How EU made a fundamental error when determining Irish house prices are not overvalued

Every year the European Commission produces what it calls an Alert Mechanism Report. The purpose – in the commission’s words – is to “detect, prevent and correct imbalances that are adversely affecting, or have the potential to adversely affect, the proper functioning of the economy of a member state”.

The latest one, published two weeks ago, contains a chapter on housing. It warned that several member states were at risk of a painful correction in house prices as rising interest rates puncture the mini boom in values seen during the pandemic. Houses are more than 10 per cent overvalued in over half of EU member states, it warned, and more than 20 per cent overvalued in nine countries: Austria, Belgium, the Czech Republic, Denmark, Germany, Luxembourg, the Netherlands, Portugal and Sweden.

However, when it came to Ireland, it said house prices were “not overvalued”. In fact, they were undervalued to the tune of about 10 per cent.

“Concerns associated with house price developments are present,” the report said, noting nominal year-on-year house price growth in the Republic increased to14.6 per cent in the second quarter of 2022. However, it said the commission’s “valuation gap metrics do not show signs of potential overvaluation”.

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The finding will leave many here scratching their heads particularly when we know average house prices nationally, in Dublin and in Dún Laoghaire-Rathdown, the most expensive local authority area, are seven, 10 and 14 times the average full-time income here.

[ Smart Money: How can we tell if Irish house prices are overvalued? ]

The commission’s report, however, makes a fundamental misstep in drawing its undervaluation conclusion. It uses aggregate income variables based on grossly inflated gross domestic product (GDP) numbers, getting an inflated sense of per capita income here and a faulty sense of the long-term income trend. The commission uses GDP for a uniform measure across the bloc. Of course in Ireland GDP is skewed by the presence of multinationals to such a degree that it does not reflect the real economy.

Many also maintain that the long-term ratios between income and house prices are no longer relevant as they relate to an era before real estate became a turbocharged investment asset and price became a gross multiple of income.

ESRI perspective

Using a different methodology, the Economic and Social Research Institute (ESRI), in its latest quarterly bulletin, came to an entirely different conclusion, estimating that house prices here were in fact overvalued by at least 7 per cent, probably more.

The think tank modelled where house prices should be on the basis of various economic and demographic factors such as income, population, credit and interest rates.

It found that prices were about 7 per cent above their expected trend values as of the end of last year. Unlike the pre-2008 period, when the overvaluation of property was driven by excess credit, this time around prices have been inflated by pandemic-related factors such as increased savings and curtailed supply combined with “the increasing share” of institutional investors in the market, it said.

“The analysis is up to the end of 2021 so, given the pace of growth in house prices in 2022, the overvaluation right now is at least 7 per cent, possibly even a couple of percentage points higher,” the ESRI’s Kieran McQuinn said.

“That doesn’t necessarily mean that house prices are going to fall by that amount, but what it does suggest is that the substantial increases in house prices that we’ve witnessed cannot continue into the future and you’re likely to see a significant moderation in terms of house price growth in the coming quarters and over the next year,” he said.

McQuinn said it was too early to say whether the current slowdown would eventually morph into a price correction.

The rate of house price growth nationally fell to 10.8 per cent in September, extending a pattern of deceleration seen in recent months. But remember that figure is a snapshot of the market several months ago as it is based on transactions in June and July.

Risk factors

Rising borrowing costs have triggered a rapid cool-down in real estate markets across the world and a correction in the some of the more overpriced markets.

In the commission’s post-programme surveillance report, also published last month, it assesses the performance of Ireland’s economy while flagging some risk factors related to the housing market here.

It warns that “house price growth has been outpacing incomes, raising the risk of imbalances”. On the outlook for the market here, it says “house price growth is expected to moderate in the second half of 2022 as real incomes decrease and mortgage interest rates increase”.

A senior EU official, cited in a report in The Irish Times, said Ireland had seen steep rises in house prices and this was clearly becoming a “social problem”.

“In the case of Ireland, our indicators point that housing price increases are not as high as we have seen in other member states. Prices have been increasing, but the pace of increases have not been as high as elsewhere,” they said.

“What we see in Ireland is there is very fast demographic growth. What we see is a shortage of supply compared to the demand.

“This is essentially translating into a social problem, but we don’t see this being a major economic imbalance that would affect the banking sector itself,” they said.

In a nutshell, we have a chronic social problem when it comes to housing but a battened-down banking system that isn’t exposed to housing values in the same way as it was in 2008.