Euro area property prices: Germany versus the rest

 
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Euro area property prices: Germany versus the rest
Current Issues
Real estate

                                  Euro area property prices:
June 29, 2012                     Germany versus the rest
Author                            The euro area real estate price bubble burst with a delay of one to two years
Tom Mayer
+49 69 910-30800
                                  after the US. Adjustment is far from complete and will weigh on economic
tom.mayer@db.com                  activity and banking sector health for years to come in most countries.

Jochen Möbert                     Adjustment is most advanced in Ireland, followed by Spain. Residential property
+49 69 910-31727                  prices have hardly adjusted in France, Netherlands, and Belgium. Markets in
jochen.moebert@db.com             Italy and Portugal seem to have escaped significant overvaluation.
Editor
Stefan Schneider
                                  The exception to the general picture of overvalued markets is Germany, where
                                  fundamental values remain at historical lows despite some price increases in
Deutsche Bank AG
DB Research
                                  recent years. Given Germany’s status as a safe haven in Europe for investors
Frankfurt am Main                 and in view of Germany’s likely economic outperformance of other European
Germany                           countries we envisage further price gains in the German real estate market.
E-mail: marketing.dbr@db.com      Prices are likely to rise fastest in cities with more than 500,000 inhabitants.
Fax: +49 69 910-31877
www.dbresearch.com
DB Research Management
Ralf Hoffmann | Bernhard Speyer
Euro area property prices: Germany versus the rest
Euro area property prices: Germany versus the rest

2   | June 29, 2012                                  Current Issues
Euro area property prices: Germany versus the rest

                                 Introduction
                                 Interest rate declines to the low German level in the run-up to EMU and low
                                 central bank rates during most of the first decade of EMU led to exorbitant
                                 increases in real estate markets of many euro area countries. In some countries
                                 of the euro area the residential property price bubbles burst with a delay of one
                                 to two years after the US. Adjustment is far from complete and will weigh on
                                 economic activity and banking sector health for years to come in most countries.
                                 The exception is Germany, where fundamental values remain at historical lows
                                 despite some price increases in recent years. Given Germany’s status as a safe
                                 haven in Europe for investors and in view of Germany’s likely economic out-
                                 performance of other European countries we envisage further price gains in the
                                 German real estate market. Prices are likely to rise fastest in cities with more
                                 than 500,000 inhabitants.

                                 Unfinished correction
                                 Since the outbreak of the financial crisis in 2007, many real estate markets are
                                 correcting (chart 1). The drop in prices is largest in Ireland, where also the
                                 earlier increase was most pronounced. Other notable declines occurred in Spain
                                 and Greece, where prices had also surged to excessive levels before 2007. So
                                 far there has been no visible correction in France, where prices had more than
                                 doubled during the last decade. Prices have remained above their level of the
                                 beginning of the new millennium in Italy and Portugal, but it is less clear in these
                                 countries whether earlier increases were excessive. Note that in none of the
                                 countries discussed have nominal prices returned to levels of the early 2000s,
                                 suggesting that the price correction may not be over.

                                  Unfinished price correction                                                           1
                                  Nominal house prices, 1994=100

                                  600

                                  500

                                  400

                                  300

                                  200

                                  100

                                    0
                                        94          96          98   00        02    04   06    08        10       12

                                               FR               IT        ES        GR     IE        PT           DE

                                  Sources: BIS, Deutsche Bank

                                 The exception in the performance of real estate markets has been Germany.
                                 There, restructuring at the company and general economy level left disposable
                                 incomes and, as a result of this, real estate prices flat. Signs of an uptick in real
                                 estate transaction volumes and prices have emerged only recently.

                                 But how much further do we have to go?
                                 The development of nominal prices alone is of course insufficient to spot
                                 overvaluations and assess the size of the necessary correction. In Ireland, for
                                 instance, the surge in real estate prices went along with a tripling of nominal
                                 income per capita. Hence, at least part of the rise may have been supported by
                                 fundamental factors. Therefore, we need to look at indices of affordability,

3   | June 29, 2012                                                                                        Current Issues
Euro area property prices: Germany versus the rest

                                 defined as real estate prices relative to disposable income or rents, to obtain a
                                 better picture of the potential additional need for adjustment. By and large, the
                                 two most common affordability indices, the price-to-income and price-to-rent
                                 ratios, have developed fairly similarly, so we can focus on only one of them, the
                                 price-to-income ratio.
                                 Real estate prices are strongly affected by legal and regulatory issues such as
                                 maximal loan-to-value ratios, rent control, tax deductibility of mortgage interest
                                 payments, foreclosure procedures, etc. Fortunately, the impact of these factors
                                 on prices is relatively stable as legal and regulatory frameworks change only
                                 very slowly. Therefore, historical averages of affordability indices should be
                                 good enough to determine the fair value for each market. For our assessment of
                                 the necessary adjustment we take the difference between actual affordability
                                 and its historical average.
                                 Our indicators suggest that many euro area residential property markets are still
                                 overvalued (chart 2). Although there has been considerable adjustment in
                                 Spain, the market is still overvalued by roughly 25% on our metric. However,
                                 following the past price correction, Spain fell from the top 3 overvalued
                                 residential markets in the euro area. In Belgium, France and the Netherlands
                                 houses are still less affordable than in Spain. Price-to-income ratios are
                                 overvalued by roughly 40% in these countries and have broadly moved
                                 sideways so far.

                                 Houses not yet affordable                                                                          2
                                 Affordability ratio of house prices to income, long-term average=100, index

                                  160

                                  140

                                  120

                                  100

                                   80

                                   60
                                     1995        1997         1999          2001        2003        2005       2007   2009        2011

                                                   NL                  BE                   FR                 ES            IT

                                 Source: OECD

                                 Against this backdrop, the adjustment in Ireland stands out (chart 3). The price-
                                 to-income ratio dropped within four years by more than 50%. In Greece, house
                                 prices grew only slightly faster than disposable income until 2007 and
                                 affordability has corrected to the long-term average. However, prices are likely
                                 to be dragged down by falling disposable incomes in the future. Germany is the
                                 only country where affordability is clearly below its long-term average and may
                                 rise on the back of higher incomes. Thus, the German market seems to offer
                                 good fundamental value on top of its status as a safe haven in the euro crisis.

4   | June 29, 2012                                                                                                     Current Issues
Euro area property prices: Germany versus the rest

                                 Germany and the periphery                                                                           3
                                 Affordability ratio of house prices to income, long-term average=100, index

                                  160

                                  140

                                  120

                                  100

                                   80

                                   60
                                     1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

                                                              GR                           IE                        DE

                                 Source: OECD

                                 Could markets undershoot their long-term averages?
                                 Several peripheral euro area countries are in a severe recession. In such an
                                 environment house prices may not level off at the long-term average. There is
                                 the risk that affordability indices undershoot. Historical data shows that several
                                 markets were undervalued for a couple of years (chart 4). The data since the
                                 mid-seventies suggest that affordability indices have a minimum threshold at
                                 around 80 during the cycle. This level could mark the downside of the
                                 adjustment discussed above. Based on this metric, only Germany seems to
                                 offer fairly safe value.

                                 A long-term view of affordability                                                                   4
                                 Ratio of house prices to income, long-term average=100, index

                                  140

                                  120

                                  100

                                   80

                                   60
                                        77               81                  85                   89            93           97

                                                   DE                   ES                   IE                IT            NL

                                 Sources: OECD, BIS, Deutsche Bank

                                 How long will the adjustment take?
                                 Without negative exogenous shocks and assuming a continuation of the smooth
                                 and slow adjustment process from 2008 to 2012, we would expect the Spanish
                                 market to have adjusted back to the long-term average of affordability by 2016
                                 and to the downside level of an 80% price-income ratio by 2020. As mentioned
                                 above, in Greece and Ireland affordability indices are already below their long-
                                 term average. If prices continued to decline as in the previous years the Irish
                                 downside would be reached within 1 ½ years and the Greek within four years.

5   | June 29, 2012                                                                                                       Current Issues
Euro area property prices: Germany versus the rest

                                  Adjustment paths                                                                                      5
                                  Affordability ratio of house prices to income, long-term average=100, index

                                  160

                                  140

                                  120

                                  100

                                      80
                                        2000              2004                 2008                2012             2016             2020

                                                             GR                             IE                        ES

                                  Sources: OECD, Deutsche Bank

                                 Adjustment scenarios                                                                                    6

                                 Years to adjust                  Long-term average (baseline)         80% of long-term average (downside)
                                 ES                                            4                                        8
                                 GR                                              0                                     4
                                 IE                                              0                                     1
                                 Source: Deutsche Bank

                                 It is very difficult to forecast the developments in the strongly overvalued
                                 Belgian, French and Dutch markets. Historically, in Europe only every second
                                 boom ended in a bust. If legal and regulatory changes, which have contributed
                                 to the high price levels, are maintained, price-income ratios may not have to fall
                                 to past averages.

                                 A closer look at Germany
                                 The macroeconomic environment is clearly supportive for rising real estate
                                 prices in Germany. Despite the deep global recession in 2008/9, Germany has
                                 experienced average annual real economic growth of 2% since 2005 compared
                                 to less than 1% between 2000 and 2005. The economy and residential property
                                 prices developed quite similarly. Nominal house prices declined by around 10%
                                 between 2000 and 2005 and then stagnated until 2009, before rising at 2 to 3%
                                 p.a. in the last couple of years. Condo apartment prices rose by around 4%,
                                 considerably faster than the inflation rate of 2.3% in 2011. By international
                                 comparison, house prices in Germany have therefore performed in an anti-
                                 cyclical way and have been less volatile. Low mortgage rates and the flight to
                                 safe havens are likely to continue to support German house prices in the near
                                 future.
                                 The recent increase in residential prices went hand in hand with a rise in
                                 disposable income, so the price-to-income ratio remained flat. The German
                                 economy is forecast to grow by 0.8% this year and by 1% in 2013. Assuming
                                 that affordability were to go back to its long-term average until 2020, house
                                 prices could grow 3 pp above the growth rate of disposable income. For
                                 example, if the average growth rate of disposable income were 2%, then house
                                 prices could increase by 5% p.a. to produce an affordability index of 100 in 2020
                                 (charts 7-8).

6   | June 29, 2012                                                                                                          Current Issues
Euro area property prices: Germany versus the rest

                                 German scenarios: Affordability                                                                         7
                                 Ratio of house prices to income, long-term average=100, index

                                  100

                                   90

                                   80

                                   70
                                        99                03                  07                 11              15                 19

                                                  prices +1%, income +2% p.a.                         prices +3%, income +2% p.a.
                                                  prices +5%, income +2% p.a.

                                 Sources: OECD, BIS, Deutsche Bank Research

                                 German scenarios: Prices                                                                                8
                                 House prices 2005=100, index

                                  170
                                  160
                                  150
                                  140
                                  130
                                  120
                                  110
                                  100
                                        99                03                  07                 11              15                 19

                                                  prices +1%, income +2% p.a.                         prices +3%, income +2% p.a.
                                                  prices +5%, income +2% p.a.

                                 Sources: BIS, Deutsche Bank Research

                                 Is there a risk of overvaluation?
                                 In its Monthly Report, the Bundesbank recently analysed the development of
                                 residential property prices. Some formulations in the report, such as “bold
                                 increases in prices”, were read as expressing fears of the Bundesbank that price
                                 increases could further accelerate. However, irrespective of ECB policy,
                                 excessive price movements could be checked. Thus, bank regulators could
                                 tighten mortgage standards and legislators could raise property taxes or stamp
                                 duties. However, prices could still spin out of control if foreign investors crowded
                                 into the German market because of fear of a break-up of the euro area, or if
                                 domestic investors allocated more funds to real estate. German households
                                 hold financial assets worth EUR 4,900 bn and own dwellings worth
                                 EUR 3,600 bn, leaving considerable room for portfolio shifts into real estate.

                                 All real estate markets are local
                                 From 2009 to 2011, German residential property prices surged in large cities
                                 and rose robustly elsewhere (chart 9). Prices stagnated or declined only in some
                                 structurally weak regions, in particular some small cities in east Germany. The
                                 strongest boosts took place in large cities with more than 500,000 inhabitants,
                                 where prices of single-family homes and condominiums increased by more than
                                 7%.

7   | June 29, 2012                                                                                                         Current Issues
Euro area property prices: Germany versus the rest

                                                    Price growth from 2009 to 2011                                                                     9

                                                    Inhabitants (in thousands)                   Single-family home (%)               Existing condos (%)
                                                    Above 500                                                        7.5                               7.9
                                                    200 to 500                                                       3.5                               5.6
                                                    100 to 200                                                       3.8                               5.4
                                                    Below 100                                                        4.0                               3.7
                                                    Germany (average)                                                4.2                               5.9
                                                      West                                                           3.9                               6.3
                                                    Sources: BulwienGesa, Deutsche Bank

                                                    Conclusions
                                                    Our review of price and affordability measures in euro area residential real
                                                    estate markets has shown that adjustment from past overvaluation is far from
                                                    complete in most markets and will weigh on economic activity and banking
                                                    sector health for years to come in most countries. The exception is Germany,
                                                    where fundamental values remain at historical lows despite some price
                                                    increases in recent years. Given Germany’s status as a safe haven in Europe
                                                    for investors and in view of Germany’s likely economic outperformance of other
                                                    European countries we envisage further price gains in the German real estate
                                                    market. Prices are likely to rise fastest in cities with more than 500,000
                                                    inhabitants.
                                                    Thomas Mayer (+49 69 910-30800, tom.mayer@db.com)
                                                    Jochen Möbert (+49 69 910-31727, jochen.moebert@db.com)

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