No margin for error on Nama
ECONOMICS:A WEEK on from the unveiling of the National Asset Management Agency (Nama), there has been a lot of commentary about how reasonable its core assumption is – ie that property prices need only increase 10 per cent over the next decade, writes RONAN LYONS
On the face of it, this is a reasonable assumption, and below what many would expect to be trend growth in property prices. Over a 10-year period with no significant bubble or bust, the figure could be closer to 25 per cent, just ahead of inflation.
However, it is an assumption that relies fundamentally on three other assumptions to come good – assumptions that need to be teased out, particularly if the taxpayer is expected to foot the bill.
The first underlying assumption is that the market has bottomed out already. Not only that, but that it has bottomed out where the Minister says it has – ie, an average fall of 47 per cent from the peak. The second key element underpinning the Nama assessment is that property yields are high relative to European and historical averages. The third pillar is that any yield correction will come from properties rising in value, rather than rents falling.
The Minister for Finance has said that the best estimate of the fall in prices from the peak for Nama’s properties is 47 per cent on average to date. The importance of this figure needs to be properly understood to reach an accurate assessment of the prospects for Nama.
The “10 per cent in 10 years” scenario assumes that, after overshooting on the way down, the property market will rebound and plateau at 39 per cent below its peak value. This would, of course, have been a very different soundbite, but it is essentially what the Minister is saying. It means, for example, that if the true fall from peak-to-trough in Nama’s loan book turns out to be, say, 60 per cent, the Minister expects the market to rebound by 50 per cent in the next 10 years.
The important thing to note here is that small percentage differences on the way down turn into huge differences on the way back up.
If the fall is slightly bigger than 47 per cent on average – say 55 per cent – we need a 36 per cent increase in the next decade, not a 10 per cent one. A pessimistic scenario, where we witness a 70 per cent fall from peak to trough, requires property values to double in 10 years for Nama to break even.
On the second point, Brian Lenihan has stated that yields on Irish property are high relative to historical and European averages. But, in the more relevant terms of the likely contents of the Nama loan book, is this actually the case?
The first point to make is that the general public has not been given enough information to make an accurate judgment.
For example, in relation to one-third of the €88 billion in loans, we simply don’t know what the collateral is: these are described only as “associated loans”. Ultimately, we know they are property-related, but we don’t know what kind of property. It is entirely possible that they significantly increase the loan-to- value of Nama’s book – making the whole project riskier again.
We do know a little bit about the almost €60 billion in land and development loans that are destined for Nama. For example, €21 billion of the loans are related to Irish land. A further €16 billion is invested in Irish developments. This €16 billion breaks down between commercial and residential projects.
An exact breakdown between the two is given only for Anglo Irish Bank. It suggests a 50-50 split between commercial and residential, indicating that about €8.4 billion of Nama’s loan book is connected to Irish residential construction projects at least partially under way, while €8 billion is in commercial projects under way.
Amazingly, it is only this latter segment of the market, commercial, worth about €8 billion at the peak, that is the subject of any form of yield analysis. Even then, the Nama documentation only looks at yields on commercial property for one location (Dublin). It compares Dublin yields with the city’s long-term average and with a range of other European cities, finding that yields in August 2009 were slightly higher than both.
In residential property, however, yields are significantly below historical averages, at 3.3 per cent on average. The Nama document itself takes 6 per cent as closer to a “normal yield”. If the breakdown between residential and commercial projects is roughly 50-50, the yield for development projects in Ireland is substantially below the 6 per cent taken as a healthy target, not above.
Lastly, the Minister for Finance has stated that because yields are above where they should be, property values will increase from current levels towards some “long-term economic value”.
There are two ways in which a yield can decrease – property values can rise or rents can fall. There is one very strong argument as to why any correction may come via falling rents – oversupply, a legacy feature of Ireland’s property market since the boom.
We can see this in residential lettings, where rents have fallen by a quarter from the peak. The adjustment may be slower in commercial property, where the ban on downward rent reviews means the market has to find other ways of lowering rents, such as rent-free periods. But that doesn’t mean it won’t happen.
Let’s say, for the moment, that Nama’s calculations on commercial property are right and that property prices do fall, on average, by 47 per cent, and that yields are above average. Let’s even leave aside for the moment lending for Irish land acquisition and all foreign projects, leaving the focus on Irish residential and commercial markets.
According to the ESRI and daft.ie, the average fall in house prices in Ireland so far has been no more than 35 per cent. Suppose oversupply in commercial and residential segments of the property market leads to a 20 per cent fall in rents in the next few years.
If, as a result, yields converge to 6 per cent, it suggests a long-term economic value on these loans of €44 billion, not the €54 billion stated by the Government in the Nama framework. It is scarcely credible that Nama’s entire estimation of long-term value hinges on rents, despite evidence to the contrary, holding constant in a subset (Dublin) of a subset (commercial projects) of a subset (projects under way) of a subset (Ireland) of the total loan book – a segment that accounts for perhaps 5 per cent of the loan book in total. Is that good enough?
A range of genuine alternatives to the Nama proposal have been offered, for example Dermot Desmond’s idea for an extended and modified guarantee, outlined in this paper last week. If, however, the Government honestly believes that Nama does offer the best way of fixing Ireland’s financial system, it needs to get the fall in prices, the yield and the correction right.
On all three, the analysis presented by the Government so far seems at best lacking in detail and at worst fundamentally flawed.