Thursday, August 30, 2012
The rental yield in 2010 remained elevated at almost 9.5 per cent
In the aftermath of the financial and economic crisis of 2007, property market conditions around the world are increasingly being seen as a potential source of economic risk which, if not addressed appropriately, could destabilise financial markets and economic conditions. An analysis of the property scene is essential both from an economic stability perspective and also from the social perspective of housing affordability.
The ratio of house prices to personal household income (PIR) gives a rough indication of housing affordability keeping all other things affecting prices (like interest rates, number of new households, supply conditions, expectations) constant. It can be considered as one measure of overvaluation in property prices. An increase in this ratio means that house prices are rising faster than income levels. This makes it more difficult for households to purchase property, and is an indication of worsening affordability.
In theory, property is an asset which can be sold such that the increased indebtedness of the household is equally matched by the ownership of property as an asset. However, in practice, property is not a very liquid asset; it may take months or years before a buyer is found at the asking price. This may prompt households with significantly reduced income levels to default on their loans before the property could be sold.
The lack of market liquidity may imply that property prices can rise faster than income for quite some time. Problems can arise however if the economic conditions change (say, due to a period of unemployment, a reduction in income or an increase in mortgage rates) for a number of households at the same time. This often occurs in prolonged recessions.
At this point, many households could be trying to sell their homes at the same time causing a severe market correction in property prices.
As property prices fall, the market value of assets backing the household debt also declines, undermining the balance sheet position of households. This may lead to what is termed ‘negative equity’ – the value of the property becomes less, than the borrowing amount prompting some households to default on their loan payments.
The PIR in Chart 1 is an estimate based on the property price index of the Central Banks of Malta and the average price of property used by Falzon, Zammit & Camilleri (Quarterly Review, CBM, 2005:1). Income data and total number of employees were obtained from NSO.
Residential prices increased at a faster rate than income levels in between 2002 and 2006 which could be an indication of overvaluation in property prices. There has been a downward movement in the PIR since the onset of the international financial crisis in 2007. The decline in this ratio is due to a combination of falling house prices and rising incomes.
Based solely on the PIR, the correction that has taken place in the last four years has probably brought prices closer to their sustainable values and reduced the extent of overvaluation in house prices.
Although the PIR in 2010 is still higher than the pre-2002 ratios, it is difficult to quantify exactly the extent of overvaluation (if any) based solely on this indicator. Income is not the only economic variable affecting property prices.
Other variables to be considered are the expected future capital gains from the property, risk factors, monetary conditions, like interest rates, the level of bank lending and bank lending standards, taxation, demographic conditions (which determine demand by first-time buyers and secondary home buyers) and supply conditions in the market.
Assuming a moderate per capita income growth of two per cent per annum and assuming an equilibrium PIR equivalent to 2002 levels, the gap from equilibrium – in respect of residential property prices – hovers between 20 and 30 per cent. This gap can be closed gradually if income levels rise faster than property prices, other things remaining equal.
The chart seems to indicate that such a correction has taken place since the onset of the international financial crisis. In 2011, the PIR seems to have slightly gained momentum in the upward direction, especially in respect of apartments.
The analysis in this article, though relevant, remains a partial analysis focusing primarily on the income variable. More conclusive judgments on the real estate market would require a deeper analysis of the other variables.
Data on commercial property prices is not yet readily available in Malta. To temporarily address this issue, an experimental commercial price and rent index was computed. Data was collated on the basis of a sample of classified adverts appearing in a local weekly newspaper.
The readings, which included the date, the commercial property description (shop or office), the location, the area in square metres and the price or daily rent, were taken from the first issue of each month of a local Sunday newspaper (the sample includes, on average, 59 observations pertaining to property for sale and 74 observations pertaining to property for rent for each year).
The observations were segmented in five districts to make comparisons between different regions in the country. Subsequently, a price and a rent index per square metre (for comparison purposes) were constructed on a quarterly basis.
The index reflects the aggregation of data for both shops and offices with the median of each quarter interval being calculated and quarter one of 2006 as the base year (2006 Q1 = 100).
The data collected permits the estimation of commercial property rental yields. The rental yield may be expressed as the rent over price per square metre. This is the rate of rental income generated for every euro invested in commercial property.
The yields were calculated on a weighted median system in order to reduce the volatility related to missing observations and outliers typically present in a small sample. Falling yields can be an indication of an oversupply of rentals and falling rents or else a rising property market with rising commercial property prices or else a combination of both.
On the other hand, rising rental yields signal either a strong rental market with rising rents or else a falling property market with falling commercial property prices, or both.
The sample period covers the occurrence of the global financial and economic crisis, and the period of downturn experienced by the Maltese economy in 2009 which was followed by a gradual recovery in 2010. Hence, the analysis sheds light on how the commercial property sector in Malta fared when subjected to these shocks.
Commercial property prices increased between 2006 and 2008, while the rent index moved in the opposite direction. As a result, the rental yield went down over the period preceding the 2009 downturn. The 2009 environment in Malta may have reduced demand for commercial property with the price of commercial property almost reverting to the 2006 level.
In the meantime, the rent index recovered, possibly reflecting the substitution of demand for the purchase of commercial property with the demand for rent. The rental yields consequently increased. As the economy recovered in 2010, the demand for both owning and renting a commercial property recovered while national accounts data suggest that construction activity remained subdued. As a result both the price and the rental index increased. Overall the rental yield in 2010 remained elevated at almost 9.5 per cent.
While further evaluation of the property sector in Malta is necessary preliminary results suggest a property market which often responds to economic conditions usually with a lag, particularly in the residential sector. Property markets around the world often exhibit similar characteristics.
It is however necessary to keep this in mind when evaluating the property market in general, and the financial net worth of individuals, households, companies and financial institutions in particular.
This article, prepared by the Economic Policy Division within the Ministry of Finance, represents a partial economic analysis of the real estate sector in Malta. It has also made use of experimental research on the commercial property sector in Malta where research is lacking.