppose the family living in Dave’s house are moving out to buy their own home. One of the reasons Dave was so lenient with his tenants was that he knew, once they were gone, he would be back to the market rent. This has now been taken away from him. Even though his tenants have moved on, and even though his next-door neighbour is charging a rent €500 more than he is for the same property, the most he charge his new tenants is 4% a year more.

We should not be surprised, then, if Dave decides to sell up. The problem is that, if he sells to another investor, they face the same level of rental income as Dave does. The new system of Rent Pressure Zones has effectively devalued Dave’s investment… unless he sells to an owner-occupier.

Now that Rent Pressure Zones have been introduced, there is likely to be a silent exit from the market of landlords who were muddling through and who thought they were doing the right thing by being nice to their tenants. If they stay in the market, their asset is devalued, so they have a strong incentive to leave by selling to an owner-occupier.

If Rent Pressure Zones are here to stay, the first step in addressing these problems is to better measure rent inflation, by reflecting not only “between lease” rent inflation in the headline stats but also “within lease” inflation. We should not be surprised if this dramatically changes our picture of what has been happening renters since 2011.

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A version of this article appeared in the Sunday Independent Property Section on February 12th, 2017.

Would you rather be fat or tall? Time for Dublin to grow up

The figures from this latest Daft.ie Rental Report make grim reading not only for tenants but for policymakers also. The annual rate of rental inflation – at 13.5% in the final quarter of 2016 – was the highest in the history of the Daft.ie Report, which extends back to 2002. The rate of inflation in rents is high across the country, with only Connacht seeing inflation of less than 10% currently, of all the major regions. (Its rate of inflation is 8.9%.)

Indeed, in 45 of the 54 sub-markets analysed, there is double-digit inflation in rents currently. In Dublin, rents are now rising by almost 15% a year, the highest since the middle of 2014. It means that rents in the capital are now up almost 65% from their lowest point in 2010 and are a full 14% higher than their previous peak at the start of 2008. In the four other cities, inflation has eased back somewhat in recent months but remains between 10% and 13%.

Unsurprisingly, the issue is a severe imbalance between supply and demand. Fewer than 4,000 homes were available to rent across the country on February 1st. While this marks a 10% increase on the same figure a year previously, it is still well below the lowest point for availability during the Celtic Tiger. Then, stock on the market reached its lowest point in April 2007, when slightly fewer than 4,400 homes were available to rent nationwide.

The crucial difference between 2007 and 2017, however, is the size of the renting population. We won’t know for another couple of months how many households in Ireland rented at the time of the 2016 Census, but it is unlikely that the number then is less than the number in 2011. At the time of the 2011 Census, roughly 475,000 households lived in rented accommodation, just under 30% of the total. In 2006, there were just 145,000 households in the private rented sector, together with a further 155,000 in the social rented sector.

It is likely that much of the growth of roughly 150,000 extra renting households between 2006 and 2011 was the private rented sector, given the limited social housing available in recent years. Thus, the private rented sector doubled in just five years – and may have increased further since. And yet, instead of availability doubling, it has fallen, even compared to the worst days of the Celtic Tiger. And in Dublin, the problem is most acute.

Recently, the Government launched a consultation period for its National Planning Framework. This will be the successor to the National Spatial Strategy, which aimed to develop a system of gateway towns and hub towns around the country. Much of the media discussion around the launch focused on the idea of Dublin “eating up” the country and how policymakers should focus instead on ‘balanced regional development’.

While policy can help a city thrive, it is foolish to think that politicians have control over the economic forces at work in determining city size. Indeed, one of the most remarkable laws in economic geography is known as Zipf’s Law. It states that the biggest city in an economy is on average twice as big as the second biggest city, three times as big as the third biggest, and so on. This is true more or less all over the world, with – if anything – the world’s largest cities being too small, rather than too big.

Some respond to this with “Ireland is different”. In some ways, it is. Dublin is more than twice as big as Cork. But the same holds true for Vienna in Austria and Budapest in Hungary. What all these countries have in common is that their current borders do not match their past ones. The island of Ireland is a much more natural economic unit than the Republic and the North are individually. And sure enough, once Belfast and Derry are included, Zipf’s Law starts to look like a much better description of Irish cities.

What does this have to do with policy? It means that population is not a game of redistribution. Trying to redirect people from Dublin to other cities in Ireland merely stunts the growth of the country as a whole. If you want to stimulate growth in the fifth, fifteenth and fiftieth biggest cities in your country, you should encourage growth in your largest, not try to stop it.

This does not mean, of course, that sprawl should be ignored. There is absolutely no reason for Dublin to take up nearly as much space as it does. Greater Tokyo, with a population of over 27 million people, fits into 9,000 square kilometres. Greater Dublin, with a population of less than 2 million people, takes up almost 6,000 square kilometres.

Dublin can drive population growth across the country without “eating up” the countryside. For this, though, three things need to happen. Firstly, Dublin needs to be allowed to grow up. Height limits of between four and six storeys in one of Europe’s fastest growing cities merely translate into lost jobs and higher rents. After all, why be fat when you can be tall?

Secondly, homes need to be built on brownfield, as well as greenfield, sites. Looking around Dublin, it is littered with grossly underemployed land, in the form of army barracks, golf clubs and bus depots, built on the fringes of the city in the past but now in prime central locations. A land tax would help achieve this reuse of our scarce and valuable urban land.

But, even if these regulatory changes were brought in overnight, we still would not see the apartments being built that are needed to stem rental inflation. And the main reason for that is the extremely high cost of construction in Ireland, compared to other high-income countries. An audit has been promised – let’s hope it delivers.

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A version of this appeared as the commentary to the 2016Q4 Daft.ie Rental Report, released on February 14th, 2017.

How to build enough homes

6,200 newly built homes were sold in Ireland last year, an increase of almost 100 on the total for 2015, and twice the number of new home sales seen in 2011, 2012 and 2013. Given the early part of 2015 was period of significant activity – as borrowers rushed to use their mortgage approvals from before the Central Bank rules – the fact that volumes increased again in 2016 can only be viewed as a good thing.

So far, so good. However, the bulk of what is being built still does not come on to the market. When the final figures come in, it is likely that 2016 will have seen 15,000 new dwellings completed. Thus out of every ten dwellings built, only four ever come on the market – the other six are self-builds. Indeed, of the 80,000 new dwellings completed since the start of 2010, just 32,000 have come on the market.

This huge gap is not normal – in most countries, the bulk of new homes built would be for the market, rather than self-build. It reflects a long-standing problem with land usage in Ireland. Those building for themselves often do so on family land, which is free, or else as one-offs on cheap land far away from urban centres. Such building imposes huge costs on the rest of society, with knock-on effects for services, such as healthcare and broadband, which rely on density to be cheap.

Overcoming this problem will require a fundamental rethink about how we use land in Ireland. One aspect of this is about regional development. A narrative has emerged that “Dublin is too big”. This misses the point completely that in any economy, and certainly in an economy the size of Ireland, leading cities determine the size of the rest of the economy: in simple terms, if we want our fifth, fifteenth and fiftieth biggest cities to be bigger, we need our biggest city to be bigger. This is not something we get to choose – these are the laws of economic geography.

In addition to rethinking the role of our cities, we also need bottom-up measures that encourage far better use of land. As I’ve written previously in this column, our cities and towns are riddled with “last use” rather than “best use” examples of land usage, with army barracks, industrial estates and bus depots taking up sites that would be far better used for residential or commercial purposes. To encourage public and private organisations to use land better, we need to introduce a land tax – a measure that would also penalise speculation, land hoarding and cynical vacancies.

But that is only part of the problem. A far bigger part of the problem is not that there are 9,000 self-builds but that there are only 6,000 dwellings built for sale. In a country growing as rapidly as Ireland, between 40,000 and 50,000 new homes are needed each year. Allowing 10,000 of those to be self-builds, this means that construction of homes for sale needs to be roughly five times the size it is now.

And that huge gap between what is needed and what is happening is due largely to the high level of construction costs in Ireland. This refers to hard costs, so issues around profit margins, VAT and site costs are contributing to this. Experts say that it costs roughly 50% more to build a home of 100 square metres in Ireland than in other parts of Europe. This is the nub of the problem.

The second half of 2016 saw two important changes to the housing market. Firstly, first-time buyers of newly built homes were given access in the budget to their past income tax, of up to €20,000, to lower the deposit needed. Secondly, that minimum deposit requirement for first-time buyers was lowered even further by the Central Bank. These measures will boost prices and, in so doing, the argument goes, stimulate new supply.

Unfortunately, such measures do not address the underlying problem in the new home segment today. Ireland – with its rapidly declining average household size – desperately needs new homes other than three- and four-bedroom semi-detached houses in estates. It needs student bedrooms near universities, central apartments in high-rise blocks for young professionals, and suburban mid-rise apartments for well-to-do downsizers, as well as many more types of home.

Until the high cost of building in Ireland is addressed, though, we are likely to see only baby steps towards a sector building at least 40,000 dwellings per year. The Minister for Housing announced an audit of construction costs in Ireland, compared to its peers, last October. The results of that study can’t come soon enough!

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A version of this appeared in the Sunday Independent Property Section on February 6th, 2017.

Property in 2017 – the year ahead

2016 saw a number of important policy shifts in relation to property in Ireland, particularly in the final few months of the year. The first was creation of a Cabinet-level Minister for Housing, a sign that – with the change of government – the severe shortage of housing was finally being taken seriously by those in power.

The second substantive change was the long announcement, from about mid-summer until the Budget, of “help” for first-time buyers of newly built homes in the form of a tax rebate. This kicks off in earnest with the new year and is likely to combine with the third change. This was the revision of the Central Bank’s mortgage rules, which came through in November. These revisions mean first-time buyers no longer require a deposit larger than 10%, even if they borrow more than €220,000.

Combined, these two measures create something of a two-tier market. Take two otherwise identical families, on the same household income and with two young children. Their only difference is that one rents the two-bedroom apartment they live in currently, while the other owns it.

Both families are looking to buy a newly built family home in the Greater Dublin Area, at a cost of €400,000. The family that own their apartment will need to produce a deposit of €80,000 (20%), while the family that rent their apartment will – once the tax rebate is factored in – need a deposit of just €20,000 or 5%.

In terms of how this will affect the market, both the rebate and the change to Central Bank rules will have the effect of further stimulating demand and thus pushing up prices. In a way, they are complementary measures. The tax rebate will have the biggest effect on cheaper new homes (those costing between €200,000 and €400,000), while the rule change will have a bigger effect on more expensive homes, including second-hand ones.

Either way, the expectation for the year coming is for a return to house price inflation in Dublin after something of a two-year pause, with average prices in the capital increasing by just 4% between early 2015 and late 2016.

Increases of at least 5% and probably closer to 10% will also be expected in the rest of the country, as strong demand interacts with a lack of supply. The country needs at least 40,000 new homes a year – and probably closer to 50,000 once obsolescence and immigration are factored in. But the current hope is to get construction of 25,000 new homes by 2021.

There is an excessive focus on the “starter home”, however. In fact, when you look at Ireland’s demographic structure, there are close to enough family homes in the country to cater for our families. What Ireland lacks – more than any other high-income country – is apartments.

This shortfall is unlikely to be addressed in the coming year, however, as the cost of building apartments is prohibitive, compared to average incomes. The break-even monthly rent for a two-bed apartment – even with free land – is roughly €1,600 but in most parts of the country, a two-bed rents for less than half this.

So, while there will be a fuss about the vacant site registers (and in time the vacant site levy), until the hard costs of construction have been dealt with, expect little improvement in the chronic lack of accommodation for one- and two-person households. Government Ministers lodging complaints against developments in one of the small number of areas where apartments are viable certainly doesn’t help.

One area that has recovered somewhat in recent years and is likely to continue to strengthen in 2017 is purpose-built student accommodation. Ireland is in the middle of a long higher-education boom. This appears to have been missed by the Higher Education Authority: a 2015 report of theirs predicted student numbers to rise from 168,000 to 193,000 in the decade to 2024. Instead, there are likely to be 193,000 students as early as this September, seven years ahead of schedule!

In that context, all new purpose-built student accommodation is welcome, even if it will only really cater for better-off students. The reason this is the case is the same problem that bedevils residential construction in Ireland currently: how expensive it is to build. Looking at the pipeline of student accommodation, it is likely that this will be only just enough to meet new demand and will do little to take existing students out of the general private rented sector.

So 2017 is likely to be another year of very strong demand for all types of residential property: sales, rental, new, second-hand, urban, rural, houses, apartments, student living and assisted living. It is also likely to be yet another year of weak supply in all these segments.

Solving this would mean dramatically reducing the cost of building a home – by something like 35%. Even if the causes of this cost gap are identified, it is likely to take a year to bring costs down and then a further two years before these lower costs translate into anything like the level of construction the country needs.

So don’t be surprised if there’s a similar-sounding piece this time next year!

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This piece originally appeared in the Sunday Independent on January 8th, 2017.

Supply, supply, supply: the new housing mantra

Below is my commentary to the latest Daft.ie Sales Report, which reviews the market in 2016. Its overall point is that Ireland needs roughly three times as many new homes to be built per year as is currently the case.

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Nationally, the average list price rose by 8% in 2016, very similar to the 8.5% seen in 2015. Compared with static prices in 2013 – although this masked huge regional differences – and an increase of almost 15% in 2014, perhaps this, then, is the new normal. The graph below shows the number of markets (out of a total of 54) that fall into one of four categories: falling prices (in year-on-year terms), rising slightly (0-5%), strongly (5-10%) or unsustainably (above 10%). As you can see, the most common change has gone from falling (the blue line; pre-2014) to 10% increases (red line; 2014 and 2015) to 5-10% increases in the last couple of quarters. The green line (0-5% increases) only briefly emerged as “normal” before fading away in recent quarters.

House price changes, by market, quarter and inflation bracket
House price changes, by market, quarter and inflation bracket

Normal does not mean healthy, however. We know that in a healthy housing system, any extra demand for more housing is offset by more supply – in other words, the real price of housing should be stable, once general inflation is taken account of. In Ireland, general inflation has effectively been zero not just over the last 12 months but indeed over the last decade.

So Ireland is currently trapped in a situation where housing prices are increasing far faster than prices in the rest of the economy. This is not sustainable but the latest indications are that this high rate of inflation is embedded in the market, due to strong demand and weak supply.

We know from the initial Census results that the country added 170,000 extra people between 2011 and 2016. Given the likely composition of new households – between 2 and 2.5 people per household on average – this means that the country added almost 75,000 new households in those five years.

We know from the same source, the Census, that there were just 17,000 new homes added to the stock of dwellings in the last five years, once holiday homes are excluded. In other words, for every ten new families formed, just two new dwellings were built, for the entire period from 2011 to 2016. (Completions numbers were much higher than this, but this includes properties built during the bubble and only connected to the electricity grid more recently. It is also a measure of “gross” construction and doesn’t account for buildings going obsolete.)

Bad as that may seem, the picture is worse again. Firstly, the period 2011-2016 was largely one of net emigration, with 125,000 people leaving between 2011 and 2015. There is a clear move toward net immigration, though, emigration falling from 90,000 to 75,000 since 2013 while immigration has risen from slightly more than 50,000 in 2012 to 80,000 this year.

Migration is driven by those in their 20s and 30s, in other words the very groups forming households and starting families. Based on the 2011 Census, we know that every additional 10,000 migrants require on average 4,000 dwellings, so even if net migration remains relatively low – at say 20,000 a year over the next few years – that will add 8,000 to the number of new homes required annually.

This is in addition to the core demand resulting from “natural increase”, in other words a surplus of families being formed over families dying. A fast way of checking the size of this natural increase is to compare the size of the cohorts of women aged 30 and 80. There are roughly 35,000 women aged 30 in Ireland currently, which gives a good baseline of household formation – ultimately, the vast majority of these women are likely to be part of one household each. There are just 10,000 women aged 80. Thus, there is a natural increase in number of households each year of at least 20,000 and closer to 25,000.

On top of this, demographics are changing – not least, people are living longer. Coupled with other factors, including a greater fraction of people who do not have any children, separation and divorce, Ireland’s average household size has fallen from more than 4 people in 1971 to roughly 2.7 people today. However, it is still the highest in Europe, where the average is just 2.3.

This may sound like a small difference but it is hugely important for how many new homes are needed per year. For example, if Ireland’s population did not increase but the average household size fell from 2.7 to 2.3, an additional 300,000 dwellings would be needed. Realistically, that convergence will take time, but it is likely that declining household size will add at least 10,000, if not 15,000, to the number of new homes needed each year.

The last factor when figuring out how many new homes are needed each year is one that is most often forgotten: obsolescence. The Department of Housing and CSO estimate that roughly 0.8% of the housing stock goes obsolete each year: in other words, the typical dwelling lasts about 125 years. This means that, every year, about 16,000 dwellings fall out of use.

That figure seems somewhat high and, while 125 years may be an accurate guide for rural cottages, urban properties typically remain in use due to renovations. But even a depreciation rate of 0.5% a year would mean 10,000 dwellings are needed annually just to stand still.

Adding all these up, there are roughly 10,000 dwellings needed each year to offset obsolescence, a further 10,000-15,000 needed to accommodate Ireland’s smaller households, between 20,000 and 25,000 on top of that to house the natural increase – and to top it all off, likely a further 8,000 or so due to net migration.

In total, Ireland needs at least 40,000 new dwellings a year and probably closer to 50,000. These will be concentrated in and near the urban centres and will be disproportionately homes for one- and two-person households, such as apartments, downsizer homes and student accommodation. As the latest figures show, without this kind of supply, we will all have to spend more and more of our income just to have a home.

When does a housing bubble start?

Yesterday, former Minister for Finance Charlie McCreevy appeared before the Oireachtas banking enquiry. His refusal to answer whether or not he believed Ireland suffered a property bubble that burst in 2007 was not only great TV, it also brings up some important issues. For example, the Irish Independent reports:

The conflict arose when Mr Doherty asked the former minister if he believed there had been a property bubble in the previous 15 years before the financial crisis. Mr McCreevy insisted he would only answer for his time in office and there had been no property bubble during that time… [after legal advice] Mr McCreevy said from 2003 to 2007 house prices grew at an extraordinary rate. He supposed that was a bubble. But he said: “I don’t believe the policies I pursued helped to create that bubble.”

The clear implication is that Mr McCreevy believes that, if there was any housing bubble at all, its roots do not lie in decisions made in the period 1997-2004, and that in reality there was no bubble at all. Given the title of my doctorate at Oxford was called “The Economics of Ireland’s Housing Market Bubble”, you might not be surprised to learn that I disagree.

First, I think it is important to note that there are two ways of diagnosing bubbles. They can be thought of as statistical bubbles and economic bubbles. A statistical bubble is one where the growth rate in the price of an asset, such as housing, grows at a rate that is unsustainable for any reasonable period of time. Between 1995 and 2007, house prices in Dublin increased by 300% in real terms (i.e. stripping out inflation), or 12.2% a year. Between 1997 and 2004, McCreevy’s term in office, the increase was 136%, or 13.1% a year. (Nationwide figures are comparable, although slightly lower for the period as a whole, although not necessarily in every year.) Thus, by any statisticians metric, it was a bubble – put another way, if 12% growth had continued for 25 years, a house costing €100,000 in 1995 would have cost €1.7m by 2020.

Economists like to get at causes, though, and a 10% increase due to – for example – a lack of supply has very different implications for what policymakers should do than a 10% increase due solely to first-time buyers needing a smaller deposit and thus being lent more. To economists, a bubble in asset prices is not just any old increase in prices, it’s an increase in prices due to excess capital/money. In the housing market, this means too much mortgage credit. Of course, to sustain people borrowing and lending too much, you need expectations. So the two ingredients for an economic bubble are over-optimistic expectations and excessive credit.

The graph below is, in effect, the one-chart summary of one of my D.Phil. chapters: what drove real house prices in Ireland during different market cycles (measured in changes per annum). Falling income (measure here relative to supply), pushed down house prices in the 1980s, together with higher real interest rates (a term that includes house price expectations). This reversed somewhat during the period 1987-1995, which income, as well as demographics (fewer people per household) pushing up prices by nearly 5% a year. Note, however, that credit conditions – measured by the ratio of mortgage credit to deposits – were not pushing up house prices as this time.

Irish annual house price growth, by driving factor, 1975-2012

The period 1995-2001 saw very strong house price growth, driven by a combination of tailwinds, including incomes growing proportionately faster than housing supply. By the time these supply constraints were removed – through the follow-up to the Bacon reports and other measures – borrowers and lenders now expected rapid house price growth. These unrealistic expectations were facilitated by rapidly easing credit conditions. Crucially, almost all house price growth from 2001 to 2007 was driven by a relaxing of credit conditions.

What this means for Mr McCreevy is that it is simply not credible for him say that there was no housing bubble on his watch. Bubbles, driven by asset factors in particular expectations and credit, grow out of booms, when demand outstrips supply. The 1995-2001 boom created the 2001-2007 bubble. A Minister for Finance in 2004 could have tried to burst the bubble, but not prevent it. To do that, the Central Bank mortgage rules would have had to have come in not in the mid-2010s but in the late 1990s.

A post-script. Mr McCreevy has come to be known as a man who strongly believes in pro-cyclical fiscal policy. As he clarified yesterday, as Minister, he believed “When you have it, you spend it.” Exhibit B below is a graph I show my first-year Economics students. It is the average all-in tax rate paid by a household on an average income, by country and year from 2000 to 2007 (source: OECD). At a time when the Irish economy was growing more rapidly  than ever before, the state took a declining share of these higher incomes. I think a strong case can be made that much of the austerity undertaken by Ireland in the period since 2007 would not have been necessary if tax rates had been in line with other developed countries and that Ireland sorely missed a Minister for Finance able to spot that Irish fiscal policy was increasingly unsustainable and take the steps necessary to correct the path.

Average all-in tax rates, by country and year

 

Expectations, credit and house prices

Happy new year to all readers – after an-almost two-year hiatus (or at least severely restricted service), I hope to return to regular blogging this year and have revamped the site to reflect how times have changed since 2008, when “Version 1” launched.

Of course new year means new quarter and new quarter means house price reports… The latest Daft.ie House Price report is out this morning. The PDF is available here. For me, the key takeaway is as follows: house prices fell in the final quarter of 2014 and it seems very unlikely to have been statistical noise or a seasonal effect.

35 areas are analysed in each report. For each of the first three quarters of the year, an average of 32 showed quarterly gains in asking prices. For the final quarter, this flipped, with 30 of 35 regions showing a fall. For Dublin, this was the first quarterly fall since mid-2012. (Given the size of increases earlier in the year, a one-quarter fall still leaves the year-on-year change large and positive: 20% in Dublin and 8% elsewhere.) Broadly speaking, a mix-adjusted analysis of Price Register transactions shows the same. While it is only one quarter, it seems more than just a statistical blip.

For me, the check-list of what matters for house prices contains five items: [1] household incomes, [2] demographics and [3] housing supply (“the fundamentals”); and [4] credit and [5] expectations, these last two being the “asset factors” that can create and destroy housing bubbles. None of the fundamentals changed dramatically in the final three months of the year (the only thing you could argue was a slightly higher volume of listings in Dublin), so the change after September must be due to asset factors.

The Central Bank proposed in October to cap residential mortgages as early as January 2015, although this could not affect prices directly in 2014. So the last remaining candidate is expectations.* The quarterly Daft.ie report includes findings from a survey of housing market sentiment. This survey indicates that, yes, those active in the housing market did revise downward their expectations about future house price growth, particularly in Dublin. Whereas those surveyed in September expected a 12% increase in Dublin house prices over the next 12 months, this had fallen to less than 5% by December. I expect that the Central Bank would be happy if it were the case that their proposals strengthened the link in people’s heads between fundamentals (in particular people’s incomes) and house prices.

As for my opinions on the Central Bank guidelines themselves, I submitted a response to the Central Bank’s Consultation Paper, which is available online here. The TL;DR version is “max LTV good, max LTI bad”. I made similar points at an Oireachtas hearing on this and related topics in late November.

* Some have argued that the end of Capital Gains Tax relief was what drove trends in the final months of 2014. The theoretical reasoning behind this is unclear – it is not obvious that this would affect supply more than demand – while practically speaking, it is also not clear how this would have managed to infiltrate the vast bulk of the market which is not of interest to investors. When asked what they thought was driving house prices, those active in the housing market rarely mentioned tax factors, instead picking credit and supply as the main factors.

Rent allowance and the curse of good intentions

Earlier this week, the Irish Times ran a story entitled “Daft.ie to continue use of ‘rent allowance filter’ on searches“. The thrust of the story was that the Department of Social Protection (DSP) had asked Daft.ie to remove a function that allows landlords to refuse to let to people on rent allowance and that Daft.ie said no. With the local and European elections just around the corner, unsurprisingly politicians jumped on board. Labour TD Aodhan Ó Ríordáin said that he was disappointed over this decision and would like Daft.ie to come before the Social Protection Committee – of which he is a member – to explain themselves. Perhaps summing up the mood for some, a spokesperson for Focus Ireland said: “Can you imagine the uproar if landlords were allowed to say, ‘Travellers or Muslims not accepted’?”

One of life’s big lessons, in my opinion, is that nine times out of ten, if someone else is acting in a way that seems odd to you, you probably don’t know the full story. And so it proves with this. As most readers will know, Daft.ie employ me to undertake the analysis for the quarterly Daft.ie Reports and, by coincidence, the latest Rental Report was out on Monday. So, the day the story broke, I was in Daft HQ and was able to find out the real story. For me, it is a salutary lesson on the curse of good intentions.

Actually, I had been aware that Daft.ie was working with the DSP. In early April, the unit responsible for Rent Allowance got in touch with me originally about this and I passed them on to Daft.ie. Over the following few weeks, Daft and the DSP worked through a plan and in late April, the filter was removed on a trial basis. The trial was supposed to last a week – but collapsed after just two days due to overwhelming user feedback. The users who complained were – wait for it – those in receipt of Rent Allowance. They were joined by one of the country’s largest charities, who got in touch with Daft.ie, asking them to reinstate the filter.

To see why, put yourself in the shoes of someone on Rent Allowance. With the filter, you go to Daft, tick the box that says “Are you looking for places that accept Rent Allowance?” and (as of this morning) are given about 700 results for Dublin city. If you follow up on any of these ads, there is no question of being turned away because you are on Rent Allowance. If that box is taken away, you would be given all 1,800 rental properties in Dublin. This sounds like good news, but the true cost of the missing box is revealed when you start following up on these ads. Roughly speaking (based on today’s numbers), you have look three times as hard to find a property that will even consider you. And time has a cost, whether you’re on Rent Allowance or not.

The removal of the filter – while no doubt well-intentioned by all concerned – actually made matters worse for the very people everyone is trying to help. Much as with rent caps, which I discussed earlier in the week, hiding what you don’t want to see will not address the underlying causes. So, why are landlords so keen to discriminate against Rent Allowance recipients?

Note that in Dublin, where rents are rising at almost 15% year on year, roughly two thirds of landlords currently will not consider someone on Rent Allowance. In contrast, if you were to search in Donegal, where rents are actually still in decline, almost all landlords would accept someone on Rent Allowance (190 out of 230, based on this morning’s numbers). While this story started out with a technical issue, namely a button on a website, the underlying issue is economic and inextricably linked with Monday’s Daft Report and indeed the broader housing crisis: a lack of supply. The tighter supply is, the more picky landlords can be. For example, I know of houses in Dublin currently where landlords are able to say “no, I don’t want three 20-something professionals renting here, I want a family”. No landlord in Dublin would have been that choosy in 2009, when rents were collapsing.

We could of course simply make it illegal for landlords to discriminate on the basis of Rent Allowance, being a 20-something professional or any other criteria we don’t like. But again, that doesn’t address the underlying issue and merely pushes the problem out of view. If those of us who do not have to depend on Rent Allowance want to help those who do, hiding the problem will not make it go away. To assuage our “middle class guilt”, for want of a better term, we need to look at the underlying issue of a lack of supply. And for that, as I argued on Monday, we need to look in particular at how the government controls planning and land use. Hopefully Deputy Ó Ríordáin will be to the forefront in calling for land use and planning reform – I’m more than happy to share my thoughts with him.

Construction, not rent control, the solution to the housing crisis

Today sees the publication of the latest Daft.ie Rental Report. The full report is available here, while below are my thoughts on what the latest report tells us.

Most analysis of the housing market – both sales and rental – is currently done through the lens of the last housing bubble and where it was when it burst in 2007. However, that is a point of view that is increasingly out of date. In the rental market, for example, rents bottomed out in Dublin and Cork cities in late 2010 and had actually bottomed out a year earlier in Galway city. Ireland’s urban centres are four years into a new housing market cycle – and yet there is still very little evidence that anything is being done about what is now a chronic shortage of accommodation in Irish cities.

With local and European elections just a couple of weeks away, a number of candidates – particularly in the Dublin constituency – have been talking about rent control as a necessary remedy for the ills of rising rents. However, while the desire to simply make illegal what you don’t like is understandable, it mistakes the symptom for the underlying disease.

On the one hand, tenants already have reasonable security of tenure. Since the Residential Tenancies Act 2004, once a 6-month probationary period has been passed, tenants have security of tenure in four-year cycles, something that is known as a “Part 4 Tenancy”. (To ensure this is the case, tenants who have signed one-year leases need to notify their landlord about their intention to stay – more here.) There are a certain number of conditions under which a landlord can terminate a tenancy, but getting higher-paying tenants is not one of these.

On the other hand, rising rents are caused by a lack of accommodation in urban centres and reducing rents will discourage the provision of new accommodation, thereby making the problem worse. What we have seen in both sales and rental markets is reasonably robust demand for accommodation in Dublin and other cities, which has pushed up both rents and prices. These should be acting as a signal to bring about new supply – so why has significant new building not started in Ireland’s cities?

Whether construction of new homes takes place depends on whether revenues exceed costs. Revenues come from rents and house prices, which both appear to be at the cusp of affordability given incomes in Ireland. Therefore, if rents and prices are high enough, the solution is about reducing costs in construction – not about capping rents and thus further discouraging the very construction that would alleviate the accommodation crisis.

The cost base in construction includes capital, labour, land and regulation, as well as materials, whose prices are typically set on world markets. What is needed now is for the Government to go through each element in the cost base and develop actions to lower costs. It may surprise some readers to learn that the cost of building a house is 3.3% higher now than in 2007.

Labour costs in construction fell once, in March 2011, when hourly rates were reduced by 7.5%. But in an economy where the average disposable income fell by 25% between 2006 and 2012, and where there are significant numbers of long-term unemployed construction workers, is that enough? More importantly, the minimum hourly rate for a basic operative in Ireland at €13.77 remains a quarter higher than in West Germany (€11.05, a figure which will rise to €11.30 by 2017). Department of Environment figures indicate that for every €1 of materials, €2 is paid in wages, so the wage rate in construction has a real effect on levels of construction.

Just as important is the cost and supply of land. If people are allowed to hoard land or sit on derelict or vacant sites, this imposes a cost on the rest of society. Dublin City Council’s proposed levy on derelict and vacant sites may help encourage unused land to be used, but it can do nothing to encourage land to be used better and its biggest effect may be just a clamour to have some activity – any activity – on these sites to avoid tax.

Related to this, various levels of government currently deploy a bewildering array of planning and building regulations and charges, each of which increases the cost of building. While standards of quality should not be sacrificed for political expediency, many of the regulations – such as minimum sizes – appear to very little connection to quality and instead look like the preferences of planners and policymakers trumping those of households.

How the system currently treats land and planning regulations needs, at the very least, to be streamlined. Overhauling a dated and complicated system of stamp duties, development levies, commercial and industrial rates and amenity contributions, not to mention the Local Property Tax, with a single unified Site Value Tax is clearly the best solution to join up the very disjointed Government system that underpins Ireland’s construction sector.

The Government’s new strategy for the construction sector will be published shortly. No dobut the headline measures will relate to capital, with a fund for construction projects or targets for the pillar banks featuring prominently. But capital is only one part of the puzzle. Labour, land and regulation are just as important. It is to be hoped that the new strategy will contain specific measures to lower the cost of both labour and land, as well as streamline the Byzantine system of planning and building regulations. Only a holistic approach will be good enough if Ireland’s latest housing crisis is to be stopped.

House prices: bubbles versus booms

The end of one quarter and the start of another sees the usual slew of economic reports and the start of Q4 is no exception. Today sees the launch of the Q3 Daft.ie Report. In line with other reports in the last week or so, and indeed with the last few Daft.ie Reports, there is evidence of strong price rises in certain Dublin segments. What is new this quarter is the clarity of the divide between Dublin and elsewhere: all six Dublin regions analysed show year-on-year gains in asking prices (from 1.4% in North County Dublin to 12.7% in South County Dublin), while every other region analysed (29 in total) continues to show year-on-year falls (from 3.1% in Galway city to 19.5% in Laois).

The substantial increases in South Dublin over the last 12 months have led to talk of “yet another bubble” emerging, with internet forums awash with sentiment such as “Not again!” and “Will we never learn?”. To me, this is largely misplaced, mistaking a house price boom for a house price bubble. Let me explain.

Firstly, I should state that, unlike “recession” which is taken to mean two consecutive quarters of negative growth, there is no agreement among economists on what exactly constitutes a bubble, in house prices or in other assets, but the general rule is that prices have to detach from “fundamentals”. For example, the Congressional Budget Office defines an asset bubble as an economic development where the price of an asset class “rises to a level that appears to be unsustainable and well above the assets’ value as determined by economic fundamentals”. Charles Kindleberger wrote the book on bubbles and his take on it is that almost always credit is at the heart of bubbles: it’s hard for prices to detach from fundamentals if people only have their current income to squander. If you give them access to their future income also, through credit, that’s when prices can really detach.

In that vein, I think it would be useful for commentators to distinguish between price bubbles and price booms, even if that distinction may be less clear in real life than in theory. Stop any friendly economist and they will tell you that the price is just the outcome of the interaction between supply and demand. If supply falls, or if demand rises, this will push prices up. We are familiar with house price booms in Ireland: between 1995 and 2001, significant growth in house prices – even adjusting for inflation – was the result of a number of factors (fundamentals). These include demographics (how many people per household on average), household income and the supply of housing.

House price growth between 2001 and 2007 was, in contrast, a bubble, driven by banks over-extending themselves (lending relative to deposits) and over-extending borrowers (higher loan-to-value). Every increase in incomes that happened in that period was offset by an increase in the supply of housing. House prices rose because banks went from lending out 80% of their deposits to lending 180% (by borrowing themselves from abroad).

Somewhere in the middle of this split between boom and bubble is what’s known as “user cost”, basically how interest rates compare to people’s expectations about house prices. Expectations are clearly central to bubbles as no-one will pay €400,000 for a 1-bed apartment unless they expect it will be worth at least as much in the future – so we can say that expectations are a necessary precondition. However, while I may expect that this apartment will be worth at least €400,000 in ten years, unless I can turn my desires into effective demand, that’s not enough. And that’s where credit comes in. So, when we are talking about prices being a multiple of average incomes, expectations are necessary but not sufficient to bring about a bubble.

What do we see in the Irish market at the moment? We certainly do not see easy credit: fewer than 2,000 mortgages are given out to first-time buyers each quarter at the moment, one fifth of the number given out in 2005 and 2006. But whereas now is too few, then was almost certainly too many. What is the right level? Well, there are about 7,500 births to first-time mothers per quarter, which gives us an idea of how many households are being formed. Allowing for households that never buy (and for the moment excluding households that never have kids), this means a healthy market would see perhaps 6,000 mortgages being issued each quarter to first-time buyers. What we have is – still – a housing market starved of fresh credit, not stuffed with it.

This suggests that what we are witnessing is being driven more by fundamentals than by credit. For simplicity, if we think of house prices as demand divided by supply, it is clear that rising prices may be nothing to do with too much demand and may instead be driven by too little supply. This helps explain why it is Dublin, and not the rest of the country, that is seeing rising prices at the moment: Dublin has no oversupply from the bubble. This is being compounded by negative equity preventing trader-upper type moves, creating a crunch in a market where there is at best moderate demand.

The limitation to a neat split between house price booms driven by fundamentals and house price bubbles driven by credit is market momentum. Rising prices now may generate rising prices in the future because rising prices now affect people’s expectations. But the point made above still remains: unless those expectations can tap in to credit, they will not translate into a rise in demand.

Does this mean there is nothing to worry about? Absolutely not! The graph above shows the ratio of prices for a four-bed semi-d in South County Dublin to one in Mayo, and the same ratio for a one-bed apartment. The “Dublin differential”, which was steady from 2006 to 2009 and falling until early 2012 has increased dramatically since then. For a one-bedroom apartment, it has doubled (from 120% to 240%).

Rising prices may be good for those who already own their homes but for those looking to buy, affordability of property in the capital is paramount. When prices rise because of a bubble, you can prick the bubble by restricting the supply of credit, but this is invariably messy (UK: take note!). When prices rise because of a boom, what is needed to moderate prices to simply an increase in supply. What we need to understand now is why there is so little construction happening in Dublin, when the city clearly needs it.

Thoughts on the above welcome in the comments below.