Although inflation has made its comeback in Western economies after decades of oblivion (the great moderation), in public discourse on the housing market, the impact of current inflation levels is quite often ignored. In particular, people talk about the nominal price level of the housing market without looking at the real price level.
For a long time, the difference between nominal and real value trends was semantic. As a result, we have become sloppy in comparing historical figures of the housing market. Now the time has come for investors in owner-occupied mortgages to become more careful again and look at things in a real perspective. Below is a modest attempt to do so.
After nine years of sharp price increases in the owner-occupied housing market, culminating in a 15.2 per cent price rise in 2021, the feeling of a bubble is pervasive. Our Calvinist gut feeling that says «this can’t go on like this» is slowly giving way to: «see, I told you so». We feel we are on the eve of the long-awaited correction, but in real terms, this bubble has already burst. A 5.8 per cent drop in the sale prices of the owner-occupied housing market in the third quarter of this year at a conservatively assumed inflation rate of 10 per cent a year, is a de facto real price drop of 15.8 per cent.
By comparison, in the trough of the previous housing market crisis in 2012, also the year when house prices fell the hardest during that period, the real price fall was «only» 9 per cent. Viewed this way, the housing market crisis is already in full swing. Put another way, in an economy where practically everything is getting more expensive, it is shocking that the asset for which there is a large supply shortage shows a nominal price fall of almost six per cent.
Price driving effect
For this reason, it remains to be seen, how real it is that multi-year substantial nominal price declines will occur in the housing market in the coming years. Of course, rising mortgage rates are an acute problem for first-time and variable-rate borrowers. However, this is offset by CLA wage increases that increase nominal borrowing capacity. With a borrowing capacity of 4.5 times gross income, three years of wage growth of 5 per cent per year from a modal income already results in an additional borrowing capacity of EUR 26,000. This amount is equivalent to 7 per cent of the average selling price of a home in 2021. This increased borrowing capacity has a price driving effect.
The distinction between a nominal and real price drop is all the more relevant because the housing market is pre-eminently a market dominated by debt financing. Debt involves a nominal obligation to repay. It therefore makes quite a difference whether you experience a real or nominal drop in value when you sell your house or have to repay your loan. For investors in the housing market, this means that the current tipping point in the market should be of less concern than the one in 2008. This time, the impact of defaults on mortgage portfolios can be expected to be at a lower level. Given the very tight labour market, the number of expected defaults also seems less pregnant than 2008.
The above is less obvious for commercial real estate, which has a different supply-demand balance and where loans generally have shorter maturities. The increased interest rate is therefore an acute problem for a larger part of that market. The housing market itself will also show some nominal turbulence - witness the latest figures from the Dutch Association of Estate Agents. However, as long as supply continues to lag behind housing demand, scarcity will continue to lift the wings and house prices will soon regain their original nominal highs. With interest rates rising sharply, the current sentiment therefore offers long-term investors in owner-occupied mortgages mainly opportunities to partially offset the monetary depreciation.
Justin de Ridder is a partner at Nectar, a private markets real estate firm. He has a background at ING. This is a guest contribution from him first published on Investment Officer’s Dutch website.