Safe as Houses: Is the trend your friend?

Don Walshe
Don Walshe is a Senior Economist with Goodbody Stockbrokers. Previously he worked in Goodbody Economic Consultants as a Senior Consultant having come from the Department of Economics, University of Limerick. Don has a M.A. degree in Economics.

June 2003

The old adage 'safe as houses' accurately reflects significant demand for property over all other asset classes throughout 2002.

At a time when the global economy is struggling to recover from the investment excesses of the technology boom and geopolitical uncertainty is close to crisis levels on the back of the Iraqi conflict, it is not surprising that investors' tolerance for risk has declined markedly. Given that property is perceived as a low risk asset, the demand for property has comfortably outstripped other asset classes, causing capital values to appreciate significantly over a relatively short time period.

Property and bonds are both regarded as low risk investments: property because positive demographics create a natural demand for accommodation; and bonds because governments need finance and can always print money to avoid default should the need arise. In the long run, low-risk assets such as bonds and property should generate lower returns than riskier assets such as equities where returns are fundamentally linked to developments in corporate profitability. From time to time however, investors' attitude to risk changes which has a significant impact on the demand for one asset over another.

The rapid increase in property prices in Ireland has reduced the return (yield) on housing assets, particularly when one takes account of declining rents due to the surge in demand for buy-to-let properties. However, despite yield pressure due to rising capital values and falling rental incomes, investors are still willing to accept lower returns because the risk-return profile of the property market remains attractive to investors.

Despite the resilience of residential property demand, the marginal buyer's ability to pay is always constrained by cash, savings and the ability to borrow. In a low interest rate environment, as is the case presently, the ability to borrow is the prime support for underlying demand. Simply put, the more you can borrow, the more you can afford to pay. In a low interest rate environment, there is always the risk that households take on too much debt which would leave them seriously exposed to any downturn in household income. This is why the Central Bank tries to ensure that commercial banks do not relax the terms of lending to the extent that households become overly leveraged.

Conservative lending policies are positive in so far as the average household is cushioned from an economic downturn in terms of ongoing ability to meet mortgage repayments on a monthly basis. For many commentators, this ease of repayment or low debt burden allows for prices to rise indefinitely. There is, however, a wider dimension to conservative lending policies by the banks which also has a direct impact on affordability.

Assuming banks will only lend you a fixed percentage of the house price, the cash deposit required to finance a house purchase rises as the price rises. As disposable income growth slows, this rising deposit requirement begins to represent a quickly growing share of income for the marginal buyer. In the UK for example, the deposit requirement now stands at 124% of average income compared with a peak of 105% at the peak of the last housing boom in the late 1980s. As such, the rising deposit requirement represents an unambiguous decline in affordability for the marginal buyer, despite low interest rates.

So why then, you might ask are house prices still rising by 20% in the UK and 15% in Ireland on an annual basis? In my opinion, there are two reasons. Firstly, house prices have risen so much relative to mortgage repayments that a significant amount of equity, or capital, has been generated by the market. As this represents an effective increase in savings, the negative effects of a rising deposit burden are partially offset. Secondly, and critically in my view, the marginal buyer still expects greater capital appreciation in housing assets relative to all others. This expectation, of course, is based on recent experience and should not be regarded as anything more than a transient support for the market.

Expectations of price increases also cause the decision to invest in property to be brought forward as investors want to avoid 'missing the boat'. This can lead to a surge in demand which softens sharply once the expectation of price increases begins to dissipate. The buy-to-let segment of the market is most sensitive to changes in expectations and a growing yield gap with other asset classes.

The most dangerous phrase in economics is 'this time it's different'. With survey data showing that 35% of Irish property investors have been in the market for less than one year, previous housing corrections in the UK, Japan and Germany are likely to prove instructive.