Here we are in 2006, and the big question is, is there a bubble in the Spanish property market?
For my part, I’ve thought there was a monumental Spanish property bubble as far back as 2004, but that doesn’t mean much, as I’m as often wrong as not. But there is plenty of evidence to support my case. For a start, over the past few years Spanish property prices have risen to record levels both in real terms and in relation to average incomes. The following table shows how much Spanish real estate prices have risen in recent years.
This has sparked a heated debate as to whether Spanish property prices can be justified on rational economic grounds. On the one hand are those who argue that Spanish property is fairly priced given economic fundamentals, and on the other those who believe that Spanish property is suffering from a classic asset price bubble.
Robert Shiller, and economist at Yale University (and one of the few Americans to have seen the stock market bubble for what it was) defines a property price bubble as occurring when property prices are driven more by (or to a large extent by) expectations of future price increases than by the need for an abode. In other words when prices are driven by the belief that property is an easy way to make money. Is this the case in Spain?
Arguments against a Spanish property bubble
Real estate in Spain is expensive by historical standards but that does not mean to say that it is overpriced (a bubble). In fact the price of Spanish property truly reflects the level of supply and demand (which is a function of ability to pay), and demand is driven by housing needs rather than speculation. Therefore Spanish property prices will not decrease unless there is some external shock – for instance a massive increase in the price of oil that floors the economy and undermines people’s ability to afford property. Without an external shock the price for property is at the equilibrium level and not a function of irrational expectations of future property price rises.
Price is a function of supply and demand. Prices in Spain are high because there is more demand for property than there is supply to meet this property. Demand is high for the following reasons:
Very low real interest rates. Real interest rates in Spain are extremely low by historical standards and have even been negative recently. This makes the cost of buying Spanish property with a mortgage cheaper than it has been in the past. This opens up the market to more people than before and drives up demand.
Structural changes in the Spanish mortgage market. Deregulation, innovation, and competition in the Spanish mortgage market mean that lenders are prepared to lend more money, for longer periods, to more people than ever before. Thus even though average house prices have increased, initial average monthly mortgage payments have declined, as have down payments, making property more accessible to a greater number of people. This drives up demand.
Real incomes have been rising steadily in Spain. Spain’s entry into the EU, labour market deregulation, and general improvements in its economy have made Spain much richer than it was 20 years ago. Richer citizens mean that more people can afford to buy a home. This drives up demand.
Changing demographics and lifestyles in Spain, including a greater number of divorces and children leaving home earlier, mean that more people need a home than before. Some will rent but many will choose to buy, given the low real interest rates and mortgage factors that make the cost of property cheaper. This drives up demand.
Foreigners buying in Spain. Due to its climate, appealing culture and surroundings Spain is becoming the California of Europe. Large numbers of wealthy Northern Europeans are buying real estate in Spain, especially in costal areas. They are expected to continue to do so in increasing numbers as the baby boomers retire. This drives up demand in the costal areas where there is a limited amount of land for building.
Property is a good investment – no doubt about it. Spanish property has proven itself to be an excellent investment over the long term. People believe that property is less risky than shares because even in the worst scenario of drastic price collapse you still have a tangible asset where as shares can leave you with absolutely nothing. Also it is easy and cheap to borrow against property, which substantially drives up returns in a rising market, and real estate often enjoys tax breaks that stocks and shares can only dream of. More people than ever before are beginning to realise this and therefore including Spanish property in their diversified portfolios. This drives up demand.
On the other hand the supply of Spanish property is relatively fixed in the short-term and government regulations often make it difficult to increase the supply. More properties will be built to meet rising demand but the delay in delivery means that price rises are the only way for the market to clear.
Another argument that is used to challenge the existence of a property bubble is the high transaction costs involved in buying property, which discourage speculators and help to keep bubbles at bay. This would suggest that the high prices relative to previous periods are due to the demand for housing and not because of property speculators buying in the expectation of making easy money.
For all these reasons, so the argument goes, Spanish property is not overpriced and therefore is not suffering from a bubble. Therefore there is no reason to think that prices will fall in the future.
Arguments for a property bubble in Spain
The price of property in Spain does not reflect the true demand for housing. Demand is being driven by a number of temporary factors that are bound to disappear, and with them high property prices. Therefore present prices are forming a bubble that will pop under its own weight regardless of any external shocks. The arguments supporting this point of view are as follows:
The house-price-to-income-ratio in Spain (average house price divided by average income) is at its highest level ever and 68% above its long-term (30-yr) average according to The Economist. Comparable figures for other countries are 50% in UK, Ireland and The Netherlands, 23% in the US and 33% in Australia. Property prices can only be supported by people’s ability to pay for housing and this is now under great strain in Spain.
Spanish property prices have risen faster and higher in real terms than in any previous property boom, and have now reached record levels. A study by the IMF (reported in its 2003 World Economic Outlook) finds that a sharp rise in house prices in real terms is much more likely to be followed by a bust than is a share-price boom.
The Bank for International Settlements has found that house price busts usually take place 2 years after stock market crashes. Although this has not happened this time it is mainly because interest rates have been and remain unusually low. However this only postpones the housing crash and causes it to be bigger than it might have been.
Spanish house prices have been rising much faster than rents, which has driven down rental returns. This is corroborated by a recent study by the Barcelona property consultants Forcadell that shows Barcelona rental returns down to 3%-4% from a previous level of 6%. The Economist argues that house prices should always rise more or less in proportion to rents because assets should always be priced as a function of their underlying potential cash flow. The fact that property prices and rents have diverged implies that people are buying in expectation of capital appreciation rather than due to underlying fundamentals. When asset prices diverge from actual or implied cash flows then bubbles arise.
People often argue that a fixed supply of land coupled with rising demand will justifiably push up the price of property and keep it high. However Hong Kong, where land supply is more limited than in many places, has witnessed price decreases of over 60% in the past 5 years after its property bubble burst.
It takes time to build properties and this encourages property bubbles. A genuine rise in demand and a fixed supply of property increases prices in the short term. Rising prices give buyers expectations about future price rises and lenders an incentive to lend more, both of which further push up demand and prices. This stimulates developers to start expanding supply dramatically. But given the time it takes to build new properties many more are started than might otherwise have been the case. When all the new properties come onto the market supply exceeds demand (already under pressure from high prices) and prices start to fall, pushing the whole process into reverse. More new properties were started in Spain in 2003 than in any other European country. The number of new properties stated in Spain last year was more than the combined total of France and Germany put together, and 33% of those started in the US – an economy that is 7 times bigger than Spain’s. Therefore Spain is probably nearing the point where the whole process goes into reverse (a bubble bursting).
For various reasons Spanish investors have always tended to focus on property – a tendency that was reaffirmed by the stock market crash. Thus many buyers in Spain are investors or speculators, which is why the market is showing bubble-like symptoms. This is supported by the fact that many properties in Spanish cities lie empty – they are neither homes nor being rented out and are purely bought for speculative purposes.
People have come to view Spanish property as risk free and easy way to make money. Because they have a habit of looking to the past to provide a map of the future they now expect prices to rise strongly, just as they expect the sun to rise tomorrow. This means people are underestimating risk and this is always the starting point for bubbles. When people believe that there is no risk involved and that prices will rise strongly they will pay any price for property. However strong rises in the past are no indication of what will happen in the future. Look at Japan, where property now costs less than half what it did in 1991.
For all these reasons, so the argument goes, Spanish property isoverpriced and suffering from a bubble. Therefore prices are likely to come down significantly in the future due to the Spanish property bubble.