What’s driving the rapid property price rise?

The marked turnaround in the housing market, especially in Dublin, over the past year or so raises several important questions. What factors are driving the rapid increases in house prices? Should we be worried about these gains? And what should policymakers do, if anything, to put house prices on a more sustainable trajectory?

House prices in Dublin have risen 13 per cent over the past year and inventories of unsold homes are shrinking fast. Given the economic turmoil of the past few years it’s not easy to pin down the exact drivers of the turnaround in housing. But a useful place to begin is to compare recent developments in the housing market with what might have been expected to have happened based on the international experience with housing booms and busts.

By some measures, the behaviour of house prices in this country over the past decade has followed the pattern of past episodes of booms and busts in other countries. Typically, home prices decline for four or five years after reaching their peak. Sure enough, the Central Statistics Office’s nationwide index for residential property prices declined over the five-year period from 2008 to 2012, before turning up a bit in 2013. The drop in house prices restored the prices-to-rents and prices-to- disposable-incomes ratios to near historical norms, as in previous episodes.

In other ways, however, house prices here over recent years have deviated from the typical pattern.

For starters, real (that is, inflation- adjusted) house prices during a bust typically give up all of the gains registered in the five years before the peak. Such a pattern would have seen house prices drop to their level in early 2002. In the event, house prices plummeted to their 1999 level, leaving prices at the trough roughly 20 per cent below what the international experience would have predicted. Interestingly, the first signs that the housing cycle was turning appeared in late 2012 when rents – often the canary in the coal mine for house prices – began to rise.

Plunge in construction
Second, although housing busts are typically associated with a steep contraction in new homebuilding, the plunge in construction in Ireland since the onset of the crisis has been extraordinary. The "shuddering halt" in homebuilding saw housing completions slump from about 94,000 units in 2006 to fewer than 10,000 units annually over the past three years.

Third, after bottoming out, house prices usually remain flat in real terms for several years. In some cases, prices have bumped along the bottom for a decade or longer. Although it is too early to tell whether nationwide prices are on a sustained upward path, it’s clear that prices in Dublin are rising rapidly, at a time when consumer price inflation is roughly zero. The sharp reversal in house prices in Dublin has come as a surprise to many observers, much as the hard landing did at the end of the last boom.

These three atypical features of house price movements require closer scrutiny. As best I can judge, they reflect a combination of three factors.

First, the depressed level of construction of new homes over the past few years has resulted in a shortage of supply of housing in urban areas. The shortage is most acute in Dublin, where the broader economic recovery is most advanced. During the crisis, potential homebuyers postponed purchasing houses amid unprecedented levels of uncertainty about prospects for their personal finances. With consumer confidence improving, this pent-up demand for home ownership is becoming evident. In addition, demographic developments are putting upward pressure on the rate of household formation. A recent report by the Housing Agency estimated that nearly 80,000 new homes in urban areas will be required over the next five years to meet the needs of Ireland’s growing population.

Second, house prices in Dublin may have overshot on the way down. From peak to trough, house prices tumbled 57 per cent in Dublin compared with a drop of 49 per cent in the rest of the country. Given the incredible degree of overbuilding in some rural parts of the country, it’s not clear why the largest declines should have been registered in Dublin. Some of the recent recovery in Dublin may be serving to correct this misalignment.

More generally, some of the drop in house prices nationwide of more than 50 per cent from peak to trough may have been in response to the excessive pessimism about the country’s economic future that became a feature of the national debate during the height of the crisis. For a while it seemed that commentators were tripping over themselves to produce the gloomiest predictions. Indeed, economic commentary has generally been pro-cyclical over the past decade, exacerbating both the boom and the bust.

Third, property prices are currently rising at a heady pace in many countries. Even the bankrupt city of Detroit has seen a surge in house prices recently. A major factor has been the unprecedented policy actions taken by central banks around the world, which have driven interest rates and bond yields to historically low levels. In Ireland, unlike other countries, these policies have not resulted in lower interest rates on new mortgages. In fact, banks have increased borrowing costs on new loans in part to cross-subsidise loss- making tracker mortgages. Instead, these actions have boosted the housing market because the lower returns on financial assets such as cash and bonds have prompted some people to shift part of their savings into housing. Hikes in the Dirt tax and the pension levy arguably have also played a role. This partly explains the influx of cash-rich buyers into the market.

Double-digit growth in Dublin house prices is less of a problem today than at the height of the bubble because prices are now much lower. Moreover, the market today is not being fuelled by a dangerous expansion in credit. Nonetheless, policymakers ought to be concerned about swings in the housing market and a response is needed to make future house prices more predictable.

New homes in the right places
A key part of the solution will be to build new homes in the right places. That means Dublin, not Meath or Kildare. New homes are also needed in the cities and suburbs of Cork and Galway. The proper utilisation of space in urban areas will be vital to delivering new supply. The reality is that our cities have too many commercial property units and vacant spaces where instead there should be townhouses and apartments. As an added bonus, new homebuilding will create much-needed employment and boost the public finances.

Most importantly, we need the banks to get back into the business of funding property development. Banks, by extending development loans and mortgage credit, are always and everywhere the drivers of property cycles. But the time lag between starting a housing development and selling the completed homes means the banks (and developers) must be willing and able to bear risk.

The biggest concern is that today’s heady gains in house prices in some areas become embedded in expectations of future prices. The Government’s forthcoming strategy document for the construction sector will need to convince people of two things. First, that there is a credible plan to ramp up supply in the right places; and, second, that the authorities have the tools to ensure that house prices in, say 2020, will not be too far above today’s levels – and won’t shy away from using them if necessary.

Dr Alan Ahearne is head of economics at the National University of Ireland, Galway