SOME READERS MIGHT remember that two years ago, it was announced that Irish houses were likely 7% overvalued.
Since then, property values have risen by a further 11% – so about 18% overvalued, right?
Well, in recent weeks it was announced once again that house prices are overvalued; but ‘only’ by 10%.
Wait, what? What’s going on?
Well, let’s take a look at why Irish house prices were called overvalued in the first place, why they rose in spite of that – and why they will likely still rise even further.
The observation that Irish property prices were probably too high was made in a paper published in October 2022 by the ESRI.
This was based on a model used by researchers which compares property prices to disposable income and mortgage interest rates.
Researchers for the think-tank said they thought two key factors were behind what they considered to be the over-valuation of Irish house prices:
The ESRI said house price inflation would likely drop off in the medium term as people spent their pandemic savings and as mortgages rates were expected to rise sharply.
‘It is clear, going forward, that the recent surge in savings and wealth is not sustainable over the medium term,’ the paper said.
‘Therefore, changes in house prices will become re-aligned with movements in income over [the medium term]… This means that recent increases in house prices are likely to moderate substantially over the short to medium term.’
Since then, the researchers have been proven wrong, as house prices have once again increased substantially. This increase has come even as interest rates did indeed surge, making mortgages more expensive.
So, why did this happen?
Well, a new study published by the ESRI has tried to answer this question.
Researchers still consider there to be two fundamental factors in determining property values: income levels and interest rates.
So if interest rates surged since October 2022 – in other words, just as the last study was published – why did property price inflation accelerate?
This is where the new part of the study comes in. Basically, the ESRI thinks consumers’ expectations play a major role in property prices. If people expect house prices to rise, they’ll behave in a certain way [buying more property] which actually will cause them to rise.
The ESRI thinks three main variables factor into consumer expectations: expected trends around house prices, household income, and inflation.
It tested this idea using a model looking at historical housing data and found there was a statistically significant link between income expectations, expected house price growth and actual house price growth.
By contrast, while interest rates did have an impact, it was reduced compared to the other two.
‘Households are more influenced by expected changes in real interest rates than in changes in the actual rate,’ the study said.
Interest rates started to surge from October 2022, but the fact that they would rise had been well-flagged for months in the media.
This idea has other implications – namely, that house prices sometimes behave in a way which is ‘non-rational’.
‘The tendency for households to have house price expectations that are different from rational expectations, which are often associated with efficient markets, can exacerbate the variability of house price movements,’ the ESRI said.
‘While actual movements in real interest rates do not appear to significantly impact changes in house prices, expected changes in real interest rates do.
‘Periods of significant house price appreciation, which are maybe initially due to variations in fundamental variables in the housing market, can then be amplified by alternative house price expectations among consumers.’
What does all of this mean?
Basically, even though house prices may have been overvalued in 2022, there was a reason that they continued to rise.
The ESRI expected at the time that interest rate rises which had started to kick in would help lower prices.
In reality, what they’ve found in the 2024 study was that consumers had already priced in these rises before they started to take effect. So the actual impact when they came into effect was more muted than expected.
Another factor is the Central Bank easing mortgage lending rules, letting people borrow more money to buy houses.
This was announced in October 2022, only a few days after the ESRI paper was published.
Since then, there has been a rise in the levels of mortgage debt, which the ESRI recently found are back near Celtic Tiger levels.
This has also resulted in homeowners spending a high proportion – 33% - of their disposable income on mortgage repayments. Again, this was the highest level since the boom.
This has left many households vulnerable to risks such as any fall in real wages or increase in unemployment.
Ok, so given all that – can we finally say that Irish house prices are actually overvalued?
Well, as stated earlier, the ESRI’s model now puts it at 10%.
Perhaps the more important question: does the overvaluation mean that house prices will slow down now?
Well, clearly no, given that they already rose in 2022 after the ESRI’s initial prediction.
Again, there may be something which may not be considered in their 2024 analysis, like how consumer expectations and the impact of interest rates were not fully accounted for. Or there could be a change in external actors, like with the Central Bank loosening its lending rules.
But perhaps most importantly, the ESRI itself has said it still expects house prices to rise.
Why, if they also think they’re overvalued? Well, the Irish economy is still performing well. Real incomes are rising, which as we’ve learned, is a strong indicator of future house price rises.
The European Central Bank has also signalled it will continue its recent policy of cutting interest rates. Again, the rate cuts themselves may not have a major impact – but the anticipation of them might.
Then there’s also our old friend, housing supply – or, more accurately, lack of it. Ireland still isn’t building enough homes to meet current housing demand
Various estimates have put the number of homes needed annually at 52,000 a year, or even as high as 82,000.
New dwelling completions for 2024 are expected to finish somewhere between 33,000 and 36,000, so likely well below what is needed.
And that’s not even factoring in the backlog of homes needed from all the other years that Ireland has missed its housing targets, which makes the problem worse and worse with time.
So despite warnings of overvaluation, without a new external actor coming into play, don’t expect property price falls just yet.
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