Assessing real estate prices is complex, as it depends on economic and banking conditions, the structure of real estate markets, borrower solvency, fiscal policy, and the yield differential with other financial assets.
110 basis points. This is the increase in French residential real estate prices since 2000. In index terms, French real estate has appreciated more than the Spanish, American, or British real estate markets.
This illustration skews the analysis of the real estate market because it is based solely on price trends. However, there are many factors that explain why this increase is sustainable and why there has been no depreciation since 2008.
The purpose of this article is to highlight the three criteria that we must consider in order to conduct an effective and objective analysis. However, without drawing conclusions about the existence or otherwise of a real estate bubble in France, a more in-depth study would be necessary.
FIRST CRITERION: THE ECONOMIC AND FINANCIAL ENVIRONMENT
Housing supply and demand provide an initial perspective on the evolution of the real estate market. We can therefore look at the number of homes available over different periods, housing starts, and building permits. The aim is to observe the balance between the volume of available housing and demand. Changes in the number of building permits also depend on legal constraints, which differ from one country to another. These variables are justified by constraints on both sides of the market:
– The characteristics of supply relate to the stock of available housing, which is dependent on the tax environment (capital gains tax, tax deductions) and investors’ rational choice to ration supply in order to support rising real estate prices. This housing stock is the result of geographical and regulatory constraints.
– Demand characteristics depend on variables that facilitate the desire to purchase real estate for rental purposes or to become a homeowner. Purchases for rental purposes depend on property income and tax incentives (in France, the Borloo, Robien, and Malraux laws). Purchases for residential purposes are justified by demographic structure and other tax incentives. This desire to purchase real estate is realized according to the maximum amount that can be paid, which depends on credit access conditions, borrowers’ net wealth, financial assets, future income expectations, and guarantee systems that ensure the lender’s solvency in the event of default.
In addition to these fundamental conditions of the real estate markets, there is also the economic context. The business cycle strongly influences buyer and seller confidence based on variables such as construction activity (housing supply), the deterioration of public finances that may require fiscal restrictions (housing supply and demand), and the labor market (employment market conditions, borrower vulnerability, and future employment prospects).
As in any other market, economic agents anticipate changes in price dynamics based on the economic context. In real estate, this dynamic translates into a decline in transaction volumes due to agents’ wait-and-see attitude. For example, if sellers anticipate a rise in real estate prices, they will decide to put their property up for sale at a later date. If buyers anticipate a fall in real estate prices, they will postpone their purchase decisions. As the real estate market is slow to adjust due to the nature of the assets and regulations, the wait-and-see attitude of agents leads to a decline in transaction volumes. This is a key indicator for anticipating a market reversal.
Furthermore, the structure of real estate markets between ownership and rental properties can represent a strong variable for adjusting housing supply through fiscal policy. For example, the rental property stock is low in Spain, Ireland, and Cyprus, countries affected by a depreciation in real estate assets. The excess supply of housing relative to demand for real estate can thus be corrected by tax measures that encourage the rental of housing (tax exemption measures, taxation of property income).
Furthermore, it is essential to distinguish between new and old housing, as demand differs between the two. The real estate market in the Paris region is characterized by supply conditions (old housing, and therefore limited supply) and demand conditions (the most attractive old housing is often sought after by foreign buyers). These two conditions do not characterize the real estate market outside the Paris region, where prices are relatively lower.
Finally, demographic pressure and the vacancy rate (properties offered for sale or rent by their owners or awaiting occupancy) are representative of housing needs. Demographics justify an excess supply of housing in anticipation of strong future demand. The vacancy rate can be explained by tax distortion and speculative strategy.
The tax distortion concerns the legal and tax advantages granted to tenants and landlords. This unequal treatment encourages some landlords not to rent out their properties for fear of tenant insolvency or an inability to evict them if necessary. Furthermore, this unequal treatment is exacerbated by the advantages enjoyed by tenants, particularly in terms of housing assistance. These conditions encourage new players to enter the rental property market.
The speculative policy pursued by certain real estate asset management groups leads them to maintain a sustainable proportion of vacant properties in their portfolios, resulting in a rationing of housing supply that fuels the high prices of properties in their real estate portfolios. Thus, for a given number of properties, rationing leads to an increase in rents and therefore an increase in real estate prices. Economically, this policy is profitable if the opportunity cost of not renting out a number of properties is lower than the increase in the value of the entire portfolio.
These five aspects (supply/demand, economic conditions, market structure, type of housing, and demographics/vacant housing) must be studied specifically for each country and region. A more comprehensive and neutral view can be obtained by considering a second criterion: borrowing conditions.
SECOND CRITERION: BORROWING CONDITIONS
Borrowing conditions are based on the average characteristics of loans granted in a country: the split between variable and fixed rates, the average maturity of loans, the loan-to-value ratio, the split between amortizable and bullet loans, financial assets, debt, and mortgage guarantee systems.
The proportion of variable-rate and fixed-rate loans varies considerably between countries. For example, while it was 15% in France and Germany in 2007, it reached 67% in Ireland and 91% in Spain. Variable-rate loans are indexed either to the prime rate or to the Euribor, for example at 3 months (Ireland) or 1 year (Spain, France).
When a borrower takes out a variable-rate loan, the rate they benefit from is lower than that applied to a fixed-rate loan. In return for this advantage, the borrower takes the risk that the rate on their loan will increase, sometimes above the rate on a fixed-rate loan, all other things being equal. This type of loan has two disadvantages. One disadvantage is for the borrower, who cannot fully anticipate the evolution of the annual payments they will have to make. The other disadvantage is for the lender, who is limited in their risk control activities. The characteristics of variable-rate loans make it easier for a larger number of people to become homeowners, but can have serious consequences if their use is not properly controlled. Three examples in particular come to mind: the subprime crisis, the Dexia affair, in which loans to local authorities were indexed to the Swiss franc, and the Libor manipulation scandal.
The average maturity of loans is a second characteristic of loan financing. It is high in Spain (30 years), Ireland (31-35 years) and the Netherlands (30 years), while the average maturity in France is limited to 19 years. However, it is difficult to consider that a real estate bubble results from long-term loans and variable annuities. Portugal, whose economy has not been affected by a real estate crisis compared to Ireland or Spain, has 99% variable rates and loan maturities of 30 to 40 years. A shock to the real estate market is more a result of market structure and supply and demand, with loan terms being sensitive to this shock and increasing the risk of borrower insolvency, without contributing to the shock to the real estate market.
One thing is certain: in France, if real estate has reached such high levels, it is partly thanks to credit, as wage growth has lagged far behind real estate inflation. Indeed, the average net wage in France increased by only 23% between 2000 and 2010 (source: INSEE). Households have therefore filled this gap by increasing their debt. Another factor could have enabled households to purchase more expensive properties: the use of their savings. Although the French are known to have one of the highest savings rates in the world, this rate has not fallen since 2000. It is therefore through credit that households have absorbed the rise in prices.
The loan-to-value ratio is an indicator used to track a borrower’s debt for real estate investment. Borrowers are seeing the value of their real estate decline, with the risk of having to pay annual installments linked to a loan amount that exceeds the value of the property in question. This relationship, measured by the loan-to-value ratio (LTV), exceeded 100% in the Netherlands and Ireland in 2011.
The LTV ratio must be observed according to the nature of the loans granted: amortizable (the principal is repaid gradually with interest) or bullet (only interest is included in the annual payments, with the principal due at the end of the loan):
– In the case of an amortizable loan, both the repayment of the loan and the value of the property will affect the LTV ratio.
– In the case of a bullet loan, only the value of the property, i.e., changes in real estate prices in a country, will affect the ratio.
Thus, a significant proportion of interest-only loans (30 to 50%) is likely to keep the LTV ratio high despite a decline in prices. Therefore, measuring a borrower’s creditworthiness using the LTV is only possible if the proportion of amortizable or interest-only loans is known.
On the other hand, a high LTV ratio, which would mean that the value of a property is lower than the amount of the loan, with a high proportion of amortizable loans, is not sufficient to conclude that the borrower is insolvent. Two additional variables must be examined: the borrower’s financial assets and collateral.
A borrower’s financial assets are an essential factor in measuring their creditworthiness. For example, South Korean households have a debt level 1.8 times higher than their gross disposable income, yet this average debt level is mainly (80-90%) concentrated among households in the wealthiest quantiles. In short, while the average South Korean household is heavily indebted, its ability to repay its debts is very strong given its assets. In Europe, the risk of insolvency is higher in Ireland, where the difference between the debt ratio and net financial assets of households is 36 points of GDP, compared with 10 points in Spain and -40 points of GDP in the Netherlands, where households have financial assets 1.3 times greater than their debt. These three countries are suffering from a real estate crisis, but the microeconomic risks are greater in the peripheral countries than in the Netherlands. In France, the difference is 80 points of GDP, with net financial assets far exceeding household debt. Thus, a depreciation of real estate assets in these two countries would be less likely to increase the risk of default on mortgage loans.
Finally, guarantee systems complement the risk of insolvency through private insurance contracts or a government institution. This system is important in France, where 58% of loans in 2007 were covered by guarantees, and in Cyprus, where the figure was 55% (the two highest proportions in the eurozone), while the proportion did not exceed 1% in Spain and 2% in Ireland.
THIRD CRITERION: THE TAX ENVIRONMENT
The fiscal environment is a key criterion. The economic and/or financial environment and borrowing conditions are often not enough to justify changes in real estate prices. Supply and demand are therefore more dependent on tax incentives than on interest rates or the creditworthiness of borrowers. We will discuss the fiscal environment in France, excluding other markets.
Taxation and real estate are closely linked in France. It is the country that devotes the most public funds to housing: nearly 2% of GDP (€40 billion) and even 2.7% if we include the benefits given to social housing tenants in the form of below-market rents. There are two main flagship measures.
The first measure aims to increase the supply of rental housing and is justified by the significant heterogeneity of the real estate supply depending on geographical area. The legislator has defined four zones based on the existing housing supply: A (Paris, French Riviera), B1 (outer suburbs, so-called expensive municipalities), B2 (outskirts of the Ile-de-France region, other expensive areas, municipalities with more than 50,000 inhabitants), and C (rest of the country). This classification serves as the basis for the application of advantageous tax measures and rent regulations. The various measures allow owners to deduct up to 22% of the value of the property from their property income over nine years through a depreciation process. The deduction rate depends on the location of the property and whether it meets low-energy building standards. This measure has had the effect of creating significant distortions between housing supply and demand in certain regions, particularly those with lower populations, as some investors have focused heavily on areas where the deduction rate is highest (B2 and C), without regard for the level of housing demand, which has remained rigid.
The second key measure is the deductibility of borrowing costs, which allows households to deduct the interest on a loan taken out to purchase real estate from their property income. This measure may partly explain the rise in real estate prices, as it encourages households to take out loans. For example, if an investor invests €500,000 in cash with a 4% return, they will earn €20,000 per year. If they also take out a €200,000 loan with the same rental return, they will earn €28,000 per year and will have lower interest expenses thanks to the deductibility. The gross return on the capital invested therefore increases from 4% (20,000/500,000) to 5.6% (28,000/500,000) in the case of full deductibility (i.e., when the cost of the loan is zero). To further increase their return, investors have a greater incentive to take on debt if they are in the higher income tax brackets. From a macroeconomic perspective, this incentive naturally supports an increase in real estate prices.
In addition to these two flagship measures, there are other mechanisms that encourage households to channel their savings into real estate. These include the following measures: no capital gains tax on the primary residence, a 30% allowance on the value of the primary residence for wealth tax purposes, degressive taxation of capital gains after five years of ownership for second homes, tax deductibility of renovation and improvement costs, and a micro-property regime that reduces property income taxation.
In particular, there is a tax distortion whereby rents are not deductible from taxable income, while the imputed « income » from the personal use of one’s own property is not subject to tax. The current income tax system therefore transfers wealth from tenants to landlords. This is highly detrimental to low-income earners, who, relative to the population as a whole, are more likely to be tenants than homeowners.
Despite the government’s efforts, France is one of the developed countries where real estate scarcity is most acute, particularly in the Ile-de-France region. According to François Meunier, this is because rising prices do not lead to an increase in the production of new housing due to overly complex and inconsistent land rights, disincentive systems for local authorities, and overly restrictive land use plans. However, from a microeconomic perspective, an inelastic supply renders public policies aimed at providing subsidies to tenants or owners ineffective. A study by Gabrielle Fack estimates, for example, that for every €100 given in housing assistance to a tenant, between €50 and €80 ends up in the landlord’s pocket in the form of rent increases, and therefore ultimately in higher real estate prices. Similarly, helping homeowners to purchase a primary residence has the same effect: it translates into higher prices that benefit homeowners (if the property is old) or developers (if the property is new).
From a theoretical point of view, one may question the legitimacy of these measures, which distort the asset allocation process. Some economists, such as Reinhart and Sbrancia (2011), consider that financial repression occurs « when a government takes measures to direct funds that, in the absence of market regulation, would go elsewhere. » This financial repression is based on two main pillars: the creation or maintenance, through regulatory measures, of a captive domestic investor base—which is the case here—and the explicit or implicit capping of interest rates, particularly those on government debt.
This third criterion of real estate prices leads us to highlight one of the most pernicious tax distortions. This is the fact that rents are not deductible from taxable income, while the imputed « income » from the use of one’s own real estate is not subject to tax. The current income tax system in France therefore transfers wealth from tenants to landlords, which is highly detrimental to low-income earners who, relative to the population as a whole, are more likely to be tenants than homeowners.
CONCLUSION
We have identified three factors that determine real estate prices:
– the economic and financial environment ( housing supply and demand, economic context, real estate market structure, new and old housing, demographics, vacancy rates)
– borrowing conditions ( variable/fixed rates, loan maturities, loan-to-value ratio, credit distribution, creditworthiness, guarantee system)
– the fiscal environment ( tax incentives for renting, fiscal distortion from tenants to landlords)
Other criteria exist, such as real estate speculation. This criterion, linked to portfolio management optimization, aims to invest in real estate when the yield differential with a risk-free asset is positive and greater than for other investments, which will be the subject of a future article.
References
Luca Agnello, Ludger Schuknecht, « Booms and busts in housing markets: determinants and implications, » ECB, No. 1071, July 21, 2009.
Housing finance in the euro area, ECB, March 2009.
François Meunier, « Duflot un coup d’épée dans l’eau, » Telos, September 27, 2012.
