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Saturday, 1 October 2011

How Low Can House Prices Go?

Ireland’s property boom was the biggest, and our crash the most violent. In a week that brought news of a further drop in house prices, Economics Editor DAN O’BRIEN explains why the market won’t recover any time soon...

‘THE FUNDAMENTALS of the property market are sound, going forward.” This mantra was repeated constantly during the boom by those who believed that no risks were attached to soaring property prices.

If any reminder was needed of how badly wrong this view was, it came this week with new official figures showing yet another fall in residential property prices in August. This, according to statisticians, brought the total decline since the property-price peak, in late 2007, to more than 43 per cent, one of the biggest drops in the world.

The latest figures from the auctioneer Sherry FitzGerald, also published this week, are worse still, suggesting that average prices are down by a huge 58 per cent since the bubble burst.

The belief that property was a one-way bet became ingrained during the Tiger era. Perhaps this was understandable: the longer any phenomenon continues, the more normal it looks. Such is the psychology that generates price bubbles. And Ireland led the world in the size and duration of its bubble.

According to the Economist’s property-price index, no other European or North American country experienced price rises of the same magnitude over such a long period. In the decade from the index’s start date, in early 1997, Irish property prices quadrupled. The only two peer countries to see a rise of remotely similar proportions were Britain and Spain, where prices trebled. The US saw a much more modest rise over the same period, of about 130 per cent, which was not unusual internationally.

Ireland experienced the largest property bubble and the most violent property crash. That crash, alas, is not over yet, and prices are unlikely to stabilise until next year at the earliest. If the 2011 rate of decline in residential property prices continues for another 12 months, prices will fall by about 15 per cent from their current level. Given the headwinds facing the market, that is more likely than not.

But the highly paid consultants who arrived in Ireland to stress-test the banks after last December’s EU-IMF bailout are working on an even gloomier set of assumptions. Their baseline view is that prices will fall by a further 20 per cent before the market hits bottom. In their worst-case scenario, the decline would be almost 30 per cent. That would bring the fall from the 2007 peak to 59 per cent.

Although there are benefits to lower prices in the longer term, the weak property market feeds through to the wider economy in many ways. One of these is the wealth effect. When prices are rising, people feel better off as the value of their home – usually their biggest asset – grows in value. On average, they save less and spend more.

When prices are on the way down, all this goes into reverse to create a negative wealth effect. Now people are salting away far higher proportions of their already shrunken incomes. The result is to reduce further the level of activity in the domestic economy.

So how far will prices fall and for how much longer will the economy be afflicted by the resulting negative wealth effect?

It is not necessarily the size of a bubble that determines how low prices will go when they fall. More important in the Tiger bubble was the extent to which it was inflated by unsustainable drivers, such as risk-blind bankers hosing money at anyone taking a punt on property.

Looking at other countries helps in assessing where Irish prices are likely to end up. Consider our nearest neighbour, where prices have fallen by a relatively small 11 per cent since 2007, a fact that has provided one of the few positives for Nama, which offloaded some of its London trophy properties this week at no cost to beleaguered Irish taxpayers. Among the most important reasons for Britain’s house-price stability are its tight planning laws, which mean that few new houses are built across the water.

It was different here during the property frenzy, when building permits were extraordinarily easy to obtain. The result was that, in 2007, 90,000 homes were built here while 180,000 were built in Britain, wildly disproportionate figures given that the population of our neighbouring island is more than 13 times greater than that of the Republic.

If there is an undersupply of houses in Britain, the building mania here between 1997 and 2007 has led to a huge oversupply. While the extent of that oversupply is contested, nobody doubts the existence of a large stock of unsold homes. According to the property website daft.ie, the number of unsold properties on its books up to the second quarter of this year had remained stubbornly high, with hardly any reduction over the past three years. This glut will weigh on the market for some time to come, putting continued downward pressure on prices.

IF BUILDING TOO MANY houses can end in tears, so can bad lending by banks. Although the US did not look out of the ordinary in the property-price rises it experienced from 1997 to 2006 (130 per cent compared with Ireland’s 400 per cent), it has suffered the second-worst rich-world crash (after Ireland), and the residential property-price drops from coast to coast are now greater than those during the Great Depression in the 1930s.

One of the main reasons for the US economy’s woes was the quality of bank lending. American financiers gave the world subprime mortgages. The idea behind these was simple and seemingly good: lend to people who, traditionally, would not be entertained by a bank manager, but charge a higher rate of interest to cover higher default rates.

If the theory had its attractions, the practice was a disaster. The proportion of subprime-mortgage holders who defaulted was many multiples higher than what had been projected. The repercussions of these defaults triggered the worst global financial and economic crisis since the 1930s.

While subprime-mortgage lending made a mercifully late appearance in Ireland, sparing us an even more painful crash, Irish bankers dished out mortgages on the rosy assumption that nothing could go wrong with the property market. At worst, they believed that prices would plateau, unemployment would remain low and economic growth would continue, if at a more modest pace.

But if banks lent too much during the boom, they are not lending enough now. The latest figures, released yesterday, show that bank lending for property purchases continued its long decline in August. The lack of new mortgage financing is yet another factor weighing on the market, as is the rising cost of financing mortgages for those who have been able to secure them.

At a time when almost all of the drivers of demand are weak, the psychology of buyers in a market where prices are falling has a further negative effect. When prices rose, seemingly inexorably, it was all about getting a foot on the property ladder, at almost any cost. But now that prices are falling, also seemingly inexorably, most rational people want nothing to do with the property ladder.

This is part and parcel of any deflationary dynamic: potential buyers postpone their purchases in anticipation of even lower prices, sucking even more demand out of the market and adding momentum to the downward spiral.

Can any good come from all of this? Certainly, even if the potential benefits may not be glaringly obvious at this juncture.

Too-high property prices impact on everything from the quality of people’s lives to national competitiveness. Although the collapse in prices has left many people in dire straits and brought down the banks, more affordable housing and cheaper commercial property serve the wider interest.

Even if those looking to buy homes have not benefited much from lower prices (because of the mortgage famine), the huge falls in prices of commercial property, such as offices and factories, have already made Ireland much more attractive to companies looking to set up shop or expand existing operations.

Economists do not agree on much, but there is a consensus that new businesses, be they foreign or home-grown, will create the jobs and wealth to generate sustainable recovery, however long that takes.

Why our banking crisis was so costly

As the chart above shows, Irish residential property prices have fallen by more than in peer countries, but this does not explain why the Irish banking crash has been many times more costly than elsewhere. Last week, for example, the IMF estimated that the direct budgetary costs of Ireland’s crisis had reached almost 40 per cent of all income generated in the economy in a single year. In the US, which has suffered the second-largest house-price crash, the net cost to taxpayers was just 3 per cent.

The reason for the size of Irish banking losses lies in horrifyingly bad lending to property developers. If there was a bubble in the residential market, there was a superbubble in commercial property. Prices of offices, shops and factories rose higher and have fallen far more sharply than those of homes, and some development land is worth just 5 per cent of the amount paid for it.

Property developers have gone bust en masse, bringing down the banks that fought to lend to them. In this respect, Ireland is depressingly unique.

DAN O’BRIEN - Irish Times

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