Wednesday, May 28, 2008


This article was written by Martin Rojko, a real estate analyst and frequent guest writer at Capitalism & Freedom.

According to indicators used for measuring a housing price bubble, residential property values were inflated last year in many european countries. Morgan Stanley´s and Global Property Guide´s data indicate, that market distortion is in Spain, Ireland, Baltic states, Netherlands, Denmark, Czech republic, Great Britain. As these data were gathered in 2006, it´s more than probable more markets join now a bubbled group including Slovakia.

According to TREND calculations the price of mostly selling apartment (one-bedroom, 60 m2 livable area) were equaled to eight-year disposable household income in Bratislava area. Although numbers (not only) such these should be counted carefully, sticking out income and price is a matter of fact. Also another indicator of rental property yields signals the bubble. While a few years ago an owner in Bratislava could make 10% or more from an apartment, now it is approximately 5% (less than mortgage interest in banks). It is the result of doubling apartment prices and stabilising rents.

A long history of western developed markets suggests a normal yield of around 10 – 12%. Property gets cheap when yields approach 15 – 20%. Numbers lower than 6-8% mean overvaluation. According to ECB note house prices in euro zone are overvalued by 15 to 25% by this indicator from their historical averages.

The second indicator, price-to-income ratio, tells how many years of pretax annual earnings are necessary for a household to purchase a house. The historical rule of thumb is that one annual income indicates undervalued properties, two and three annual incomes normal valuation, and four and more annual incomes overvaluation and bubble territory.

This situation has clear solution. To bring the ratio of prices to rents and incomes back to fair value, both must rise sharply or prices must fall. Housing prices now fall in Ireland, Latvia, Estonia, Spain and Great Britain.

We can often hear some experts said that european countries haven´t so crazy lending standards as in the USA and that´s why there´s no danger to afraid of a bubble. It´s a clear misunderstanding. Subprime mortgages don´t create a bubble although it can boost it. Look at Great Britain, Ireland or Spain. There haven´t been much relaxed bank´s lending conditions (especially comparing to the USA), so why the current turmoil? Because home prices are not justified by fundamentals – income, and rents. The bubble is reality.

Now the question stands whether it will burst and harm the whole economy or slowly blowing-out. Considering three mentioned countries I see the greatest danger in Spain. First, there is a huge home supply at prices which people simply can´t afford to pay. Currently cca 650 000 unsold units. Developers will be forced to decrease price maybe 30% down to sell them. But in the meantime many firms get to financial problems and go bankrupt. Second, Spain has the highest construction sector share on GDP in Europe (nearly 18 %). When developer, building firms have troubles, banks and whole economy have also. Of course, government interferes and pumps subsidy package to the economy, but this step only postpones clearing of the market.

There´s another (empirical) point we must be aware of. It is a tight correlation between US and euro area housing prices. The latter following the former with a lag of about two years. US started to decline in 2006, so maybe this year eurozone is in order.

But what about emerging euro countries? Well, as mentioned above the bubble exists in many of them. One thing is clear. Prices are rising slower than in previous years, in some markets (Estonia) they are heading downward with mild heavy impact on a part of mortgaged buyers. They have stabilized in polish Warsaw (been for 9 months cca on the same level) and start to stabilize in Bratislava. While up to day growth was driven in most part by foreign investors, they are now (also due to so called “mortgage crisis”) away. Developers thus hope domestic buyers will continue, but prices are too high for middle classed society (as largest pool of potential clients), because they are set-up still for wealthy and investors.

Now the question is whether incomes will rise so quickly that homes will sell at this level or prices should go down. I think second alternative is the most probable (and not because of I´m not living in my own). And the sooner sellers realize this, the lesser will be impact of bursting bubble in later times. The opposite side of a coin is firms are misguided by monetary policy of central banks, which manipulate interest rate according to their needs, while a real value of the money (or better said the means of payment) can be much higher (see US). And another question here arises (when not talking of abolition), whether one central bank for many differently phased markets is the best way to cope with problems.

Martin Rojko, author is a reporter in (real estate server of business weekly TREND) and runs a blog


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