May 13, 2009

Collapse in house prices will be good for economy

Posted in Irish Independent · 1 comment ·
Share 

Many people in recent weeks have tried to explain what is happening to the economy.

How can we visualise why credit has dried up? How do we rationalise the fact that we went from a situation of so much money we didn’t know what to do with it, to a situation of no cash at all? Where did it all go?

One interesting way to look at this, and this column has used it before, is to think of events in the natural world.

Think of the aerial photos of the Serengeti at the beginning of the annual rainy season. What was a parched arid climate where nothing grows suddenly become florid, verdant and full of life. Animals, flowers insects flourish and the place is abuzz. We see migrating wildebeest, crocs and birds and then, at the height of the season, the whole plain is crackling with energy, fuelled by that most precious of commodities, water.

Then as the seasons change, the water begins to evaporate. Life disappears from the edges of the plain, animals flee, plants die and as the waters recede life recedes with it. In the end, there is only a pathetic lush patch at the source of the river, everything else is barren, lifeless and arid.

Credit in the Irish economy acts the same way as water does in the real world. When it gushes into the various different nooks and crannies of the globe, economic life and vitality springs. So, all over the country, the water of the economy ushers economic vitality in — credit. Anything is possible, anywhere. Money gushes out of the traditional core countries such as the US and Europe and finances projects in the most remote places, giving people hope.

Then the financial season changes, due to the psych- ological interaction between investors’ hopes and fears, and the money retreats back to the centre again, leaving the exposed areas like the high plain of the Serengeti, exposed and lifeless. This process is happening all over the country now as businesses are left to fend for themselves without their lifeblood, credit.

This is why Irish house prices will continue to fall and fall. We are the victims of the retrenchment of credit. No-one will lend to our banks and they won’t lend to everyone else.

Yesterday, I drove to Galway from Dublin and then up to Letterkenny. It was quite a trip, but it gives you a good idea about what is happening in our towns around the country and why the thousands of vacant properties will continue to fall like a stone.

Every single town I passed has a huge ghost estate on the outskirts: Athlone, Craughwell, Oranmore, Tuam, Castlerea, Sligo, Ballybofey, Bundoran, all the way up to Letterkenny. The place is full of them. These houses will never sell for the prices that are demanded. The reason is simple: they are still madly overvalued.

In most cases the houses will never produce any rental income. With unemployment rising so quickly and emigration replacing immigration, there simply are not the people to fill the houses. Even if credit were available, there is no demand.

Also, if we look out a few years, the banks will have to wean themselves off all the money they were borrowing abroad to sustain the boom. For the two main banks this was 160pc of their deposit base. Put simply, the banks were lending €16 for every €10 of deposits. In order to get their capital ratios back to a reasonable level, this figure needs to go back to parity. This financial pendulum swing means billions of euro will be sucked out of the economy in the next few years and not replaced.

So, how low will Irish house prices go? To establish this, we need to figure out what a house is worth.

A house is just a simple investment and should be valued according to some financial benchmark. In America, where they have had booms and busts in every generation, the long-term price of a house is equal to 14 times the annual rent the place can generate. Using this valuation, where could Irish prices go?

So, let’s pick a typical ghost estate area such as Oranmore in Galway. If you go on Daft.ie you will find all the answers. If you want to buy a three-bed semi in Oranmore, it will set you back €335,000. However, you can rent the same place for €800 a month. What’s more, there are 75 vacant three-bed semis in Oranmore advertised on Daft.ie alone.

Using the American valuation method, it implies that the house generates rent for the owner of €9,600. The house is worth 14 times that which gives us a value of €134,400. Yet the seller expects to get €335,000 for it!

In other words, to make it worth your while buying the house, the price would need to more than half from where it is now. We have to assume that the days of large capital gains on houses are over. Therefore, the average Irish house in these estates is likely to fall by anywhere between 50pc and 60pc in the next few years. And even that is assuming that prices don’t undershoot on the downside the way they overshot on the upside.

This is a tragedy for the people who own the properties, and for us, because, ultimately, many of these shells will find their way into the NAMA. However, looking out a few years, the fall in the price of houses will be very positive for the economy.

Cheap accommodation, like cheap energy, is a competitive plus for any economy. In fact, if we look at successful European economies, cheap accommodation relative to wages is the basis of a dynamic economy.

After all, we are amongst the least densely populated countries in Europe. By the time this recession is over we will have house prices that will reflect this sparse population. And the economy will be stronger for it.


  1. Tom79

    How low will house prices go in Dublin? I believe that with the continued reduction in credit the house prices in Dublin will also collapse to about 30% of their peak value.

You must log in to post a comment.
× Hide comments