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House Prices Hang over a Sloping Hillside

Marc Coleman, Economic Editor, The Irish Times

2nd Aug 2006

Marc Coleman is our guest blogger, analysing the Quarter 2 2006 figures.

Like any self-respecting seven year old, I used to spend childhood Saturday mornings watching cartoons on TV. The one I best remember had Tweety bird being chased around by a cat somewhere in the vicinity of the grand canyon. Over the cliff flies the bird. Somehow, the cat follows. After a ten yard run on thin air the cat stops, looks down and hurtles to the bottom leaving a ring of smoke on impact.

Like most other asset markets, house prices are driven by both fundamentals and confidence. When confidence departs from fundamentals, we're in trouble. For fundamentals read the state of our economy, our personal finances, interest rate levels, and a few more. Fundamentals are rational. Confidence isn't. In the cartoon the cat keeps going over thin air until he looks down; it's when he actually realizes that the ground beneath his feet has vanished that the fall happens. So it is with overvalued asset prices. As long as buyers are confident that prices will continue to rise, they do. When enough people lose faith, a slide is hard to stop. But how do we know when prices have departed from fundamentals?

Thankfully the cliff analogy is a bit extreme. Irish house prices are not hanging over the edge of a canyon. A sloping hillside is a more accurate, and comforting, analogy. Somewhat overvalued, the gap between where we are and where we should be isn't yet critical, a fall of several, rather than hundreds, of feet. But if house price inflation doesn't moderate soon, the gap could soon become too large to avoid a very painful correction.

Last September the Organisation for Economic Co-operation and Development (OECD), a high level think tank, calculated that Irish house prices were 15 per cent overvalued. But with house price inflation slowing to 5 per cent back then, the Central Bank was unconcerned: Provided house price inflation remained a few points below the rate of growth in nominal incomes, any overvaluation would correct in over two or three years without any need for a fall in house prices. The re-acceleration of the rate of house price inflation - as calculated by the Daft.ie House Price Index - to 14 per cent in April is scary. So is the equally rapid slowdown to 6.2 per cent by July. Is a downturn in the market going to happen?

Despite some overvaluation in the market, this is unlikely. Two fundamental events justify the reacceleration in prices since this time last year. As last year drew to a close, the expected release of SSIA moneys, which began this May, became bankable as deposit leverage. The second more significant event was that at the turn of the year banks became much more liberal with mortgage lending policies. Old multiples of gross income went out. New, and more liberal, measures of net income came in. More important still was the lengthening of mortgage repayment periods - with 40 year mortgages now not uncommon.

So the recent price resurgence is 'fundamental' in nature: The stock of credit available for house purchase increased significantly in a short space of time, but the supply of houses in sought after areas did not. Throw more money after the same amount of goods and prices rise: It's the oldest law in economics.

The question is what happens next? Give or take a percentage point or two, the 15 per cent overvaluation that the OECD spotted last year is still there: The fact that the latest Daft.ie Asking Price Index shows buy-to-let yields remaining very low confirms the picture.

For a soft landing, several things need to happen. In his next and last pre-election budget, Brian Cowen will probably want to ease the burden of stamp duty for first time buyers. The reintroduction of a differential stamp duty regime between owner occupiers and investors - tried but reversed in 2002 - may also be a prospect. Those changes will help cool price pressures and, provided they are phased in over several years, won't frighten the horses (announcing a programme of stamp duty reductions over a three year time period could be electorally appealing).

The more important long-term issue is supply. To some, the recent resurgence in house prices is puzzling, in spite of all the extra credit sloshing around the market. How can it be, they ask, that 86,000 houses are being built a year, 21 houses per thousand of the population and the highest rate in Europe, and yet house price inflation is still accelerating? The answer is the oldest adage in this market: Location, location, location.

As the preliminary census has revealed, population is growing quickly around the commuter belt and outer ring of greater Dublin. But it is actually falling in Dublin proper. Use of land within the M50 is highly inefficient: In a land footprint the size of Berlin, we are housing less than one third of Berlin's 4 million population. Unfortunately this is where people want to live. Interacting with the extra availability of credit, the extraordinarily low density of housing within the city limits is helping to push up prices far higher than elsewhere in Ireland, pushing up the national average rate of house price inflation.

Any sound housing and planning policies will correct this bias by freeing up land in more commutable parts of Dublin, and other major towns. But again, a graduated measured approach to this will be conducive to an orderly correction. The welcome moderation in price inflation provide a good first half of that desired outcome. Government policies are its crucial second half.