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Knowing what we don't know

Brian Devine, Brian Devine, Chief Economist, NCB Stockbrokers

6th May 2009

Brian Devine, chief economist with NCB Stockbrokers, commenting on the latest Daft research on the Irish property market.

Dr. Alan Ahearne, Special Advisor to Minister for Finance Brian Lenihan, was last week quoted as saying that "there are two kinds of economist, those who know that they don't know and those who don't know that they don't know". I disagree with his synopsis; I believe that there are two types of economist, those that are willing to admit that they don't know and those that are not willing to admit that they don't know. This is not designed to be a cop out but is simply a reflection of the fact that the current outlook is exceptionally uncertain. Given such uncertainty one must question the validity of publishing point forecasts (e.g. GDP will be down 8% in 2009, property prices will fall 40% from peak to trough) as if they are gospel. Point forecasts of Irish economic variables seem to be a mainstay in the media these days.

Now before putting myself out of a job I must state that I am not saying that forecasting should be abandoned or that it is of no relevance. On the contrary, forecasting economic variables is extremely important for considering the impact that these variables will have upon society (e.g. unemployment), fiscal policy (e.g. exchequer deficit), bank losses (e.g. property prices) etc... But if point forecasts are to be published there needs to be more acknowledgement of the fact that these forecasts are hugely uncertain.

Specifically in relation to the property market there have been plenty of forecasts regarding how far residential prices (ranging from -35 to -60%) and to a lesser extent residential rents (ranging from -20 to -35%) are going to fall from peak to trough. Some studies/views on how far prices will fall are based on historical comparisons with previous OECD housing busts. Others invoke the idea of a "fair value" for housing based on, for example, one or more of the following: income-price ratios, mortgage repayment burden, rent-price ratios, rental yield, credit availability, population growth, interest rates and growth in per capita disposable income.

The problem with trying to forecast prices/rents based on the concept of fair value is that prices overshoot and undershoot fair value. The magnitude of the overshoot/undershoot is ultimately determined by psychology. While the psychology of never ending price rises fuelled the market on the way up, economic/job uncertainty and the expectations of further price falls will be the important psychological factors on the way down.

Knowledge of historical busts, historical relationships and fair value are useful guides as to what direction prices/rents are heading but they are ultimately only that. This guide as to where prices/rents are heading needs to be continually updated to reflect activity in the housing market, the economy and policy variables such as tax.

At the current juncture there is little reason to believe that house prices will not continue to fall as future employment prospects remain bleak, further tax hikes are in the pipeline, confidence remains low, emigration is likely and there remains a large supply of properties available for sale. Affordability may have improved sharply but until confidence and job certainty are restored this means very little to many perspective buyers. Psychology actually reinforces the negative sentiments arising from real income uncertainty. In fact, after months of sliding house prices, potential Irish home buyers are rapidly becoming not simply risk-averse, but loss-averse. In other words, no matter what models about fundamental house values imply, people are simply avoiding losses by withdrawing from property transactions. A shift in psychology rather than simply an upturn in incomes and growth is needed to trigger a mass-return of buyers to the market. This is the major known unknown in determining where prices/rents eventually end up.

Vendors have acknowledged that the outlook for the sales market is challenging and as such there has been a large shift of properties from the sales market to the rental market with the result that the stock of properties available for rent on Daft has more than doubled from 10,817 in April 2008 to 22,161 in April 2009. Of course the stock available to rent could have increased if the demand for rental properties had actually declined but in fact the demand for rental properties is up with the number of monthly lettings averaging 12,858 in the year to April 2009 versus 7,954 in the year to April 2008. The increase in demand for rental properties reflects the fall off in demand for house purchase and possibly a shift in attitudes towards renting more generally.

Yet, we still hear strongly the story that the Irish have always been and will always be wedded to the idea of home ownership as a fundamental part of maturing into adulthood. If such a story about Irishness and adulthood maintains its hold, house prices will eventually settle at a higher level, and changes in the market will depend on macroeconomic conditions, rather than on the type of seismic shift in Irish culture described by Gerard.

As of April 2009 rental asking prices were down 16.4% y-on-y as the supply of properties has outstripped demand. The Daft rental index is now down 17.5% from its February 2008 peak and back at levels last seen in May 2005.

With the sales market likely to remain weak, rental supply will remain strong. On the demand side there will be continued pressure on disposable income from tax hikes, job losses and wage cuts as well as the likelihood of emigration. All in all, as with the sales market there is little evidence that achieved rents will stop falling, and at this juncture the peak to trough fall is likely to head towards the upper end of the range mentioned earlier. But the outcome is highly uncertain.

The uncertainty of forecasts is being exacerbated by the lack of clarity in Government policy regarding the future path of income taxes, property taxes and mortgage interest relief. Uncertainty in this regard can be reduced with increased transparency in relation to fiscal policies. As William Henry Harrison, the 9th US President, said "The prudent capitalist will never adventure his capital... if there exists a state of uncertainty as to whether the Government will repeal tomorrow what it has enacted today".


Rental Index
Rental Index

Stock and Flow of Rental Properties
Stock and Flow of Rental Properties


Snapshot of Rents Nationwide
Snapshot of Rents Nationwide