Property market approaching critical point


The economy may be about to enter a period of prolonged recession, writes Morgan Kelly, the economist who predicted the property slump

Writing in this newspaper a year ago, I suggested that, in the light of past property booms abroad, Irish house prices were at risk of falls of around 50 per cent in real terms. At the time I imagined, again based on what had happened elsewhere, that selling prices would stabilise at their peak values for a year or two, and then fall slowly by a few per cent a year for up to a decade.

My forecast has turned out to be wildly optimistic. In the past year Irish house prices appear to have fallen by around 10 to 15 per cent. While still short of the 20 per cent fall in Finland in 1991, this is on a par with the largest falls experienced during the Dutch and Swedish collapses.

However, the Irish property market is giving signs of approaching a critical point where vague individual anxieties coalesce into a general panic and prices collapse. Should a collapse occur in 2008, it is most likely to start among heavily-indebted builders, many of whom have not sold a house in over a year, coming under pressure from banks to liquidate their large amounts of unsold inventory.

What has made the Irish house price boom different from any other (apart from the concurrent boom in Spain) is that it has occurred alongside a building boom. In most economies, the housing stock is overwhelmingly second-hand houses whose owners are reluctant to accept price cuts. When a downturn occurs, most people refuse to sell and the market effectively dries up for a few years until prices rise again. In Ireland, by contrast, the supply of houses has expanded rapidly: at the peak of the boom in 2006 we built almost 90,000 units, or one for every 16 households. This fell to around 70,000 last year and, ominously, a large proportion of these failed to sell.

This raises the question of why, given the number of unsold houses, builders are planning to build another 50,000 or so units this year? Once we know the answer to this question, we are in a position to understand why Irish house prices are now at risk of sudden and large falls.

To start, we need to remember that, because of delays in the planning process, this new building represents projects undertaken by developers in the very different climate of two years ago. There are now two distinct groups of developers.

The first group own land, typically have vivid memories of how their fathers and uncles went bankrupt in the 1980s, and have all stopped residential construction. The second group, who are by no means the smallest developers, have borrowed heavily to buy land and have no choice but to keep on building.

If you are a builder who borrowed €20 million in 2006 from a bank and some mezzanine investors to buy land for 100 houses and have just received planning permission, you have no option but to go ahead and use your remaining €11 million credit line to build the houses and hope for the best. However, at some stage this loan will have to be repaid, at least in part, and the only way to do this is by selling houses at whatever price you can get.

For their part, banks are now in the position of throwing good money after bad: having lent money for land which has depreciated in value, they are lending more money to build on it in the hope that they can recoup their losses, or at least delay the inevitable change in value that may leave some of them with solvency problems of their own.

However, with the recent bankruptcy of McEnaney Construction, banks have sent a definite signal to developers that their patience and liquidity are finite. Despite their understandable reluctance to initiate a downward price spiral, in the next few months increasing numbers of developers will be forced to follow the lead of Capel Construction and cut prices by 20 per cent and more.

However, just as expectations of price rises were self-fulfilling, so now are price falls. Buyers know that the longer they delay the less they will pay, and have the added fear of negative equity to keep them out of the market.

It is appearing increasingly unlikely that builders will be able to move their inventory at any price that can remotely cover their borrowings, making a wave of bankruptcies inevitable.

The houses built by a bankrupt developer become the property of the lending bank, which would typically auction them off, in one or more lots, to other developers.

However, for these developers to be able to bid, they need loans from banks. With Irish banks already having sunk €100 billion into property development, and needing to conserve liquidity as the international financial system moves towards a major solvency crisis, such loans may not be forthcoming. It is not hard to imagine a scenario where tens of thousands of new units built by bankrupt developers are sold for a fraction of their construction cost or simply boarded up, leaving most existing apartments and commuter-belt houses effectively valueless.

Any collapse at the bottom end of the market will roll upwards to reduce second-hand prices sharply, while the presence of large number of families who cannot move house because they have negative equity will ensure that the second-hand housing market remains frozen for a very long time.

With rising unemployment, falling tax revenues, and sharp falls in stock prices, it is becoming evident that the problems of the Irish economy run a good deal deeper than a few overpriced houses.

The building boom of the last eight years has deeply distorted the economy, leaving us with worrying numbers of mis-skilled workers, heavily indebted households, unaffordable Government programmes, and over-extended banks.

Most importantly, as the Irish economy moved from one driven by exports to one based on selling houses, its international competitiveness has fallen sharply.

While the word competitiveness had vanished from our national vocabulary, the examples of Germany, Italy and Portugal are there to show how a domestic boom with falling competitiveness tends to be followed by prolonged recession.

Morgan Kelly is professor of economics at UCD