ANALYSIS:Price to income ratios suggest there is a way to go yet before property prices stabilise
WHEN BUBBLES burst it takes time for society to recover its financial nerve. Before this can start, there must be some degree of certainty that all losses have been accounted for.
There are persuasive arguments for believing that this point has not yet been reached in Ireland. A key priority for the State must be to get house prices back in line with their long-term value, and consequently with incomes, and keep them there in order to underpin competitiveness.
There are other issues to be dealt with such as the parallels in the commercial and retail property sectors.
As last week’s report by Finnish banker Peter Nyberg showed, Ireland got carried away with the availability of easy money. The result was we blew much of the gains made earlier in the Celtic Tiger period. Irish house prices increased between 1996 to 2007 by around 330 per cent – a bubble extreme in scale and duration but a classic nonetheless, matching the criteria in the extensive literature on bubbles.
Yet we continue to hear cries of: “nobody saw it coming”. Plenty of people saw it coming – it was obvious to those who took the trouble to read what was being written here and abroad about house prices. There were reports and comments from international observers including the European Central Bank (ECB), Organisation for Economic Co-operation and Development (OECD), the Financial Times and the Economist, and in particular, the International Monetary Fund (IMF)
The third Bacon report in June 2000, when discussing changes in the model used for indentifying drivers of house prices, noted: “. . . the very dramatic change in the effect that the previous period’s price is having on the current period price level”. This is the essence of a bubble – a cycle of buying driven by expectations of further price increases unrelated to any increase in fundamental value.
The fear of a property crash permeated the Bacon reports and the limited policy recommendations emerging from the reports reflected this. In any event, the actions taken as a result of the three Bacon reports were reversed under concerted pressure from vested interests. In retrospect, how lucky we would have been if we had experienced a property crash in 1998, when the first Bacon report was issued, rather than 10 years later.
The reality is that most did not want to recognise the bubble – as implied by Nyberg. These ranged from those who were wilfully blind to regulators who saw it and were constrained from acting decisively for reasons that ranged from perceptions of the limited scope of their authority, political pressure and organisational culture.
They also included conflicted media that benefited from spending on advertising and citizens who felt they were wealthier because the price of their home had increased. The price had increased but the intrinsic value remained the same – it was still the same house no matter how you measured the price.
Many fallacious arguments were put forward during the boom to justify high house prices such as suggestions that increased demographic demand underpinned prices. This did not make any sense. Look at the slums of major Third-World cities where real demographic demand is of an order unimaginable here. There are no bubbles.
On the other hand some countries and cities, with political restrictions on development, maintain high prices whereas others, such as Hong Kong and Singapore with a small land area, manage to house large populations. Similar illogicality was behind most of the thinking and talking.
Global low interest rates and access to large quantities of easy money were the proximate cause of the bubble here and of the global financial crisis. The tsunami of cheap and easy money hit Ireland just as the tiger economy was moving into high gear. We were preparing to adopt the euro and with it access to a large pool of low-cost European finance, while at the same time new funding techniques such as securitisation provided the technical means to access these funds.
Together these developments removed the funding constraints that a small peripheral currency had previously imposed. In addition, a short-term laissez faire, caveat emptor, philosophy took over the sale of financial products and services. If the bank boards and regulators did not know or understand what was happening, what was the non-expert expected to do?
Cheap and easy money would not have been enough on its own to facilitate the inflation of the bubble. For example, neither Germany nor Canada suffered from bubbles. In Ireland, despite many timely and well-founded warnings, an array of defects in our beliefs and governance left us vulnerable.
In the end the inevitable happened and the bubble burst. Essentially our domestic financial institutions are wiped out and European institutions and the IMF direct our financial affairs.
But this is not the end of the affair. We have arrived here slowly, bit by bit, as the extent of the losses has become clearer. The question remains have we reached the end? The recent stress tests have helped but, hard as it might be to accept further bad news, it is better to get it all out in the open now.
We need functioning lenders that are properly capitalised and in a position to lend to businesses and individuals. If, after recapitalisation, there remains doubt about any unrecognised losses, banks will be constrained from lending due to lack of resources. In addition, we await the revised memorandum of understanding following the recent EU-IMF examination of the Government’s adherence to last autumn’s bailout deal.
Aside from the need to get the bad news out and sort out the banks, it seems that there is a real dilemma at the heart of national policy. Do we prioritise competitiveness by bringing house prices back into line with incomes or keep them inflated in the hope of reducing further losses to the banks and Nama (National Asset Management Agency), as well as containing the extent of negative equity?
While higher incomes are a driver of house prices, prices themselves are a driver of demand for higher incomes. If house prices remain high relative to incomes this limits our ability to regain lost competitiveness. This pressure is not going to decrease as the vast populations of China, India and other large emerging countries play an increasing role in the global economy.
In addition, well-managed economies such as Germany have, over the last two decades, brought down their unit labour costs, and compete with us in selling on global markets. This implies that average house prices must return to levels that are in line with long-term ratios to incomes, and possibly even lower as costs realign to meet increased competition.
As is shown in the incomes, construction costs and house prices chart, despite the bubble in house prices, construction costs did not increase any faster than incomes over the last 30 years. This implies that all the overvaluation has been in site prices, as well as builders’ profits in the case of new houses.
It also implies that there is a greater speculative element in site prices and unfinished estates. When house prices fall back to their true value, there may be a higher proportional reduction in the value of some of the collateral supporting loans held by Nama and the banks.
This possibility may not, as yet, be fully reflected in considerations of the level of new capital required by the banks or the likely final recoveries that will be achieved by Nama.
Hopefully the recently completed stress tests and increased capital adequacy requirements will adequately deal with a realignment of both residential and development property values. In fact it seems the State may be hoping for some stabilisation of prices at close to current levels, and that time will take care of the problem.
A significant factor behind the Irish bubble was the implicit belief that low short-term interest rates would continue indefinitely. This belief influenced buyers’ understanding of affordability and value and was one of the fallacious arguments used as a selling point for houses and mortgages.
Despite the fact that we in Ireland (as in the UK) have a tradition of variable rate mortgages, it is long-term interest rates that matter over time for determining the true value of assets. While market traders in stocks and bonds in liquid markets can react to short-term rate movements, home buyers and banks that provided long-term mortgages cannot do so.
From 1953 to 1996, (ie before the bubble), the average ratio of the price of new houses in Dublin to average industrial earnings was 5.3. That is also where it was in 1996. In 2006, it reached 13.7 and by 2010 it had fallen back to 7.4.
Based on a return to the pre-bubble level of the ratio, average house prices in 2010 should have been approximately €180,000 instead of approximately €250,000. Here we are talking about average house prices and average incomes. Of course there are exceptional houses and special buyers but for the country and economy overall it is the averages that matter.
Why does the price to income ratio revert to a stable average in all economies over long periods and roughly what value might we expect the ratio to have?
Excluding capital gains or losses, the economic value of a property is the capitalised value of the rent, less expenses (day to day and repairs and renewals), that could be earned if the property were let. This is the same as saying the rent must at least recover the cost of interest paid. The economic value is: value = net rent ÷ real interest rate.
If expenses are 10 per cent of the annual rent and the real interest rate is 5 per cent, then the value is 18 times the rent. If rents are limited to a proportion of average incomes, say one-third, the value would be about six times the average income. If interest rates are 6 per cent the ratio would be 5. For simplicity, excluding expenses: value = income ÷ 3 ÷ real interest rate.
Over long periods, long-term real (inflation adjusted) interest rates are quite stable. Although interest rates fluctuate and have been low in recent years, real rates revert to a narrow range.
UK long-term real risk-free real interest rates, (ie the rate adjusted for inflation with the State as borrower), have averaged about 3 per cent over the last three centuries and the same applies in other major economies. If we add 2 per cent for wholesale and retail banking margins, we arrive at a real cost of funds of 5 per cent. Incidentally this is the minimum rate permitted under German mortgage bond law for the valuation of properties.
It is instructive to see what the value of an average Irish house would be if the German capitalisation of net income method is used. Taking the property website Daft’s 2010 average monthly rent of €830, less expenses of 10 per cent (voids, running costs and repairs), and a rate of 5 per cent, this would also give an average value of about €180,000.
Though the statistical methods take some account of changing conditions and mix of property types etc, these are approximations based on averages and are not precise measurements.
However they show a consistent pattern and point to a persisting overvaluation of houses of the order of 25 per cent to 30 per cent.
Tomorrow: how to stop the next bubble
Martin Walsh was head of lending at the Education Building Society from 1988 to 2003 having previously worked for ICC