Are Irish Houses Built on Sand?

Pat Kilduff (Sunday Tribune, July 25 2004)

"Buy land because they are not making more of it". Mark Twain's adage has certainly been adopted by the Irish people in the past decade.

Maybe it is driven by a psyche of post-famine days when we were not entitled to own land, but Ireland has become fixated by investing in property to the extent that other assets have been neglected. Average Irish house prices have trebled over the past decade and the Irish residential property market has accelerated beyond most people's expectations. So, is jumping on the property bandwagon still a shrewd move for investors? Our view is that the buy-to-let market in Ireland is fraught with dangers.

Low interest rates and strong economic growth have made property much more affordable and mortgage relief to cover mortgage repayments with rental income and the housing supply shortage of recent years has kept prices buoyant and demand high. As a result, troops of investors have entered the buy-to-let market and it is estimated that investors accounted for 25% of all new homes and nearly 20% of second-hand homes sold in 2003.

The flood of investment in the buy-to-let market has, however, generated substantial oversupply and this oversupply has been manifested in the form of high vacancy rates and plunging rental yields. The fall in yields also comes against a background of shrinking demand for rental properties as many private renters discover that it is a far more effective use of their money to buy their own home than put the money into investors' bank accounts in the form of rents.

In recent years, rental yields have fallen from a high of around 7% to the current figure of around 2.5% to 3%, barely enough to meet the cost of mortgage repayments. Add in the fact that, on average, a rental property is unoccupied and not generating income for an average of three months in the year, then it becomes clear that the rationale for investing in buy-to-let property is more about generating a capital gain than anything else.

So if income is no longer a prime reason for investing in buy-to-let properties, what are the prospects of further increases in house prices to compensate for the slump in rental yields? Following the house price boom of the past decade, what is the likelihood of a speculative bubble building up with potentially catastrophic effects on property investors?

Property can be valued in two ways. One is based on how much a buyer is able to pay and this measure of affordability is based on a combination of interest rates and income. Due to high income growth and low interest rates in the past decade, this affordability measurement shows that the Irish market is broadly in line with historic levels.

The second valuation method, and the one more relevant to investors is to base the valuation on the rate of income return. Property, like any other measurement, must be valued not only on expectation of capital growth but also future earnings. Using this measurement, the current stagnation in rents and falling yields indicate that the market is overvalued.

With yields reduced to one-third of their average over the last 30 years, buyers seem now to be investing in property for capital gains only. But the ever increasing supply of housing has made sure that the supply shortage of recent years will not be an issue in the future - on the contrary a supply glut is likely if the rate of housing output continues to accelerate.

Not surprisingly, many Irish property investors have become wary of the Irish buy-to-let market and this has produced a surge of investment in overseas property. But there is still a large number of people who believe that investment in the home market is the more desirable option - possibly a case of "better the devil you know…".

There is a risk that the Irish property investor is becoming emotional and is ignoring the underlying fundamentals of what makes an investment valuable. These investors are jumping into property investment largely on the basis of having made money in the past. But prospective investors should remember that this is no guarantee of future gains.

Against a background of low rental yields and long rent-free periods, investors may have to supplement rental income to higher and higher degrees to cover mortgage repayments. In a time of historically low interest rates, this alone may not scare investors away but if it is assumed that we are at the bottom of the interest rate cycle, this may become more and more of a burden in the future.

While high quality rental properties in blue-chip locations will always be let, lower quality properties in marginal locations are a much higher risk as this is the sector of the market that is most likely to experience a glut in the future. At best, rental incomes of properties in this category may fall further - at worst the fall in rents may be accompanied by a fall in the actual value of the property.

The buy-to-let bubble may not have burst yet. But the prognosis for the market is not good and investors should base their decisions less on emotion and what has gone before but instead on a more rational assessment of the prospects for the buy-to-let market..

Pat Kilduff is Investment Manager with Appian Asset Management