A chief concern of property watchers is trying to gauge what a house is worth. What is a fair value for a house? In the case of the Irish property market, this may also mean “what will be the final price of a house after the crash”? And, when is it better to rent than buy?
One yardstick for calculating whether to rent versus buy is the opportunity cost method. Buying a house can be considered equivalent to renting from the bank. The interest paid on a mortgage is economic rent just the same as the rent on a property. In addition to the interest payments (rent) the bank’s tenant additionally pays a little extra each month so that the house will eventually be theirs; This is the principal portion of the mortgage payment.
The only other difference is that the purchase price (the principal sum) is fixed as of the date the mortgage is signed. One could consider signing a mortgage as 'going long' the market, i.e. expecting that house prices will be higher by the time the mortgage matures than they are now. Equally, one who chooses to continue renting is shorting the market and assumes that house prices will be lower in the future.
In signing a mortgage, the rent is not fixed. Economic rent from the bank can rise if interest rates go up, just the same as a landlord can raise one’s rent.
One could argue that in general, inflation dictates that a landlord’s rent would rise faster than the bank’s rent, but this is not true in every case.
Buying the house I live in
The following is an illustration of the opportunity cost method. It also demonstrates why house prices need to fall dramatically in Ireland to be affordable, and why even at dramatically lower prices they will still be out of the reach of many.
I live in a house that rents for €25,000 per annum. To rent the house from the bank for the same price would mean the interest portion of the mortgage would be €25k pa. At prevailing mortgage interest rates of 6% (ECB+2%, is this fair?) gives us the equation:
x ✕ 0.06 = 25000, where x is the purchase price of the house.
Solving for x, this gives us x = 25000/0.06, or x = 416,666. In other words, €416k would represent fair value for this house. Incidentally, €416k is about half the house’s peak valuation.
So we have a fair value, a price that we might expect the house to achieve after the crash in say, 4-5 years. But does that make it affordable?
Suppose I wanted to buy the house that I now rent in 4-5 years at €410k. At that time lending will be so restricted that I will require a deposit of 25-30%, or ~€110k. That’s ~€25k in savings per year! It’s a lot of money to save, but with two incomes and strict Lidl shopping, it might just be possible.
But what about the other 75% of the purchase price? This would of course have to be funded by the bank, so I would require a mortgage of ~€300k. That is more than 6 ✕ my income! While banks may be willing to lend that kind of money today, they certainly won’t be willing to do so 5 years from now. In fact, the most one could expect to get in the future lending environment is 4 ✕ primary income, maybe 5 ✕ dual income.
So even though house prices will tumble, so will the ability to purchase. So affordability, while it will improve, will still be elusive after the crash.
Tags: affordability, bubble, buy, cost, crash, credit, ireland, property, rent, valuation, value
