As we head for 2017, the global economy is desperately trying to shake off the legacy of the years past. Yet, fuelled by monetary-policy activism, and supported by financial markets herd mentality, one old reliable of financial and economic crises rears its ugly head: the prospect of property bubbles.
According to a recent IMF study, there are reasons to worry about a new housing-markets-triggered financial blowout. And although IMF data suggest that we are not at panic level regarding house-price inflation its researchers conclude that “there are several reasons to think that the present conjuncture is a time for vigilance”.
Keep in mind: in 2004, the IMF correctly warned about the rising dangers of house-price bubbles across the advanced economies. Back then, writing in the Irish press, I used the IMF model to estimate the extent of the property bubble in Ireland at around 30-40 percent. As we know, by 2012, Irish property prices fell by about 31 percent compared to late 2004 levels.
Adding urgency to the IMF call for vigilance on house prices, a range of academic studies has noted that property boom-and-bust cycles have been central to triggering financial crises. For example, a study published in 2013 in the Journal of Financial Stability noted that “…of the 46 systemic banking crises for which house price data are available more than two-thirds were preceded by boom-bust patterns in house prices”.
In other words, IMF warnings should not be taken lightly.
Global problem: Irish concerns
Today, the IMF index of global house prices shows that residential property prices are almost back at pre-2007 levels. The global index has averaged 153.8 over the first six months of 2016, against 154.9 for the same period in 2007. For Ireland itself, based on data from the CSO indexed to the IMF’s, the first six months of 2016 is 82.7. Indexing CSO data to ESRI data for the pre-2005 period, today’s Irish house prices are some 8 percentage points below 2004 levels. This is more unnerving but still suggests we around 12 months out from the point where prices become a serious concern.
The more pressing problem, however, is not prices, but price inflation.
A range of studies suggests that rapid acceleration in growth rates of prices can, in itself, represent a warning signal of a property bubble emerging. Since the onset of the recovery in Irish property markets in 2Q 2013, the average annual rate of growth in house prices in Ireland was almost 10 percent, which is five times the average rate of growth in global house prices. So far, in 2016, based on IMF data, Ireland has posted the third highest rate of house-price growth in the euro area. Including data for 2Q and 3Q 2016, Irish house-price inflation is 2.7 times the rate of growth in global residential property prices.
The European Central Bank’s ESRB ‘Risk Dashboard’ for 3Q 2016 confirms the IMF data. It shows Ireland is an extreme outlier when it comes to house-price inflation in the EU, with cumulative 3-year inflation in Irish property markets standing at just over 35 percent, against the EU average (ex-Ireland) of around 8 percent.
The ECB’s ESRB Risk Dashboard provides a quarterly insight into the estimated degree of mispricing in residential real estate markets across the EU. The chart below highlights the most recent results – for 3Q 2016.
Note: For each country, the blue bars represent the range of estimates across the four valuation methods: price-to-rent ratio, price-to-income ratio, asset-pricing and estimated-demand.
The chart shows that Irish property markets are currently priced in the range of significant under-valuation of between 4 percent and 22 percent. In other words, based on the ECB assessment, Irish property prices can rise by an average of 12-13 percent before the residential real estate market can be considered to be valued in line with fundamentals.
The disparity with economic fundamentals, estimated by the ECB, however, is much more dramatic than the IMF-revealed difference between Irish and global prices. Which gives a false sense of comfort to those Irish policymakers and regulators who read ECB reports.
The reason for this is that the ECB explicitly models demand using demographic and income factors. In this context, there is a glut of suppressed demand sitting in the Irish market, and a dire shortage of supply. The latter factor contributes around two thirds of the price gap and is exacerbated by the duration of the current construction-sector slump, now eight years old.
Meanwhile, demand is heating up, driven by rising rents (which improve the investment outlook for Irish property and create added incentives for households to secure mortgages) – though threatened by recently announced rent controls, and by demographic trends, including changes in net migration.
But, there are also some false positives in the ECB’s demand-based pricing model for Ireland. For example, the ECB analysis is based on GDP-linked data, which overestimate Irish households’ ability to pay for housing. It also includes no adjustment for income distribution across various demographic cohorts, meaning that the incomes of potential purchasers are exaggerated because of the typically higher incomes of older households.
The IMF estimates for house prices as a function of household income and as a function of rents suggest that currently Irish property prices are roughly 8 percentage points below their fundamentals-determined values.
All in, there is still some room for house prices to rise before we hit long-term-sustainability bounds. Based on 2015-2016 rates of growth in house prices, rates that already reflect changes in macroprudential policies instated by the Central Bank in 1Q 2015, excessive inflation of house prices in Ireland is likely to start around late 2017 to early 2018.
Managing the Next Bubble
While much criticism of the macroprudential risk-management policies of the Central Bank (including restrictions on mortgage lending) has been ventilated in the Irish media and political circles, these policies act to suppress demand growth on the owner-occupier side, while propping up demand from investors. Overall, the two factors should balance each other out, decreasing demand for owner-occupied housing, but increasing the supply of rental investments. (4) This is exemplified by the experience of Australian and Canadian markets, where stricter lending policies and higher borrowing costs, as well as additional taxes on property for foreign buyers, have failed to arrest price inflation.
The real problem with the Irish market is not Central Bank regulation, but the chronic volatility of the regulatory regime undermining already fragile supply fundamentals.
Consider the regulation of Irish property markets. On the supply side, Ireland’s approach to regulation has been predominantly focused on allowing local authorities to determine what can be built, where it can be built and at what cost. As a result, we have a dire undersupply of homes in the key urban areas.
While roughly 30-35 percent of the total economic activity in the country takes place in the Greater Dublin area, the same area accounted for just under 8.6 percent of all residential planning permissions granted (on average, based on the number of units granted) for the first six months of every year between 2001 and 2007. In 2015 and 2016, this proportion rose to almost 35 percent, but there is no doubt that severe underinvestment in housing stock from 2001-2014 has sustained shortages of supply in Dublin.
The problem is not likely to get any better soon. The reason for this is that the regulatory climate for Irish residential property has swung from improperly managing approvals to manipulating construction costs and rents.
These policy changes ignore the reality of economics and finance: all of the recent measures introduced by successive governments act to reduce risk-adjusted rates of return to investment in property. Regulatory uncertainty, coupled with the never-ending push for more control measures for pricing, rents, and quantity and quality of supply, increases the risk premiums required in the market for developers to undertake housing investments. Tax and pricing uncertainty when it comes to capital gains also raises the required rate of return that any developer needs to achieve before raising construction financing.
The sustainability of supply of new residential properties in Irish markets is a long-established problem. Without dramatically reversing the situation in the supply of housing, Ireland faces the risk of developing a new property-price bubble, this time around without much new investment in property to accompany rampant price inflation.
By Constantin Gurdgiev