Comment

Property valuations

Dec 03, 2018
As talk of another property bubble abounds, it’s time to assess whether house prices reflect fundamentals or froth.

Are Irish property prices overvalued? Since they hit bottom in March 2013, residential property prices have risen by 82.8% to September of this year, according to data from the Central Statistics Office. Since bottoming in February 2012, residential prices have risen by 96.1% in Dublin. According to a recent edition of The Economist, Dublin’s house prices are overvalued by 25%. To gauge whether house prices reflect fundamentals or froth, The Economist compared them with rents and household incomes. It used the average ratio over the past 20 years as “fair value”.

But does it make sense to expect house prices to hold a constant relationship to rents and incomes? I don’t think that it does, for such an analysis ignores two key developments that should cause us to expect higher house prices relative to incomes and rents.

Interest rates

All other things being equal, house prices would rise relative to incomes and rent levels as a result of a fall in interest rates.

The very first element in the Capital Asset Pricing Model formula for cost of equity is the risk-free rate of interest. If the risk-free rate falls, we would expect the cost of equity to fall. If the cost of equity and the cost of debt both fall as a result of reduced interest rates, we would expect the cost of capital to fall. If the cost of capital falls, we would expect a given stream of expected cash flows to attract a higher capital value independent of whatever might be happening to income and/or rents levels.

Consider the eurozone’s benchmark risk-free rate, the average yield on 10-year German government bonds. Twenty years ago, it was 4.2%. A decade ago, it was 3.9%. Today German 10-year government bonds yield less than 0.4%. Consider also the prospect that this big fall in interest rates is unlikely to be reversed any time soon. Instead, it is likely that we face a lengthy period before we see interest rates back at 2008 or 1998 levels.

Population

The other big factor influencing residential property prices is our population. At the height of our economic boom, in 2007, the population of Ireland was 4.34 million. Last year, in 2017, our population reached 4.78 million, an increase of around 440,000 compared to a decade earlier.

I should say that these are official estimates of our population. When the census was last carried out, in 2016, it was reported that there were 9,575 Chinese nationals staying here on Census night. I reckon that this figure is a very considerable understatement of the actual number of Chinese resident here. I would therefore guess that Ireland’s actual population growth has been even stronger than official statistics indicate. Strong population growth and strong economic growth together with low levels of construction of new dwellings explains why Daft.ie’s latest quarterly report indicates that rent levels are now 30% higher than in 2007. 

Discounted cash flow model

The best way to get a handle on residential property prices is to analyse them using a discounted cash flow model. This takes into account interest rate variations and changes in rent levels. Such models are subject to very considerable uncertainty because of the difficulty in accurately estimating key input variables. My model of Irish residential house prices does not suggest any significant deviation from fundamental value. That’s not to say that a recession mightn’t cause prices to dip, but it doesn’t support notions that residential property prices have returned to bubble levels – especially not with mortgage credit levels down 40% compared to a decade ago.

Cormac Lucey FCA is an economic commentator and lecturer at Chartered Accountants Ireland.