Dublin House Prices: Bubble or not?

The CSO recently released the latest Irish house price data, for October, revealing that residential property prices excluding Dublin  are picking up at an accelerating pace; prices rose by 4.8% over the past three months, bringing the annual increase in October to 8.7%, an inflation rate last seen in early 2007. Yet prices are still only 12% up from the lows recorded eighteen months ago and  so few would consider that the market over the bulk of the country is overheating, particularly as national prices still look far from overvalued relative to affordability, incomes or rent.

The price trend in Dublin is very different. Prices there have risen by 46% from the lows recorded in the summer of 2012 and are now 38% below the levels seen in early 2007, a peak now generally considered the height of a Bubble. That term is now reappearing in the context of commentary on the residential property market in the capital and it does arguably satisfy some of the usual criteria employed to categorise a Bubble. One is rapid price appreciation and that is certainly the case ;  the annual increase in October was 24.2%, a pace rarely seen and then only back in 1997 and 1998, in the run-up to euro membership. Moreover, the pace of price inflation has accelerated this year and  the past three months has seen a 9.3% rise, or over 42% at an annualized rate. Expectations of further price gains is also a common feature of asset Bubbles and that also appears to be present; a recent Daft.ie survey showed respondents expect Dublin prices to rise by an average 12% over the next year, up from 6% twelve  months ago, even though  only 15% believe housing in the Capital is still good value (the  value figure for housing ex Dublin is 50%).

Price expectation is an important determinant of  the actual house price trend , notably in terms of the user cost of housing ( the total cost of buying a home with a mortgage, including the mortgage rate, maintenance, depreciation and any tax breaks). That user cost is now negative, particularly so in Dublin, because the expected capital appreciation from buying a home exceeds the other costs, including the mortgage rate.

Bubbles are also often associated with leverage and Dublin fails the Bubble test on that measure as credit is clearly not a driver, or at least credit from the main Irish mortgage lenders. Data from the Banking and Payments Federation Ireland (formally the IBF) showed that the number of new mortgages for house purchase  in Ireland amounted to 5763 in the third quarter, against total property transactions of 11,257 as reported in the Property Price register, so 51% of transactions were funded by Irish mortgages, a proportion that has risen through the year ( from 46% in q1) but is still well below the 80%-85% one associates with more normal market conditions.

A final Bubble test is whether  asset prices make sense relative to fundamentals and here there is often room for debate (witness the range of views on US equity markets and Euro bond yields). In terms of housing one metric is to compare prices with  private rents , as the latter represents the amount consumers are willing to pay for the utility housing provides . Rents nationally, as reported by the CSO, have been rising now for four years, by a cumulative 21%, and have picked up momentum again in recent months after a sluggish period earlier in the year, increasing by 2.5% in the  three months to October. The CSO does not provide a regional breakdown but Daft.ie does , and their figures broadly track the official data. The website shows  strong double digit growth in Dublin rents (around an annual 15% of late, with growth elsewhere at less than half that pace)  and provides detailed rental figures across housing size and type. For example , a 3-bedroom house  in Dublin currently rents at an average €1,518 per month, or €18,216 a year. In theory, the price of any house, discounted at an appropriate rate, should give a present value equal to the rent. If we use the average new mortgage rate as our discount rate ( 3.25%, as quoted by the Central bank) that  Dublin rent implies a house price of €560,000. The Central bank data has been criticized and is going to be revised so an alternative would be to use the standard variable mortgage rate of around 4.25%. On that basis the house price would be  €430,000.

How much is the average price of a house in Dublin? Our own estimates, based on updating the Irish Permanent index (no longer published) with the CSO index gives an actual  figure around €300,000, which is broadly consistent with the average asking price of €325,000 quoted by Daft.ie. The median price of Dublin property transacted  in q3 on the Property Price register was under €280,000 so the implication is that prices in the capital are still not excessive relative to rents, despite the recent pace of price appreciation.The latter reflects ,in part, a recovery from over- sold territory but nonetheless ticks a few Bubble boxes, but not all.

Are current euro sovereign yields irrational?

The Irish Government issued a 15-year bond recently at a yield of 2.49% and the 10-year benchmark is trading at under 1.6%, a far cry from the double digit levels seen in the latter just a few years ago. Sovereign yields across the euro area have plunged of course ; 10-year yields in Italy are down at 2.3%, Spain is trading at 2.1% while Portugal is just over 3%.The perceived risk of default  over the next five years has clearly changed dramatically and judging by Credit Default Spreads is now around 10% for Italy, 17% for Portugal and less than 5% for Ireland.

German yields are lower still and bund yields can be considered the nearest thing to a risk-free rate in the euro area. Consequently, a 10-year bund rate of just 0.8% implies that the market expects short term  euro interest rates to stay low for a long time and then to rise only slowly; the implied 5-year forward yield in five years time is under 1.5%.Interest rates are also extremely low in other currencies but higher than bunds, with the US 10-year yield at 2.34% and the UK  trading at 2.1%. The 5-year forward rates also tell a  very different story- the US implied yield is just over 3% , with the UK at 2.8%.So the bund curve indicates  that investors expect inflation to stay low for a long time and not to threaten the ECB’s 2% target. This , in turn, indicates an expectation that growth will remain weak in Germany, with the prospect of  secular stagnation clearly seen by many investors  as more than just an academic debating point.

That scenario  may or may not materialize but it would appear to be a plausible rationale for the current level of bund yields. The problem is , though, that such a scenario would be very negative for other euro zone economies, particularly those with extremely high debt burdens and needing an internal devaluation to become more competitive within the zone. A prolonged period of very low nominal GDP growth, possibly with price deflation, would severely damage fiscal capacity and via the denominator put further pressure on already stretched debt ratios; Italy’s ratio in q2 of this year  was 134% , for example, with Portugal at 129%.Indeed, Italy’s GDP is already falling steadily and in real terms is back to the level recorded in early 2000.

Buyers of peripheral euro sovereign bonds can point to Draghi’s ‘whatever it takes’ mantra and  it would seem that the market views full-blown QE (i.e. buying sovereign debt)  by the ECB as inevitable and that somehow this will save the day. The Governing Council is clearly split on the issue, however, and some opposed the current plan to buy Asset Backed securities which explains why Draghi is at pains to add the qualification ‘within our mandate’ to his statement that there is unanimous support for additional non-standard policy measures.- clearly some members feel that the ECB could be acting ultra vires. So QE is not inevitable but if it did emerge (through a majority vote perhaps) it is still problematical relative to experience elsewhere. The banking system in Europe  is the main source of credit, unlike the US where the disintermediation of banks is the norm, so QE may not have much impact. Moreover Central banks in the US, the UK and Japan have bought their own sovereign bonds but the ECB has no sovereign bonds to buy- it would have to choose among the sovereign bonds of the 19 member states. How would it proceed if it chose a €1,000bn target- would it buy in proportion to the country weights within the euro area, or target higher yields? The former would imply the purchase of large amounts of  bunds and say only €12bn of Irish bonds. In addition the ECB would be buying at extremely low yields ( elevated prices) so adding a high degree of market risk to the credit risk inherent in QE.

More fundamentally, transferring ownership of some sovereign debt from one group of investors to another (in this case the ECB) does nothing to change the debt burden unless of course one believes that the ECB will effectively tear up the bonds or hold to maturity and then pass the proceeds back to the respective governments. One doubts if that would be acceptable to the Germanic school within the Governing Council, at least on any scale that would make much difference to high debt countries, but such concerns do not seem to weigh much on investors at the moment.

Odd Timing for Proposed Irish Mortage Restrictions

Interest rates are extraordinarily low in many parts of the world; the ECB refinancing rate is 0.05%, in the US the equivalent is less than 0.25% and in the UK the Bank rate is 0.5%.Rates are expected to rise next year in both the UK and the US but the respective central banks have made it clear that any increases are likely to be moderate and that  the cost of borrowing may well settle at levels below previous cyclical highs. In the euro area the economic  outlook is bleaker and most observers expect rates to remain at current levels for a number of years. This low-rate environment carries potential risks for asset bubbles and excessive credit growth so central banks have embraced the idea of macro-prudential tools i.e. measures that can be implemented to protect against systemic financial instability. The housing market is often seen as a specific stability risk and a number of countries have introduced restrictions on mortgage lending, the latest being the UK, where only 15% of new mortgages can be above a Loan to Income (LTI) ratio of 4.5.

The Irish Central bank has now entered  macro-prudential territory with proposals on mortgage lending designed to ‘increase the resilience of the banking and household sectors to financial shocks’ .Like the Bank of England there is a restriction relating to LTI, but in the Irish case the limit is lower , at 3,5, although 20% of lending can be above that limit. In addition, the Bank is also proposing restrictions in terms of loan to value (LTV ) with only 15% of lending allowed above an LTV of 80%. For Buy -to Let loans the LTV limit is 70% with only 10% of lending above that. The LTI restrictions only apply to principal dwelling homes (PDH).

The Bank refers to international evidence supporting the view that LTI restrictions can slow mortgage lending growth and ‘reduce the potential for a housing bubble to emerge‘ although the impact on house prices is less clear, with the Bank of England claiming that there is ‘some evidence of a modest and lagged effect on house price growth’. The latter conclusion is not surprising as credit is only one variable in most house price models, with income, interest rate, the user cost of housing and price expectations also playing important roles. The Central Bank also notes that LTV restrictions are more important after a crash, in limiting losses for the lender.

The proposals have generated debate, of course, with some welcoming the move as important in dampening house price inflation (despite the caveat noted above) while other have argued it will hit  the First Time buyer (FTB) particularly hard and dampen housing supply.Indeed, the LTV limit would appear to be binding now, with 44% of new PDH lending  last year above 80%, while only 7% of lending was above 4.5 LTI, with 77% at 3.5 or below.

Another issue is the timing of the proposals. House prices in Dublin have certainly risen sharply of late and are now over 40% above the cycle low but outside the capital prices have recovered by just 9% and most observers, including the Central Bank and the ESRI, still conclude that prices are not excessive relative to fundamentals such as income or rents. A greater puzzle on timing relates to the credit cycle, given that the restrictions are designed to directly impact lending.The stock of outstanding mortgage debt in Ireland has been falling now for five years and the latest figure, for September, showed a 3.1% annual decline. New mortgage lending for house purchase is picking up but amounted to  just €1.3bn in the first half of 2014 and is still being swamped by redemptions and early repayments. Ireland is therefore hardly swimming in new mortgage lending so restrictions at this time seems premature, particularly as the secondary aim of the moves is to ‘dampen pro-cyclical dynamics between property lending and housing prices’ . That might suggest that restrictions would be better served if actually adjusted for the cycle, with  the LTI limit  reduced if credit growth is deemed too rapid and  the LTV limit reduced if house prices are deemed in excess of fundamentals.

The proposals may indeed dampen  future housing cycles but also have broader societal implications. The Government  was not consulted  and is now reported to be considering some form of mortgage insurance scheme to help FTBs secure a higher LTV.The Governor of the Central Bank in a recent speech also  appeared to be more comfortable  than indicated in the proposal document with the idea of  FTB insurance although with the caveat that who provides the insurance is important. Insurance protects the lender , not the borrower of course, and has to be paid for.A broader conclusion from the Governor’s speech may be that  the proposals will see further modification before implementation, or a longer lead-in time. As it stands the restrictions do have significant implications for  young Irish households, with a longer period of saving in store and therefore a later age for home ownership, at least for some.