Ireland: Selected Issues
Author: International Monetary Fund
Publication Date:
04 Nov 2004
eISBN:
9781451818802
Language:
English
Keywords:
ISCR; CR; Ireland; house price; pay; price increase; housing P/E ratio; P/E ratio; price boom; housing demand; Inflation; Mortgages; Land prices; price expectation
Download PDF (252.2 KB)

The Selected Issues paper analyzes how fast Ireland will grow in the future. The approach of this paper is to consider the catch-up in labor utilization productivity and use independent demographic projections and other considerations to make reasonable assumptions about labor productivity and utilization growth in the future. It uses a simple growth-accounting framework, and discusses the trends in labor utilization and productivity per hour in the past. The paper also describes the spectacular boom of the Irish housing market and its key drivers from an international perspective.

Abstract

The Selected Issues paper analyzes how fast Ireland will grow in the future. The approach of this paper is to consider the catch-up in labor utilization productivity and use independent demographic projections and other considerations to make reasonable assumptions about labor productivity and utilization growth in the future. It uses a simple growth-accounting framework, and discusses the trends in labor utilization and productivity per hour in the past. The paper also describes the spectacular boom of the Irish housing market and its key drivers from an international perspective.

II. Adjustment in the Housing Market1

A. Introduction

1. Ireland’s house prices have risen dramatically since the mid-1990s, despite an interim deceleration. From 1993 to 2003, the price of new houses posted a cumulative increase of about 140 percent in real terms (220 percent in nominal terms). During the same period, the corresponding price increase of second hand houses was almost 200 percent in real terms (300 percent in nominal terms). The boom has been particularly pronounced in Dublin, where real house prices have more than tripled over the past decade. Although the strong surge in the housing market did moderate for a short period in the late 1990s—real price increases of both new and second hand houses declined from over 20 percent in 1998 to around 3 percent in 2001—house price inflation reignited in 2002 and reached 11½ percent in 2003.

A02ufig01

Nominal Irish House Prices

(Euro thousands)

Citation: IMF Staff Country Reports 2004, 349; 10.5089/9781451818802.002.A002

A02ufig02

Real Irish House Prices

(Euro thousands)

Citation: IMF Staff Country Reports 2004, 349; 10.5089/9781451818802.002.A002

Sources: The Department of Environment, Heritage and Local Government, OECD, and staff calculations.

2. The sheer length and magnitude of the Irish house price boom have prompted both the natural question of its sustainability and a wide spectrum of views in response. A number of external observers, such as the IMF (2003) and the Economist (2003), have argued that Irish house prices are significantly overvalued (by as much as 40-50 percent). In Ireland, some commentators have also cautioned that the longer prices continue rising, the higher the probability of a disruptive adjustment in the housing market (Davy Stockbrokers, 2003; Central Bank of Ireland, 2003). At the other end of the spectrum, Roche (2003) and McQuinn (2004) have contended that there is no evidence of overvaluation in the housing market.

3. The purpose of this paper is threefold. First, it describes the spectacular boom of the Irish housing market and its key drivers from an international perspective. Second, the paper presents analytical and descriptive evidence on whether recent house price increases can be fully justified by fundamentals and discusses whether house prices and expectations have adjusted to the new environment of lower income growth. Finally, it raises a number of questions about the Irish housing market, including its linkages with the rest of the economy.

4. The rest of the paper is organized as follows. Section B compares the performance of Ireland’s housing market with those in other industrial countries and highlights key developments in demand and supply that have the potential to explain it. Section C examines analytical evidence (based on alternative valuation methods) on whether the surge in house prices can be justified by fundamentals only. Section D presents descriptive evidence (from developments in the buy-to-let and second-home market, the market response to policy changes, and survey responses) on whether other factors could be affecting the recent dynamics of Irish house prices. Section E draws preliminary conclusions and raises questions about the impact that a housing market adjustment would have on the economy.

B. The Irish Boom in Context

5. Although many industrial countries have experienced sharp house price increases since the mid-1990s, the magnitude of the Irish boom has been unsurpassed. Between 1995 and 2003, real house prices in Ireland rose by an average of 10.7 percent per year, exceeding even the annual growth rates in other industrial countries with strong house price inflation, such as the United Kingdom (8.5 percent), the Netherlands (8.6 percent), and Spain (7 percent).

A02ufig03

Real Residential Prices

Citation: IMF Staff Country Reports 2004, 349; 10.5089/9781451818802.002.A002

Sources: BIS, staff estimates.
A02ufig04

Average Annual Growth in Disposable Income

(In percent)

Citation: IMF Staff Country Reports 2004, 349; 10.5089/9781451818802.002.A002

Source: OECD.

6. Perhaps the surge in Irish house prices can be attributed to more favorable demand factors. A number of facts point in this direction:

  • Growth in real disposable income in Ireland since the mid-1990s has been stronger than in any other industrial country, thereby boosting housing demand. Between 1996 and 2001, the average annual growth rate in Ireland was 7.2 percent, compared with 2.5 percent in the European Union and 3.5 percent in the United States.

  • Real mortgage interest rates in Ireland in the late 1990s were among the lowest among industrial countries, providing additional support to housing demand. In addition, the decline in Ireland’s real mortgage rates since the first half of the 1990s has been more pronounced than in many other countries.

A02ufig05

Average Real Mortgage Rates

(In percent)

Citation: IMF Staff Country Reports 2004, 349; 10.5089/9781451818802.002.A002

Sources: Ameco, CSO, European Federation of Mortgage Lenders, OECD, and staff calculations.
A02ufig06

Average Annual Growth in Real Mortgage Rates 1991-2001

(In percent)

Citation: IMF Staff Country Reports 2004, 349; 10.5089/9781451818802.002.A002

  • Financial market liberalization during the 1980s and 1990s has also supported demand by allowing a rapid expansion in credit (Table 1). The strong growth in household credit, averaging 20 percent a year since 1995, has resulted in a doubling of household debt relative to disposable income since the mid-1990s. In fact, mortgage credit alone accounts now for about 80 percent of household credit or 77 percent of household disposable income.2

  • Demographic trends in Ireland were particularly favorable to housing demand in the 1990s (Figure 1). The growth rate of household formation in Ireland exceeded those in other industrial countries, mostly reflecting rapid growth in the population aged 25 to 34 (the first-time buyer group) and stronger migration inflows.

  • The tax treatment of housing in Ireland has been more supportive of home ownership than in most other EU countries (Table 2). In particular, the existence of mortgage interest relief, the absence of a tax on imputed rent, and the exemption from capital gains tax on principal dwellings have contributed to a lower user cost of housing, thereby reinforcing housing demand.

  • Mortgage finance in Ireland has been less restrictive than in most other EU countries. For example, the maximum loan-to-value ratio is 90 percent, exceeding even those in the United States, Australia, Spain, and the Netherlands (Table 3).

Figure 1.
Figure 1.

Ireland: Demographics

Citation: IMF Staff Country Reports 2004, 349; 10.5089/9781451818802.002.A002

Sources: CSO, EuroStat, Housing Statistics in the European Union 2002, National Statistical Offices, and ODPM.
Table 1.

Financial Market Liberalization in Ireland

article image
Source: Browne, F., Gavin, D. and A. Reilly (2003).
Table 2.

Housing Taxes in European Countries (2001)

article image
Source: European Central Bank (2003).

Mortgage-related.

For principal owner-occupied dwelling.

Exemption for principal owner-occupied dwelling.

Only for principal owner-occupied dwelling.

Yes.

No.

Table 3.

Maximum Loan to Value Ratio

(in percentage)

article image
Source: Tsatsaronis and Zhu (2004).

7. The rise in housing demand triggered a response in housing supply unprecedented by international standards (Figure 2). A number of measures illustrate this trend:

  • Over 420,000 new houses were completed in Ireland between 1995 and 2003. The number of house completions reached an all-time high of 69,000 units in 2003, posting a year-on-year growth of close to 20 percent.

  • The average implied house completion rate (per thousand people) was higher than in any other industrial country between 1996 and 2000. As a proportion of the existing housing stock, the number of house completions in 2001 was about three times higher than in other housing-boom countries, such as Spain and the United Kingdom.

  • On average, residential investment between 1996 and 2001 constituted a higher share of GDP (over 7 percent) in Ireland than in any other industrial country.

  • The number of housing permits issued rose by over 80 percent between 1995 and 2001.

Figure 2.
Figure 2.

Ireland: Housing Supply

Citation: IMF Staff Country Reports 2004, 349; 10.5089/9781451818802.002.A002

Sources: Ameco, DataStream, Department of Environment, Heritage and Local Government, Eurostat, European Federation of Mortgage Lenders, National Statistical Offices, ODPM, and staff calculations.

8. Partly stimulated by supportive government policies, the enormous increase in housing supply was accompanied by significant increases in real construction costs and land prices. The cost of house construction rose by an average of 2½ percent in real terms between 1995 and 2002, but declined by almost 1 percent in 2003. Land prices are estimated to have grown by an average of 25 percent in real terms between 1995 and 2001, but to have remained broadly flat in 2002. The significant cost increases did not deter the supply of new housing, which was also aided by policy measures to increase the availability of land for residential development and to relax zoning regulations, as well as to allow higher densities at desirable locations.

A02ufig07

Average Annual Growth in Construction Cost

(In percent)

Citation: IMF Staff Country Reports 2004, 349; 10.5089/9781451818802.002.A002

C. Analytical Evidence

9. The question of whether the above fundamentals fully explain the Irish housing boom can be addressed by using two alternative valuation methods. The first approach is to estimate an econometric model of house prices as a function of supply and demand factors and examine whether the actual house prices deviate from their long-term equilibrium values. The second approach is to treat housing as an asset that reflects the discounted present value of its future “dividends,” which should be driven by fundamentals, and construct its price-to-earnings ratio.

Econometric model of house prices

10. In its generic form, the econometric model is a reduced-form equation of house prices as a function of demand and supply variables. The starting point is a system of two structural (supply and demand) equations, which is transformed into a reduced-form equation:

  • The structural demand equation is given by Qtd=f(Pt,Xtd), where Qtd is housing demand, Pt is the real house price, and Xtd is a vector of demand-shifting variables, such as disposable income, the user cost of housing (mortgage rate, taxation), demographics, etc. Some econometric specifications are based on this equation. After reversing the positions of housing demand and prices, one obtains an inverted-demand equation, linking house prices to the demand variables Xtd and the housing stock.

  • The structural supply equation is given by Qts=f(Pt,Xts), where Qts is housing supply, Pt is the real house price, and Xts is a vector of supply-shifting variables, such as zoning restrictions, real construction costs, land prices, etc.

  • The reduced-form equation for the equilibrium house price, Pt=g(Xtd,Xts), is obtained by equating supply and demand. In other words, the equilibrium price depends on all variables that affect housing supply and demand. The house price equation is typically estimated using an error-correction model. Actual house prices are then compared with the estimated equilibrium prices, which are consistent with the (supply and demand) fundamentals included in the model.

11. Empirical analyses focusing on demand-side factors generally find that house prices in Ireland are significantly overvalued:

  • A background note for the 2003 Article IV consultation with Ireland estimated a reduced-form equation of real annual house prices as a function of disposable income, real mortgage rates, and the share of households aged 25-35. If the equation was estimated for the period 1976-2002, the actual house price was about 16½ percent higher than its long-run equilibrium. However, the deviation of the actual house price from the equilibrium price (implied by fundamentals) was over 50 percent when the model was estimated for the period 1976-97.

  • Bacon and MacCabe (2000) estimated an inverted-demand equation for the period 1972-96, including variables such as demographics, disposable income, mortgage rates, and housing stock. Using the estimated parameters to compute the predicted prices for 1997-2000, the authors established that the actual house price in 2000 deviated from its fundamental value by over 85 percent.

  • Based on the deviation of the price-to-income ratio from its long-run trend, the Economist (2003) concluded that Irish house prices were overvalued by over 40 percent.3

12. If certain supply factors are included in the model, the estimated degree of overvaluation declines dramatically. Most recently, Roche (2003) and McQuinn (2004) argued that previous studies ignored the importance of supply factors in determining house prices and, therefore, overestimated the degree of house price overvaluation. In particular, Roche (2003) added two supply variables—real construction cost and land cost—to a reduced-form equation relating house prices to fundamentals.4 In this case, the degree of overvaluation in 2002 was in the range of 0-4½ percent, leading the author to the conclusion Irish house prices were in line with fundamentals. Using the same supply-side variables, McQuinn (2004) also concluded that the surge in house prices could be fully explained by fundamentals, but noted an important caveat to his results—the potential endogeneity of land prices.

13. However, the supply variable that is most important in explaining the Irish house price boom is also most likely to suffer from endogeneity problems. As highlighted in Roche (2003), “trends in land costs are the most important factor explaining the trend in new house prices” But, as the first Bacon report (1998) points out, “…A key issue is the direction of causation between land cost and house prices. In other words, is it the supply and demand for housing that is pushing development land prices or higher land prices that are pushing housing costs? From an economic point of view the balance of probability would suggest the former channel rather than the latter….” If land prices are indeed endogenous to the real estate cycle but included as an explanatory variable in the house price equation, the overall importance of fundamentals in explaining the surge in house prices could be substantially overstated.

14. Projections based on a simple econometric model suggest that house price increases should moderate going forward. We estimated a simple reduced-form equation of log real house prices as a function of demand-side factors (log disposable income per capita, real mortgage rates and net migration).5 As expected, the income elasticity of house prices (1.17) was strongly significant and consistent with results from the literature. Similarly the coefficients of real mortgage rates (−0.02) and net migration (0.001) had the expected signs and were significant.6 The estimation results indicated that if disposable income per capita were to increase by 4.5 percent, real mortgage rates were at 1.7 percent and net migration were the same as in 2003, real house price inflation should be around 5 percent by end 2004.7

15. However, one big drawback to interpreting these results is the inherently backward-looking nature of the econometric approach. In relying on historical data to estimate the model coefficients, one ignores the possibility that the relationship between house prices and fundamentals may be different in the future. Given the likely structural changes in the economy (associated with Ireland’s transition from the boom years of the 1990s to a period of slower income growth), this possibility is distinct and should not be ignored. Therefore, we turn to a more forward-looking approach to housing valuation.

House prices, rents, and the price-to-earnings (P/E) ratio

16. An alternative valuation method considers house prices in an asset-pricing framework. In this setup, housing can be treated as an asset that provides a flow of housing services. As such, its price should reflect its future income stream. Applying an asset-pricing framework similar to the dividend-discount model for equity valuation, the price of a house should be the present value of its expected benefit of ownership: rental income (market or imputed), discounted at a rate that accounts for the risk associated with holding the asset.8 In other words, the house price, Pt, is related to the rent Et and the (constant) discount rate R as follows:

Pt=Et(1+R)+Et+1(1+R)2+Et+2(1+R)3+…=∑j=1αEt+j−1(1+R)j

Assuming that rents grow at a constant rate, g, the housing price-to-earnings ratio can be derived from the above expression:

PtEt=1R−g=1rf+δ−g

where rf is the real riskless rate and δ is the housing risk premium.

17. The latter asset-pricing equation demonstrates the link between house prices and rents. Several observations are of interest:

  • The housing P/E ratio provides a useful way to examine whether housing prices are overvalued, since the ratio is invariant to the extent that supply and demand factors influence both the rental and owner-occupier markets.

  • A decline in the real interest rate, rf, (or the housing risk premium, δ), or an increase in the growth rate of rents, g, could justify a hike in the P/E ratio.

  • But an increasing P/E ratio could also signal that people are purchasing houses in expectation of capital appreciation rather than due to fundamentals. In this case, house prices would rise faster than rents, prompting a rise in the P/E ratio.

A02ufig08

Nominal Growth in House Prices and Rents

(year-on-year, in percent)

Citation: IMF Staff Country Reports 2004, 349; 10.5089/9781451818802.002.A002

Sources: CSO; Department of Environment.
A02ufig09

Ratio of Average House Price to Gross Annual Rental Income

Citation: IMF Staff Country Reports 2004, 349; 10.5089/9781451818802.002.A002

Sources: CSO; Department of Environment; 2003 Quarterly National Household Survey; and staff calculations.

18. Currently, the P/E ratio in Ireland is over 100 percent above its historical average (see chart above). A proxy for the ratio has been constructed by dividing the average house price by the annual rent paid in the private rental market.9 Interestingly, the sharp rise over the past two years has reflected the significant pickup in house price growth and the continued slowdown in rental income growth. In the first quarter of 2004, the P/E ratio is estimated at 29.

19. What can explain the recent rise in the P/E ratio? One potential explanation is that a decline in the real riskless interest rate, rf, (and, hence, the discount rate), has driven up the P/E ratio. However, real interest rates have remained broadly stable since 2000, that is, their fall preceded the rise in the ratio by almost two years. Another potential explanation is that the growth rate of rental income, g, has gone up. But actual developments point to the opposite finding—growth in rental income has fallen and been negative in every quarter since mid-2002. If one cannot find convincing, fundamentals-driven reasons for the dramatic rise in the housing P/E ratio, then two possible explanations remain: either the new and second-hand housing market owes its recent strength to the expectation of capital appreciation, or the P/E valuation model suffers from serious problems.

20. As usual, this analysis is subject to a number of important limitations and caveats.10 First, the role of leverage is not considered. As residential property is typically financed by mortgage borrowing, the return (or loss) on the initial housing investment is magnified. The impact of this factor on investor demand is not considered in the P/E analysis. Second, the tax treatment and regulation of owner-occupied and rental housing are not incorporated in the model. A more favorable tax treatment of housing relative to other asset classes could justify a high P/E ratio. Third, the model implicitly assumes that people are indifferent between owning and renting a house. A violation of this assumption would produce a wedge between rents and the flow of housing services. Fourth, the lumpiness of housing may imply a limited diversification across other asset classes and properties, possibly leading to a higher risk premium. Fifth, existing data limitations (related to the coverage, quality, and availability of house price and rental series) make it difficult to draw definitive conclusions.

21. Nonetheless, the asset valuation approach still provides a helpful reference point to evaluate future changes in house prices. The main implication of the asset-pricing approach is that the current level of house prices should incorporate not only the current values of fundamentals, but also expectations about their future values. Therefore, only changes in trends of fundamentals matter for changes in house price trends. In the absence of such changes, house prices are expected to grow in line with the growth rate of rental income, g. Assuming that over the medium run, g, does not exceed the growth rate of economywide income, future real house price increases in Ireland should not be higher than 4-5 percent, reflecting the lower medium-term prospects for real income growth.

D. Descriptive Evidence

22. Several pieces of additional evidence can also help understand the recent dynamics of Ireland’s house prices. In particular, developments in the buy-to-let and second-home markets and the market response to policy changes provide suggestive information about the role of fundamental and speculative factors in explaining the house price increases over the past few years. Also, evidence from various surveys sheds more light on the motivation and expectations of home-buyers. Together, these sources of information give some indication of whether house price expectations have adjusted to the new environment of lower growth.

Developments in the buy-to-let and second-home markets

23. The buy-to-let market has been very active in recent years, although the stock of private rental housing is still comparatively low. According to the latest Quarterly National Household Survey, private rental dwellings make up about 8 percent of the total number of residential dwellings. However, survey data collected from banks and real estate agencies point to a high level of activity in this market segment:

  • On the demand side, new “buy-to-let” mortgages constituted about 20 percent of all mortgage transactions in 2003 (Standard and Poor’s). Investors bought about 28 percent of all new properties and 21 percent of all second hand properties in 2003, compared with 25 percent and 17 percent, respectively, in 2002 (Sherry FitzGerald, 2003).11 In Dublin, investors accounted for approximately 25 percent of all purchases in the new-house market in 2003, compared with 15 percent in the second hand market (EBS/Gunne, 2004).

  • On the supply side, an estimated 30 percent of the second-hand dwellings sold during the first half of this year were previously held as investment properties, compared with about 27 percent in 2003 (Sherry FitzGerald, 2003).

24. Who has invested in the buy-to-let market and why? Recent surveys of residential investment property owners suggest that the market is dominated by small, mostly inexperienced investors, whose primary investment objective is to provide for retirement.

  • The Gunne January 2003 Annual Landlord Survey reports that about 60 percent of investors have been in the buy-to-let market for three years or less (see figure below). The survey also finds that 52 percent of the respondents have invested in the market following the reintroduction of mortgage relief for rental properties (see para 28 below).

  • The same survey shows that over 50 percent of the landlords have only one property.

  • The EBS/Gunne March 2004 Report indicates that over 75 percent of the residential property investors have specified pension saving (for themselves or their partners) as their main investment objective.

A02ufig10

Classification of investors by date of entry in the market

Citation: IMF Staff Country Reports 2004, 349; 10.5089/9781451818802.002.A002

A02ufig11

Classification of landlords by number of properties

Citation: IMF Staff Country Reports 2004, 349; 10.5089/9781451818802.002.A002

Source: Gunne Research Group.

25. Even if small in size, the buy-to-let sector could have a significant impact on the dynamics of house prices. With property investors taking an active part in the housing market, the question is to what extent they have exerted upward pressure on house prices. Lured by the substantial capital appreciation and supported by the small carrying costs observed in the recent past, many new investors have entered the buy-to-let market, possibly displacing first-time buyers and contributing significantly to housing demand and house prices. By itself, this development is not necessarily worrisome, unless there is evidence that the recent wave of property investment has been driven by unrealistic expectations about future house price increases. Unfortunately, the robust demand for rental property investment in 2003—in spite of a continued decline in private rents—suggests that new, inexperienced investors may have entered the market with such expectations, thereby fuelling the demand for housing.

26. Demand for second homes appears to be an important factor in the housing market as well. This market segment consists of households that purchase residential property as a holiday or retirement home or as a (vacant) investment property, which is not used for rental purposes. It is difficult to assess the size of the second-home market, separating it from the buy-to-let market.12 Nevertheless, Davy Stockbrokers (2003) estimate that about 40 percent of houses in 2003 were not bought as a primary residence, but rather as a second-home (or buy-to-let) property. Combining this estimate with data from the buy-to-let market (see para. 23), one could approximate second-home purchases to have been up to 15 to 20 percent of the residential property acquisitions in 2003. In other words, although housing supply has risen tremendously in recent years (see para 7), a surprisingly large proportion of it appears to be satisfying demand for second-home properties. As in the case of the buy-to-let market, some of the properties may have been acquired with the expectation that house prices would continue to grow at their current pace in the future.

Response of the housing market to policy measures

27. Identified as a significant cause for concern, the buoyancy of house prices prompted the government to introduce a package of tax measures in 1998 to slow the market.13 Following the publication of the first Bacon report, which warned that strong investor demand was causing the housing market to overheat and pricing first-time buyers out of the market, the government announced in April 1998 a set of policy measures to dampen investor demand and increase the potential supply of housing:14

  • Tax relief on mortgages for residential investment. The deductibility of mortgage interest for investment in residential property (against rental income) was removed.

  • Stamp duty. The zero stamp duty on purchases of new houses was eliminated for nonowner occupiers only. At the same time, the stamp duty for second hand houses was lowered across the board.

  • Section 23 relief. The tax relief under Section 23 for investment in private rental accommodation was restricted.

  • Capital gains tax. The capital gains tax rate on disposals of qualified residential land was reduced temporarily from 40 percent to 20 percent.15

28. However, the tax measures affecting property investors were reversed in Budget 2002. First, mortgage interest relief for investors was reintroduced starting in January 1, 2002. Second, stamp duty levels on new property for investors were lowered and brought into alignment with those on second hand property for non-first-time owner-occupiers.

29. Did the measures of 1998 and 2002 have an impact on house prices? The observed correlation between the tax changes and the pattern of house price increases is remarkably strong (see chart), raising the question whether the policy changes influenced the dynamics of house prices. Although mortgage rates were in a steady decline during the whole period, growth in house prices decelerated sharply between 1998 and early 2002 but rebounded in mid-2002. Changes in disposable income and demographics appear unlikely to help explain the slowdown and pickup in house prices during the period.

A02ufig12

Nominal House Price Inflation

(In percent)

Citation: IMF Staff Country Reports 2004, 349; 10.5089/9781451818802.002.A002

A02ufig13

Real House Price Inflation

(In percent)

Citation: IMF Staff Country Reports 2004, 349; 10.5089/9781451818802.002.A002

Sources: OECD, The Department of Environment, Heritage and Local Government, and staff calculations.

30. The policy measures could have influenced the recent dynamics of house prices in several ways. One possibility, supported by anecdotal evidence and market commentary, is that the tax changes had a direct effect on the market by pushing investors out of the market in 1998 and inviting them back in 2002. Unfortunately, the lack of representative time-series data on the residential property investment market makes it difficult to reach firm conclusions on the magnitude of this effect. In addition, the policy measures could have had an impact on house price expectations.16 While hard to verify empirically, the premise that policy actions can play a significant role in adjusting house price expectations appears to be perfectly plausible.

Expectations about the housing market

31. The distinguishing characteristics of a booming market have been analyzed carefully in the recent housing literature. Using survey evidence from U.S. cities, Case and Shiller (2003) have examined the homebuyer behavior in a boom property market, highlighting some of its interesting features. First, the vast majority of people in such a market expect significant future price increases—an average of 10 percent per year over the next few years, but about 15 percent per year over the next ten years. Second, a large proportion of the respondents view the purchase of a house as an investment. Third, people feel a sense of urgency in buying a house (over 70 percent of the respondents noted that it was a good time to purchase a property because house prices would increase in the future).

32. Although direct evidence on the motivation and expectations of homebuyers in Ireland is scarce, two recent surveys do provide interesting, but somewhat mixed, information. Conducted in August 2003, the IIB/ESRI survey Irish Consumer Sentiment towards the Property Market found that, on average, respondents expected house prices to rise by 4.8 percent over the next 12 months. However, the distribution of price expectations was quite wide, with about 25 percent of the people projecting increases of over 10 percent. (Unfortunately, the survey did not ask the more important question about longer-term price expectations.) The second survey containing useful information is the already-mentioned EBS/Gunne survey of residential investment property owners (see Para. 24). Although there was no explicit question about house price expectations, the respondents their views on investing in property and buying intentions. Interestingly, over 90 percent of the residential investment property owners considered housing a preferred choice of investment vehicle, and about 70 percent of them said that they were planning to increase their residential portfolio over the next five years. Noting the softening of the rental market, the EBS/Gunne survey concluded that investor demand would remain strong in the future, as most investors were being attracted to the market by the expectations of future capital appreciation, as opposed to rental growth prospects.17

A02ufig14

Distribution of House Price Growth Expectations

Citation: IMF Staff Country Reports 2004, 349; 10.5089/9781451818802.002.A002

Source: IIB/ESRI

E. Concluding Remarks

33. The bulk of the evidence presented in this paper on the recent house price increases suggests that the housing market has not yet adjusted to the post-Celtic tiger era of lower growth. Although an important factor, developments in fundamentals appear unlikely to justify the full extent of these increases. The qualitative evidence from Section D implies that at least part of the dynamics of house prices is being driven by the unrealistically high expectations about future price increases of some market participants. With the housing P/E ratio significantly above its long-term trend, it is worrisome that the residential investment market continues to be buoyant.

34. Going forward, house price increases need to moderate. As suggested by the asset valuation of housing, future growth in real house prices should be in line with the medium-term prospects for real income growth of 4-5 percent per annum. If house price increases—currently still running in double digits—fail to moderate to these more sustainable rates, the likelihood of a disorderly correction will rise further.

35. What would be the impact on the economy if the housing market did experience an adjustment? This remains an open (but clearly important) question, whose answer depends on the linkages between the housing market and the rest of the economy, and consequently, the answers to the following questions:

  • What would be the response of the financial sector? With 50 percent of the banks’ loan portfolio concentrated in the property sector, a sharp correction in house prices could lead to cutbacks in lending as the collateral values and banks profitability decline. This, in turn, could result in a protracted period of slow private consumption and investment.

  • What would be the response of the construction sector? Accounting for over 10 percent of total employment and over 7 percent of GDP, the construction sector in Ireland could suffer sizable output and employment losses as a direct response to an adverse shock from the housing market.

  • What would be the response of private consumption? An adjustment in the housing market could affect household consumption in a number of (direct and indirect) ways. Potential employment losses could lead to a protracted slowdown in consumption growth. In principle, consumption growth could also decelerate as a result of the negative wealth and liquidity effects associated with the adjustment in the housing market, although the strength of these channels in Ireland is not well established.

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1

Prepared by Petya Koeva and Marialuz Moreno Badia. We thank Kieran McQuinn for providing data on the Irish housing market, as well as for his valuable comments.

3

This approach is equivalent to estimating the reduced-form equation of house prices on income only.

4

The demand-side variables used in his model are the number of new migrants, the user cost of housing, real disposable income, and real household credit.

5

House prices are a weighted average of new and second-hand house prices. The weights use are the ratio of loans paid on new and other houses total loans.

6

An alternative specification including supply factors was also estimated but many coefficients were insignificant and had the wrong signs.

7

Our assumption of real mortgage rates is based on short-term euro rates of 2.3 percent and inflation in line with euro rates.

8

See Weeken (2004), Leamer (2002), Krainer (2003), and Ayuso and Restoy (2003).

9

The house price is the weighted average of new and second hand house prices. The annual gross rent is derived using the Central Statistical Office index of private rents and the monthly rental rate in the third quarter of 2003 available from the housing module of the 2003 Quarterly National Housing Survey. Strictly speaking, one should use net (rather than gross) rental income (which excludes operating costs, such as those on maintenance and property management) and only the part of net rental income that is not spent on new housing investment, i.e., the housing dividend. Because data limitations prevent us from constructing these series, we use gross rental income instead.

10

See Weeken (2004) for a more detailed discussion.

11

Preliminary estimates indicate that investors purchased 21 percent of the second-hand houses traded during the first six months of 2004, compared with 19 percent during the same period in 2003.

12

In Australia, the 2002 Household, Income, and Labour Dynamics Survey provides a breakdown of these categories, as well as comprehensive data on the characteristics of property investors (see the 2004 Reserve Bank of Australia Bulletin). To our knowledge, there is no representative household survey in Ireland that contains the same type of information.

13

In June 2000, the government also announced the introduction of an anti-speculation tax of 2 percent on the value of all newly-acquired residential investment properties for a period of three years, with exemptions for qualified rented properties. However, the tax was removed in 2001.

14

The full set of measures is outlined in the document Action on House Prices, published by the Department of the Environment, Heritage and Local Government in 1998.

15

However, the capital gains tax on disposals of all development land was reduced to 20 percent on December 1, 1999.

16

The importance of this effect was highlighted in Finance Minister McCreevy’s speech announcing the 1998 measures, which stated that “…the package of measures announced last Thursday will help restore balance to the housing market. It will also help to remove another significant factor that has been fuelling price escalation, namely the expectation or—depending on one’s perspective—fear of further major price increases. The very publication of the [Bacon] report itself together with the Government’s speedy response will help take much of the hype out of the market. It is not without significance that as the publication of the report was approaching there were increasingly frequent comments to the effect that the market’ is about to right itself and that prices are set to stabilise soon.”

17

Approximately 30 percent of the respondents said that rental income was insufficient to cover expenses.

Same Series

Other IMF Content

Other Publishers

Cover IMF Staff Country Reports
Ireland: Selected Issues
Author: International Monetary Fund
Volume/Issue:
Volume 2004: Issue 349
Publisher:
International Monetary Fund
ISBN:
9781451818802
ISSN:
1934-7685
Pages:
60
DOI:
https://doi.org/10.5089/9781451818802.002

Nominal Irish House Prices

(Euro thousands)

Real Irish House Prices

(Euro thousands)

Real Residential Prices

Average Annual Growth in Disposable Income

(In percent)

Average Real Mortgage Rates

(In percent)

Average Annual Growth in Real Mortgage Rates 1991-2001

(In percent)

Ireland: Demographics

Ireland: Housing Supply

Average Annual Growth in Construction Cost

(In percent)

Nominal Growth in House Prices and Rents

(year-on-year, in percent)

Ratio of Average House Price to Gross Annual Rental Income

Classification of investors by date of entry in the market

Classification of landlords by number of properties

Nominal House Price Inflation

(In percent)

Real House Price Inflation

(In percent)

Distribution of House Price Growth Expectations