A HIGH level of business confidence, reasonable tenant demand and low interest rates are the underlying factors driving the current buoyant property market in Ireland.
What would happen if interest rates drop to the low levels similar to those currently applying in Germany? What would be the impact on the Irish commercial property market?
The market is now well into recovery mode following almost 10 years of recession. It is currently going through a "catch-up" phase - but I believe the market is not overheated. Indeed, in the office sector, rental levels for new accommodation are barely at the level that compensate developers for the current costs of construction. In the industrial and retail sectors, rents and prices are still intrinsically good value, although there are not as many bargains as there were in 1994 and 1995.
Unlike the 1970s and 1980s, when the key driving force in the property market was the institutional investor, the major influence in determining property values is the private investor who borrows his funds from a bank. For the private investor using borrowed funds, the key factor influencing what he will bid for a property is the extent to which the rental income from a given property covers the interest on his borrowings.
Thus recent property investment activity has been heavily influenced by the Irish rate regime where the Dublin interbank rate (the wholesale cost of money) or DIBOR (the benchmark interest rate on the interbank market) is currently about 6 per cent to 6.25 per cent for medium-term funds. To this wholesale cost of funds must be added the lending bank margin's plus reserve asset cost or RAC.
At the moment, DIBOR in Dublin for 12-month money is 6.1 per cent; five-year money is 6.25 per cent. Banks need margins of 1.5 per cent to 2.5 per cent above DIBOR to cover for risk and margins. Thus in Ireland, for good medium to large projects the actual cost to a borrower of five-year money will be between 7.6 per cent and 8.6 per cent.
In Germany, at the equivalent rate for DIBOR five-year money is 5.1 per cent, and when a margin of say 1.5 per cent is added, this would give a borrower a cost of funds of 6.6 per cent to 7.6 per cent - a full 1 per cent less than in Ireland.
The equivalent figure in sterling for five-year money would be cost of funds 7.6 per cent, plus a margin of say 1.5 per cent, making the total cost of funds to a borrower at least 9.1 per cent - 1.5 per cent more than in Ireland.
I ask myself what would happen to the Irish property market if we had interest rates equivalent to the German level or UK level, as this is a possible scenario after 1999?
Take an example of a £1 million property let at £80,000 per annum in Ireland. An investor in such a property probably borrowed 75 percent of the purchase price or £750,000 using five-year money. Currently his cost of funds would be about 7.6 per cent (DIBOR 6.1 per cent plus margin and RAC of say 1.5 per cent). A 75 per cent loan at these rates on this property would absorb just under £60,000 of rental income leaving him with a surplus of a little over £20,000 as a return on his equity of £250,000. This surplus would probably be applied to paying down his debt.
If after Economic and Monetary Union, the Irish DIBOR rate for five-year money were to fall to German levels of 3.25 per cent for one-year money, or 5.1 per cent for five-year funds, and if Irish banks would accept the same margin, of say 1.5 per cent to 2 per cent, the cost of overall borrowings for five-year money would drop by at least 1 per cent to 6.6 per cent. Thus, for an investor in our notional £1 million property, instead of his funding costing him £69,000 per year, it would cost him £50,000 per year in interest leaving a surplus of £30,000 per year. An investor would give his right arm to acquire property in such a scenario.
What would happen is that this type of property investment would be in such demand that prices would increase to the point where the return on equity is more or less the same - a surplus of £15,000 to £20,000 on equity of £200,000 to £300,000. This would mean that property investors would increase their level of borrowings and bid more for such properties. This pressure would probably increase the overall prices of such properties by 15 per cent to 20 per cent.
Thus if Ireland does go into the EMU and we have medium-term interest rates similar to those now prevailing in Germany, it is likely the Irish property market is currently is undervalued.
On the other hand, if we look at the UK, where interest rates are about 1.5 per cent higher than in Ireland, property values are generated at a discount of probably 20 per cent lower vis a vis the Irish spectrum of property values. Is this what we could expect if we stay out of EMU?
Indeed, if the UK were to go into the EMU, there is currently more potential upside for UK property than for Irish property. It is one of the reasons why I am recommending my clients to look at UK property.
However, if the UK stays out of EMU and their current interest rate spectrum prevails, then the UK property market may be at a reasonable value scenario whereas the Irish property market could be overvalued. This could be the scenario if the Irish currency has some link with sterling after 1999 - ie, sterling stays out of EMU and Ireland does likewise.
In summary, the question of whether Ireland goes into the economic and monetary union and has a single European currency in 1999 is not just one for the politicians and the banks. It is a key issue that will affect the Irish property market and the owners and occupiers of property.
