By Cormac Lucey
Conflicting signals seem to be emerging from the residential property market. Last month The Economist reported that Dublin house prices were 25% overvalued compared with incomes.
In August, a survey carried out by the Central Bank and the Society of Chartered Surveyors of Ireland reported that most industry experts now expect residential property prices to rise by 5% over the next few months. The survey involved estate agents, economists, academics and surveyors.
Last weekend, a report based on actual sale prices achieved nationwide by members of the Institute of Professional Auctioneers and Valuers (IPAV), claimed that property prices had fallen for the first time in five years, hitting house prices in some of Dublin’s most expensive suburbs by as much as €150,000 or about 10% for a four-bedroom home.
Then last Monday, ratings agency S&P said that Irish house prices, along with housing markets elsewhere in Europe, are heading for a “soft landing”. In Ireland, the agency predicted another three years of strong growth until supply catches up with demand around 2021.
What is really going on? To gauge whether house prices reflect fundamentals or froth, The Economist compared them with rents and household incomes. It used the average ratio over the past 20 years as “fair value”. I don’t think much of The Economist’s analysis. Comparing house prices with average annual rents over the past 20 years doesn’t tell us an awful lot when interest rates have collapsed over those two decades.
All other things being equal, we would expect house prices today to trade at a higher multiple of rents than 20 years ago as a result.
Comparing house prices with median incomes over the past 20 years is also problematic. If the relationship between house prices and incomes has been anomalous over the last two decades, then we will have only a fragile basis for examining whether today’s prices are reasonable. And over the years 1998-2018, Irish residential property prices experienced boom, bust and recovery.
And not just any old boom but, in terms of credit growth relative to national income, one of the biggest booms in recorded history.
As for the data from the IPAV, how is that to be reconciled with official information from the Central Statistics Office? That data shows regular price rises each month between December 2017 and June of this year with national residential property prices up 5% in total over those six months.
If we examine residential property prices from a fundamental perspective there are, in my opinion, three factors that drive them. The first is rent. Making a decision to buy a residence is, essentially, making a choice between renting and owning. At the margins, these two states ought to be financially competitive with one another. That means the higher rents rise, the higher we would expect property prices to rise. Today we have rent levels that are higher than ever before.
The second is interest rates. The other trade-off when investing in property is forgoing the interest income that might otherwise be earned. All other things being equal, the higher interest rates are, the lower property prices should be. Conversely, the lower interest rates are the higher property prices should be. And right now, we have interest rates lower than ever before
In theory, only rent levels and interest rates should drive property prices, for they represent the alternatives you forgo when you opt to buy property. But there are other factors.
At the margins, tax changes can alter the attractiveness of property. And speculative froth can have a major effect, both on the way up — as a bubble inflates — and on the way down, as it deflates.
I have a fundamental model that compares the financial advantage of residential property ownership with renting over a 20-year period. The most important swing factor in that model is the rate of economic growth expected over the period. If strong economic growth is expected, one would expect property prices and rents to rise as a result.
The value of a property at which one becomes indifferent to owning or renting rises substantially. If no growth is expected, the fundamental value of the property drops considerably.
The average monthly rent in Dublin is €1,936, according to Daft.ie. If no growth in rents or property prices was assumed for 20 years, my model puts the underlying value of such a property at €375,000. But if annual growth (in both rents and prices) of 2.5% was assumed, a value of €583,000 is signalled, just over 25 times its annual rent.
Yet the average value of a property in Dublin is, according to Daft.ie, only around €370,000. Even allowing for differences in the samples of properties Daft.ie features for sale and for rent, that suggests to me there is still considerable scope for property prices to rise in the capital. What might alter this analysis? Anything that alters supply and demand.
Strong jobs growth and a parallel growth in incomes has been supporting rising rents, and thus rising property values. An international recession could put a dent in both. A recession should also reduce investors’ expectations of future growth, their estimates of future property values and therefore the amount they should be willing to pay to purchase properties here and now.
Higher interest rates would also dent rising property prices. My model uses a mortgage rate of 3%. If that increased to 5%, it should trigger a 17% fall in my estimate of fundamental property value.
A rapid rise in the supply of new properties would also weaken price appreciation, at least in the short term. And there is some evidence that supply is slowly building up from the ashes of the bust a decade ago. Yet construction still falls far short of what the growth in underlying demand requires.
All in all, I tend to agree with S&P that house prices are heading for a “soft landing”, and there will be another three years of strong growth until supply catches up with demand around 2021.
Published in The Sunday Times (Ireland edition)
September 9th 2018