THE RESIDENTIAL REAL ESTATE MARKET1
Relatively high prices for residential real estate in Luxembourg reflect both upward pressures from strong demand and bottlenecks on the supply side. While households’ financial position appears relatively sound, rising real estate exposures in domestically-oriented banks warrant close monitoring. Given the structural nature of the demand for housing, policy efforts should focus on loosening the constraints on the supply side. This should include in particular more flexible rules on land use and higher holding costs on unused properties. A review of credits and subsidies and tax policies encouraging home ownership should also be conducted.
A. Should the Housing Market Be a Source of Concern?
1. Nominal housing prices are picking up in Luxembourg. From a long-term perspective, prices have not reached the peaks seen in Spain or the United Kingdom (Figure 1), but their progression is now nearing that of neighboring countries in which some concerns about house prices have been raised, such as in Belgium and France. In addition, in the last year, sales prices in Luxembourg have picked up strongly in real terms for both apartments and houses, rising by 6% percent and 9 percent, respectively, in 2013Q4 from a year ago.
Figure 1.Nominal Housing Price Trends
2. However, this comes after a period of moderate real house price increases. Prior to the crisis, real house prices, unlike in many other EU countries, rose only modestly (Figure 2). Since then, prices declined in real terms through 2012, and it is only in 2013 that they picked up again, as inflation has been on a downward trend, and nominal prices rose strongly.
Figure 2.Real Housing Price Trends
3. Meanwhile, domestically-oriented banks’ balance sheets have become more concentrated in Luxembourg real estate. While real estate exposures are only a small proportion of total banking sector assets, at around 3 percent, they are concentrated in the handful of banks that serve the domestic market.2 In the wake of the economic downturn since the financial crisis, banks have reduced their lending to non-financial corporations, while continuing to expand mortgage lending; residential real estate exposures reached 24 percent of total assets of domestic banks in 2012, from 12 percent in 2008. With the assets of domestically-oriented banks accounting for around 2½ times GDP—broadly on par with the size of the banking sector in other European economies—, these banks are concentrated and systemically important for the economy. If one of them were to come under distress, potential recapitalization costs could be high relative to the economy’s size.
4. This note examines the factors contributing to the state of the housing market, including influences on demand and supply such as government policies, household finances, and bank lending policies. It finds that structural factors play an important role, and that certain government policies could be adjusted to address some of the structural constraints, both to induce greater supply and not to inadvertently stoke demand for ownership—with a view to preventing existing imbalances between demand and supply in the real estate market from widening.
B. Factors Driving the Imbalance Between Housing Demand and Supply
5. Both structural and cyclical factors are contributing to the divergence between housing demand and supply. Long-standing challenges in terms of land availability for residential building, and strong demand from continued population growth, continue to affect the dynamics in the market. These have been compounded by some cyclical factors such as the downturn in construction, which is partly weather-related.
6. Some structural factors are supporting housing demand …
High demand from both residents (who, with an average GDP per capita of €84,000 are among the wealthiest in the euro area) and cross-border commuters (over 40 percent of employment) who would prefer to live closer to their workplace.
A relatively high rate of population growth over the past 5-6 years of close to 2 percent. Employment growth has also continued, though it has slowed somewhat below population growth since the downturn. Further, housing patterns and a tradition of home ownership also contribute to demand pressures: a greater share of the population lives alone, and Luxembourg’s ownership rate, at 69 percent of households, is close to the EU average but higher than Germany and France.
Government policies through housing benefits for eligible households. These benefits include partial tax deductibility of interest on mortgage loans, super-reduced 3 percent VAT rate for housing remodeling and repairs, tax credits for notary acts, tax benefits on savings for housing, and other “primes”. Direct assistance amounted to around €64 million in 2012 (0.15 percent of GDP), including €51 million in interest and other subsidies. Tax credits and other revenues foregone are more substantial, at around €375 million (1 percent of GDP), including €202 million from the reduced VAT rate, €134 million in tax credits for notary acts, and €39 million of VAT reimbursement relating to housing.1
7. … while others constrain supply, despite long-standing attempts to loosen them:
Constraints on building. Insufficient housing is being built, even though land appears available.2 As of 2010, 28 percent of lands theoretically available for housing could have been ready for construction within 2 years, based on its administrative status. But there are numerous hurdles to building housing, including the administrative burden in terms of environmental and other impact studies (including requirements coming from the EU). In addition, a large degree of independence of the communes in managing land use has meant that changes to zoning are difficult to push through. As a consequence, lengthy delays are observed before construction can take place. Aware of these bottlenecks, the government adopted a “Pacte logement” in 2011 in an attempt to boost supply and ensure that public services kept pace. The plan included central government co-funding for fast-growing communes to build supporting infrastructure such as transport and community services.1 However, this plan has delivered mixed results so far. A 2012 report indicated that an average 22 percent of land available for housing use has not yet been constructed upon (including in desirable locations). The authorities are preparing a new plan to try to address this deep-rooted challenge.
Low recurring taxes on immovable property, which blunt incentives to sell and increase the opportunity cost of holding to unused land or property in expectation of rising real estate prices (OECD (2008)). A property in Luxembourg is subject to municipal ground tax, levied annually at 0.7 to 1 percent of its assessed unit value. The tax due is derived from the preceding computation multiplied by a municipal coefficient between 120 and 900 percent. The property’s unit value, basic tax rate and the municipal coefficients depend on the property’s classification such as size, age, site, and economic use. This source of revenue is very low by cross-country comparison (Figure 3).2 Increasing the revenue collected by that tax, via a tax rate increase or a re-assessment of land prices, would limit the incentives to hold on to unused land or property.3 It is worth noting that the law governing land valuation and assessment dates from the mid 1940s, and the latest land valuation for these purposes is from the 1950s.
8. Cyclical factors also play a role, both spurring demand and constraining supply.
Low mortgage interest rates spur demand. Rates are lower than those paid in neighboring countries, after a period during which they rose to comparable levels in the crisis years, and accommodative monetary policy in the euro area is likely to continue to support mortgage applications.
Slowing construction activity. Though the number of building permits approved picked up since its 2009 trough, this is not yet reflected in construction activity (Figure 4). Construction activity, resilient for some time even after the outbreak of the global economic crisis, slowed in 2012 and its rate of shrinkage accelerated in 2013. The exact reason for the divergence between building permits and construction activity is unclear, but could be related to the length of time required for administrative procedures.
Figure 3.Recurrent tax on immovable property, 2011
Sources: Taxation trends in the European Union, 2013.
Figure 4.Construction and Building Permits
9. Overall, it appears that, unless action is taken to relax bottlenecks on supply, strong demand will continue to put upward pressures on real estate prices going forward, as long as population and employment continue to grow, and new buildings are coming on stream only slowly. Conversely, it would seem that any downward price correction—for example triggered by a macroeconomic shock—would be cushioned by these structural factors. A study from the Banque Centrale du Luxembourg (BCL) found real estate prices to be overvalued by 5-10 percent in 2010.
C. Households’ Financial Situation: Still Manageable
10. Household debt is moderate, though mortgages are more prevalent than elsewhere in the euro area. Household debt accounted for around 55 percent of GDP in 2013, an increase from 48 percent of GDP in 2008. Most of household debt is in long-term mortgages (usually around 20 year maturity). Survey data from 2010-11 show that 39 percent of resident households have mortgage liabilities, and, that for 33 percent of them, this debt is on their principal residence.4 This is higher than the comparable euro area averages of 23 percent and 19 percent, respectively.
11. Debt-to-income (DTI) ratios are also higher than the euro area average, though debt-to-asset ratios are lower, reflecting large real estate holdings. The DTI ratio is around 87 percent, higher than the EU average of 62 percent, with debt-to-income ratios above 100 percent more prevalent in larger households (larger than 3 persons), and largest households (5 or more) having the lowest ratio of liquid assets. These households would be most vulnerable to a loss in employment or other shocks such as higher interest rates (see below). Debt-to-asset ratios for all household groups are below euro area averages, ranging from 11 to 29 percent. However, because assets are mostly locked up in real estate (82 percent of total assets), the “low” ratio could come under stress if asset valuations were to decline sharply.
12. Debt service ratios appear relatively comfortable, though this partly reflects the very low interest rate environment. Debt service ratios for housing loans range from 14 percent of disposable income in the largest households to close to 21 percent for singles. Interest rates on these loans are currently very low, but, because loans are mostly at variable interest rate, households are vulnerable to interest rates increases, especially as these loans are long-term. Further quantitative analysis of the financial situation of households and their sensitivity to such shocks would be useful to supplement the existing stress tests conducted by banks in collaboration with the supervisors, which shock the system through bank balance sheets. In recent years, more fixed rate loans have been granted, providing greater certainty for households on payments due.5
Interest Rates on Mortgage Loans
Sources: Haver Analytics.
13. Risks to households thus stem from a fall in asset prices, a rise in interest rates, and reduced employment prospects. As noted above, debt to asset ratios appear comfortable, but if asset prices were to fall significantly, this ratio would worsen accordingly, as the debt principal owed would not change. With most loans provided at variable rates, a rise in interest rates could put households under stress. Large households appear more vulnerable, particularly if the principal earner becomes unemployed, with only small liquid asset buffers to rely upon. In the current conjuncture, with unemployment at a cyclical high and only expected to decline gradually, unemployment risk is expected to remain elevated for some time.
D. Bank Exposures to Real Estate: On the Rise
Figure 5.Mortgage Credit from Domestic Banks
14. Banks with a domestic orientation have increased their exposures to real estate significantly since 2008 (Figure 5). These have risen to 24 percent of the domestically-oriented banks’ balance sheet in 2012, from 12 percent in 2008. In terms of domestic loans, these account for 43 percent of them in December 2012, from 22 percent only four years earlier. While this involves only eight banks, these are the banks that support the local economy. As noted above, given their systemic nature for the domestic economy, any distress felt by these banks would pose a contingent liability on the government to ensure their continued viability.
15. Banks continue to extend mortgage credit quite steadily, in contrast to peer countries. In contrast to Belgium or the Netherlands, mortgage credit growth has hovered between 6 and 9 percent over the past few years in Luxembourg, or 4-6 percent in real terms. The rate of growth has broadly followed that in France until late 2011, after which French mortgage lending growth slowed, while it continued at a stable pace in Luxembourg.
16. To help ensure adequate buffers, the CommissiondeSurveillanceduSecteurFinancier (CSSF) has tightened capital requirements for domestically-oriented banks. A capital surcharge of 2 percent (implying a 10 percent solvency ratio requirement) was applied to the four largest domestically-oriented banks, mainly in view of this real estate exposure. Most recently, effective July 2013, the authorities have adjusted up the risk-weight requirements on the part of the new loans that exceed 80 percent of loan-to-value (LTV) ratios. In addition, the authorities indicated that they would be prepared to take additional macro-prudential measures if these proved insufficient, but preferred to take a step-by-step approach.
17. Since then, credit-granting standards appear to have become more prudent. Possibly in response to the authorities’ efforts, lending surveys suggest tightened conditions in housing credit supply during 2013. Loans with LTVs lower than 80 percent currently represent 83 percent of the aggregate stock of mortgages. For loans granted since mid 2013, the average LTV lies around 75 percent.
18. Risks to banks from real estate exposures include market risk and indirect interest rate risk. If house prices were to fall significantly—following for example a sharp macroeconomic shock resulting in lower activity and increased unemployment—, asset values would fall and affect banks’ balance sheets. The CSSF has conducted aggregate stress tests for this possibility, subjecting six banks to a 30 percent decline in asset values, and a 10 percent probability of default on the resulting under-collateralized loans. All domestic banks remained above the Common Equity Tier 1 required ratio of 7 percent in this stressed scenario. Tests for increases in interest rates were also conducted by the BCL, finding that the interest rate risk is relatively low in comparison to the risk from lower economic growth.
E. Overall Assessment and Recommendations
19. Without policy action, underlying forces for housing price appreciation will likely persist. In the baseline scenario of a sustained recovery in output and employment growth, excess demand for housing will continue to stem from persistent structural factors and will require a concerted effort to overcome. Prices do not appear overvalued at this time, though they have recently picked up.
20. Households’ financial position appears relatively sound. Overall, households do not appear overly indebted, though there are pockets of vulnerability in certain segments. Households are relatively wealthy, but their assets are mostly in the form of real estate, which would also be affected in case of a shock on housing prices. They are nevertheless vulnerable to interest rate risk, market risk (valuation), and unemployment risk. A mitigating factor on valuation risk is that any price declines would likely be gradual, given structural forces.
21. Banks’ increased exposure to mortgages bears vigilance, and buffers should be maintained. The tightening in the risk weights for LTVs above a certain level for banks, and the capital surcharge for domestically-oriented banks, are appropriate. If these measures are found to be insufficient after some period of observation, further steps may be needed. Over time, consideration should also be given to maintaining higher capital requirements for domestically-oriented banks in the new Basel III framework.
22. Government policies should become more neutral in relation to home ownership vs. renting. Current policies provide incentives for ownership, spurring demand pressures further. To help make more land available for residential building, the authorities should raise the cost of holding on to unused land or property, in particular by increasing recurrent taxes on immovable properties. This could for example take the form of a revision to legislation to allow for updating property valuation assessments regularly to reflect current market values. The removal of tax advantages and tax credits should also be considered, as they feed into greater demand. With current interest rates at very low levels, removing the partial tax deductibility of mortgage interest would be less painful to households. Finally, more flexible rules on the use of land should be considered to boost supply and reduce the time required for completion of construction projects.
Conseil Economique et Social2013. « L’access à un logement abordable. »Avis CES/Logement.
PeltierFrancois.“Projection of the private households and the housing needs 2010-2030.”Working Paper du STATEC No. 55September2011.
OECD2007. OECD Territorial reviewLuxembourg.
Prepared by Piyabha Kongsamut (EUR).
See also the Selected Issues Paper: “The Financial Sector: Strengths and Challenges.”
Population density was 205 inhabitants per square kilometer in 2012, compared to 103 in France, 367 in Belgium, and 229 in Germany.
Projections show a baseline need of 6500 new housing units per year between 2010 and 2030 to deal with the projected increase in demand (Peltier, 2011). As a comparison, between 2000 and 2010, an average 2677 housing units were completed each year. In addition, some estimates suggest that, even with this plan fully implemented, around 50,000 new housing units would become available, versus a need for 80,000 units by 2030 (CES study, 2013).
See also the Selected Issues Paper: “The Fiscal Position—Sound for Now, but Significant Challenges Ahead”.
The “Pacte de logement” included the possibility to introduce a tax on vacant homes and residential buildings that have been unoccupied for 18 months, and for land approved for residential construction since 3 years but not built on. However, only a few communities are implementing this kind of tax.
BCL Bulletin, 2013/2, based on results of the 2010/11 Luxembourg Household Finance and Consumption Survey (LU-HFCS).
BCL data suggests that as much as 30 percent of housing loans provided in 2013 were fixed-rate loans.