October 29, 2015
Great expectations - the driving force behind latest property crisisPosted in Irish Independent · 119 comments ·
Is it possible that we have got ourselves into the position where we have a housing crisis again, where those at the bottom and middle can’t find a place to live and those moving from the middle upwards are locked into, yet again, bidding wars for homes where the speculator and the owner are pitted against each other? Could we be in the situation where investors and large foreign funds are sitting on land waiting for the prices to go up in order to make a killing, thus exacerbating the supply shortage? It’s hard to believe – after everything we have been through – but it’s true.
Above all, the Irish property market needs stability. It needs to be liberated from constantly changing expectations about where prices are going to go. Expectations about future prices are what destroy a property market and lead to the unhealthy intrusion of speculators in the market for accommodation.
Accommodation should be a fixed cost in an economy, a cost faced by all of us, like the cost of electricity. Can you imagine what would happen to the use of electricity in Ireland if people thought the price was going to change on a daily basis and everyone had their own generator trying to sell at the best price to a national grid? Imagine the surges and scarcities in both use and supply as users and suppliers tried to get the best price.
Now think about the housing market.
When there is an expectation that prices are going to go up, it is understandable in a capitalist system that the people who own the land will wait for prices to go ever higher, thus squeezing potential buyers. It is also understandable that potential buyers will panic when they see prices rising and bring forward their demand so they won’t be left behind. This is precisely the opposite of what is suggested by classical economics. In classical economics, we are told that when the price of something rises then the demand will fall, but this is not the case in property. When the price rises, the demand rises too.
What do you think happens to supply?
Traditional economics suggests that when the price rises the supply will rise, but is this what actually happens in real life? If owners of land and houses believe that prices are going to rise, wouldn’t they be mad to sell now when they can make more money by delaying? So supply doesn’t rise when price expectations rise, it actually falls – exacerbating the panic.
So you can see that the issue for the property market is not so much supply and demand at today’s prices as the traditional economics model suggests, but rather the reaction of supply and demand to the expectations about future prices.
As a result of this real-life observation, we need to isolate what drives expectations because if we can isolate what drives price expectations, we can work backwards to solve these erratic shifts in supply and demand, which are destroying the market and heaping such pain on the renting class.
The root cause of price expectations is the availability of credit. In countries where credit is not extended by the banking system to the property market, we don’t see property price expectations that move out of whack with the real underlying value of property or real estate. Take most European countries: we don’t see wild property price movements because we don’t see wild lending by banks that drives up prices.
But it is not just the banks that are at fault: the valuation method for property is a massive problem.
At the moment in Ireland, we value land on the basis of the last market price. This means that the value of land or a house today is based on the latest price that a buyer and seller is prepared to do a deal at. This is what investment banks call “mark to market” valuation – and this is a huge problem because, when you think about it, you can see how basing the value on the last transaction will drive expectations and credit up and down wildly.
The banks take their lead as to how much they can lend based on some percentage of the valuation.
This is what is termed collateral. As long as the valuation says that all is okay, the bank lenders feel comfortable lending against the property. This means if the price of land moves out of whack – away from the real value of land based on long-term trends in land prices – there is an in-built bias for the banks to make legitimate the last price increase by lending more against the new valuation.
Let’s look at a small example.
Consider a house that was valued at €1000 last year, and let us say the bank feels it can lend prudently 80pc of the valuation to the buyer.
The bank could lend €800 against it. Now what happens if this year the house sells for €1200 because expectations have changed?
The bank looks at the new valuation and figures that it is now prudent to lend 80pc against this new valuation. So what it lent €800 against last year, then goes up to €960.
So it is not hard to see how the new market-based valuation can amplify price increases and push them away from fair, long-term value, thus leading to panic and upward moves in expectations. This is at the core of the property dilemma – the way we value land.
Imagine if we in Ireland valued land not based on the latest market price but on long-term valuations that took into account long-term prices, yields, planning, demographics and the likely growth in the economy and incomes?
We would smooth out these fluctuations in prices and expectations because valuations would gyrate from year to year.
Next week, on Wednesday November 4, I am speaking at the Institute of Professional Auctioneers & Valuers, debating a novel system of valuing property that doesn’t currently exist in Ireland but is popular in Germany, Portugal and the Czech Republic.
The event will explore using such longer-term valuation methods. The interesting thing is that these methods may ultimately be imposed on Irish banks as part of the ECB’s move to regulate banks and bank lending more closely.
It would seem that now, with another housing/rental crisis on our hands, we should look to long-term solutions, isolating the root of the problem which is systemic, rather than looking for the next quick fix to get us past the next election.