The unlucky horseshoe

The housing crash may have been relatively short-lived but the gloom has not gone from some markets. Professor Michael Ball investigates

Last year was a year of two halves for many European housing markets. The first half was full of gloom, as reverberations continued after the world financial crisis following the demise of Lehman Brothers in the autumn of 2008.

Mortgage markets were still tightening – to the point of strangulation in some countries; economies were plunging into deeper recession; unemployment was rising; housebuilding was collapsing; and consumer and investor expectations could not have been much worse.

In such circumstances, the house price falls already in existence in 2008 could only intensify, which they did, apart from a few exceptions (namely Austria, Norway and Switzerland).

By contrast, the second half of 2009 saw housing markets in many countries bottoming out and showing signs of recovery. Somewhat paradoxically, initial signs of recovery were often first observed in sales prices, rather than in transaction levels, mortgage finance or housebuilding.

This was because in several places demand revived faster than available supply. Here, existing owners had little incentive to sell if they expected prices 
to recover more in the near future and housebuilders had little to offer in the way of supply either, because they had cut back building and had little stock left.

If the prevailing evidence is right, the European housing crash seems to have been relatively short-lived.

If the same trend continues, as it is likely to, the European housing downturn of 2008/9 will have turned out to be far smaller and more localised than most would have expected in late-2008, and vastly short of the forecasts of the doomsayers.

False dawn
That said, there is some concern that recent signs of housing market recovery is a false dawn and that prices in Europe will fall again in 2010. It would be foolish to discount such a possibility altogether, particularly given current heightened risks.

In any case, by no means all of Europe’s housing markets are exhibiting signs of recovery and, in fact, several countries are still in deep trouble.

There are a series of places where housing market performance is particularly fraught. Geographically, they are linked in a horseshoe shape in the west, south and east surrounding the rest of Europe.

The horseshoe shape starts in Ireland; passes southwards through Spain; turning eastwards through the Mediterranean islands and Greece; then northwards into much of central and eastern Europe; before ending in the Baltic States.

Their problems are especially difficult because they have a mixture of poorly performing economies, weak public finances and declining housing markets that feed into each other.

Housing markets in the unlucky horseshoe are likely to take longer to recover than elsewhere in Europe. Even then, the speed of change will vary.

Housebuilding health check
When housing markets turn down, housing supply tends to drop fast. This has been the case in many of the European markets that have seen the biggest price falls, but there has been considerable variation across the continent.

Several European economies have been badly affected by declines in housebuilding, because of the direct downward economic impact of such large cuts in aggregate demand.

The impacts were greatest in those countries which had the previously highest GDP shares of housing investment – namely, Ireland and Spain.

But wider economic impacts of the housebuilding downturn have been felt even in countries, like the UK, that had relatively low housing outputs during the boom years, because the pace of the output collapse was so rapid.

Most European housebuilding industries have been badly affected by the housing slump, even if the raw housebuilding data do not necessarily indicate major losses in output.

Part of the reason is that there has simultaneously been a collapse of commercial building as well and that has hurt developers building across both types of real estate, which is a common practice in continental Europe.

Germany has been relatively unscathed, partly because its builders have had to face a secular decline in housebuilding for well over a decade. Switzerland managed to increase its housing output through the recession, due to a strong demand for rental property that is slowly drawing to an end.

Real estate development finance has been badly affected by the financial crisis and no end is in sight. Developers, especially smaller ones, are reliant on direct bank loans and have to use risky and un-transparent assets as collateral in the form of land and work in progress.

Such asset types are now downgraded and anathema to lenders. What is more, lenders themselves are going to face much higher costs in lending to development activities because of regulatory changes in capital requirements. Traditional sources of residential development funding are therefore likely to be far scarcer in the future than they used to be.

In many European countries, a lack of good quality, well-located housing has been a prolonged, seemingly irresolvable issue. It may be even more generalised over the next few years, helping to create the conditions for yet another price boom and bust cycle.

The Atlantic difference
Many European housing markets appear to have avoided the prolonged housing market meltdown as experienced in the US. There are several reasons why European markets have adjusted relatively quickly to sudden negative shocks.

European countries have automatic stabilisers when their economies start to slide; ones that are fairly strong relative to those in the US, given the strength of welfare states, job protection and unemployment pay schemes.

There is also far less stress on trying to draw low income households into homeownership in most of Europe.

Low income homeownership programmes come with a lot of subsidy, which lowers entry costs directly, and also come with far more scrutiny, because of the types of agency used to deliver such programmes, which helps to limit fraud.

Most mortgage borrowers in Europe come from the more prosperous sections of society. They may borrow extensively but are less likely to default in tough times.

What is more, the penalties for failing to keep up with mortgage payments are far higher than in the US, giving borrowers less of an incentive to default. So, the incentive for borrowers is for them not to walk away from mortgage commitments and homes, even when there is substantial negative equity.

Defaults have risen across Europe, though at a much lower rate than in the US, where the delinquency rate on residential mortgages (i.e. more than 30 days due) had reached 8% by the first quarter of 2009, according to the Federal Reserve.

So, distressed sales by existing homeowners in Europe have been far less and in marked contrast to US experience. This is helping to limit price decline.

A further key difference from the US is that housing market problems there preceded the general financial crisis and recession, whereas they were more closely linked with it in Europe.

This has meant that it has been easier for European policy makers to act swiftly with respect to their housing markets and for households to adjust their budgets. General economic and monetary policy flowed more rapidly in the same direction as the housing market.

Those factors obviously could not stop the downturns, rather they were manifestations of them, but they have contributed to limiting the strength and persistence of decline.

With hindsight, European central bankers probably fought the battle against inflation for too long, but even so circumstances were more generally in their favour to be able to act decisively in concert with governments and their fiscal policies.

Consumer expectations of falling house prices did not become so entrenched in Europe, because price falls have not gone on for so long.

The supply side in Europe was also more favourable to the avoidance of severe market crashes. In many countries, housing supply responses had been relatively meagre in the face of substantial increases in price, which is one reason why prices rose as they did.

A paradoxical advantage of this is that there was less supply left unsold once demand fell sharply in the current downturn. What stocks there were could be run down fairly quickly before they became a continuing drag on the market.

Builders could then redirect their efforts to building homes that would sell in recovery and, thus, help to 
sustain it; rather than be stuck with unsold properties that no-one wanted any longer.

The experience of Ireland, Spain and some central and eastern European countries has been more similar to that in the US in this supply-side respect.

The argument just made is not one that suggests building fewer houses will smooth off the housing market cycle. It is only working in Europe in this particular juncture because of other features of it, particularly the low level of enforced sales from the existing stock.

Limiting supply helps to create destabilising house price booms; imposes huge costs on those that want housing but cannot afford adequate accommodation at the prevailing high prices or have to sacrifice much else in order to get it; and damages economies by restricting labour mobility.

Therefore, it is not such a good policy option after all.

Permanent changes
The future everywhere remains uncertain, and markets are by no means back to normal. The scale of the shocks in both 2007 and 2008 will take time to work their way through. There will also be some permanent changes as a result, especially in the triangular relationship between housing markets, finance and public policy.

General economic recovery is fragile, as are financial systems. Competition among financial institutions is much diminished and they will face greater costs of doing business, which will weaken credit availability and raise interest rate spreads on a long-term basis.

The regulatory future is still under debate and outcomes could have markedly adverse impacts on housing markets. Players in housing and mortgage markets will have to adjust to greater volatility; even if it is unlikely to be of the scale of the past few years.

Reassuringly, double-dips are extremely rare in housing markets. Most of Europe’s economies are recovering, which tends to favour housing demand and rising housing demand itself will quickly confront the problem of limited supply.

Mortgage finance is constrained but financial markets are improving and, in any case, monetary authorities and governments will be reluctant to risk jeopardising their financial, mortgage and housing markets, particularly after all the effort made to put them on the path to recovery.


Further information
Michael Ball is professor of Urban and Property Economics, University of Reading. To view the full RICS European Housing Review 2010, click here