Irish rental yields imply dysfunctional housing market.

House price inflation in Ireland has slowed of late, easing to 5.6% in January from more than double that pace a year earlier. The deceleration largely reflects the trend in Dublin, with prices in the capital falling by 2.8% in the three months to January, so reducing the annual increase to just 1.9%, while the CSO’s index for the rest of the country shows prices still rising strongly, by an annual 9.5%. The supply of new housing has picked up but is generally perceived to be well short of demand, so the softer tone in Dublin may reflect issues on the demand side, such as uncertainty over Brexit, affordability and the impact of the Central Bank’s mortgage controls, which limit leverage .

On the rental side the asking quote for new lets on Daft.ie. is  still rising strongly (  an annual 9.7% increase  in the final quarter of 2018) while the annual increase in rents actually paid in q4 was 6.6% as captured in the CPI or 6.9% as measured by the Residential Tenancies Board (RTB). Yet that mix of rents and house prices does not make much sense as the implied rental yield seems extraordinarily high.

According to the RTB the average monthly  rent in Ireland in q4 was €1134 and from the CSO database the average price of residential property ( as sold in the market)  was €290,800 over the second half of 2018, giving an implied yield of 4.7%. Similarly, the average  Dublin rent of €1650 implies a similar yield in the capital, while using median as opposed to mean prices pushes both yields up to 5.5%. The Sunday Times recently quoted a transaction  involving an Irish Reit with an implied  residential yield even higher, at 6.7%.

From an investment perspective a standard approach to valuation is to compare the yield on a given asset to the risk free rate, generally proxied by the 10-year government bond yield, and one would expect rental yields to be higher given a risk premium. That is indeed the case with an average differential of around 0.3% going back to the 1990’s. Yet the Irish 10-year bond yield has spent over three years below 1% and is currently trading at 0.6% so implyimg ‘excess’ returns on property of over 4% a year.

The relationship between the average mortgage rate and rental yields can also be revealing. Yields fell to 3% and below in the run up to the housing crash and as such well below the prevailing mortgage rate , but that is far from the current situation, with the latter  around 3%.

So rental yields look high relative to the cost of borrowing and the yield on alternative assets, and in a well-functioning market competitive forces might be expected to  push yields down, either through lower rents or higher prices. In fact yields have declined over thee past six years but only modestly, and that was due to  a 75% rise in prices outpacing a 60% rise in rents. Absent a big demand shock to employment the most likely driver of any moderation in rents is an increase in rental supply, which is on the cards, but that is a slow process. Moreover, rental controls benefit current tenants but at the margin may discourage rental supply, Similarly, mortgage controls will help to prevent a credit bubble but will also dampen housing supply as well as keeping potential buyers in the rental sector for a longer period.