Recently there was a good article by José García Montalvo in the Spanish daily El Pais, discussing the present state of the Spanish property market, and asking what will determine the scale of the adjustment underway. Here is a summary of the article by García, a professor and real estate expert at Barcelona’s Pompeu Fabra University.

Just like the labour market, the adjustment in the Spanish property market is taking place through volume, not prices, explains García. In the labour market, real wages for those lucky enough to have permanent contracts are rising, whilst unemployment is surging for the rest. In the property market, prices have only fallen by 9% (officially), whilst sales have slumped more than 30% and housing starts 75%. In contrast, prices have fallen 33% in the USA, but housing starts by far less than in Spain.

Now’s the time to buy?

Builders and developers, supported by the Minister of Housing, are saying that the slump is over, and now’s the time to buy (They’ve been saying that for a while; one of them even claimed that prices would explode in 2009). The main argument they use is that housing affordability has improved to what it was back in 1996, before the boom took off. But this is a specious argument, suggests García. Thanks to the credit crunch, the housing affordability ratio is now largely theoretical, at least for first time buyers. And many expect interest rates to rise substantially in the medium term, causing housing affordability to deteriorate.

More relevant than the housing affordability ratio (mortgage costs/income) is the ratio of house prices over annual disposable income, a sort of price /earnings (p/e) ratio which ignores mortgage financing issues. According to this ratio the housing market adjustment in Spain still has some way to go. It rose to 7.7 years at the height of the boom, and has now fallen back to 6.6 years. But that is a long way off the historical average of 4, which is where the ratio has dropped to in the US, where prices have fallen much faster. Thanks to lower prices there are now signs that the property market in the US is coming back to life, but not in Spain.

Long adjustment ahead

So Spain is facing a long and painful adjustment, the speed of which will depend upon various factors.

Firstly, the market’s capacity to absorb the glut of unsold new homes, variously estimated at between 1 million and 1.5 million homes. 30% of these properties were built as holiday homes.

Secondly, the government’s fiscal policy towards housing. In Spain, mortgage interest payments are tax deductible, which encourages buying over renting. The government has said it will eliminate this tax break on all home purchases from 2011, but respect it for everyone who buys before then. That should bring sales forward, but only if buyers believe the government will follow through on its promises. García questions the credibility of the government on this issue.

And finally, the way the banking sector is regulated is having a big impact on the rate at which the Spanish property market adjusts and recovers. Spanish banks and savings banks (cajas) are bending over backwards to avoid recognising bad debts, using a variety of tools like debt for property swaps, and keeping zombie developers afloat. New guidelines from the Bank of Spain have also helped the banks by reducing the bad debt provisions they have to make on bad mortgage loans (reduced from 100% to just 30% after 2 years for mortgages with LTVs of 80% or less). As a result, banks now have a bigger incentive to keep prices high, even if they don’t sell. That will delay the adjustment and recovery.

On the other hand, another recently regulation from the Bank of Spain forces banks to increase provisions on debt from property swaps, if the property then remains unsold for more than a year. That is an incentive for banks to lower prices (in some cases), so regulations are creating conflicting pressures. The point is that, because banks and cajas are now the biggest property companies in Spain, not to mention the ones with control over mortgage financing, the way the banks are regulated will have a big impact on the property market adjustment.

In conclusion, the property market is going to take time to adjust and recover, says García, implying that recent talk of ‘green shoots’ and recovery is misplaced. Stimulating the rental market will “help enormously” he says, whilst warning that the biggest error would be to inflate another bubble assuming that interest rates will stay as low as they are for the next 40 years.

It is worth pointing out that García is talking about the property market as a whole, not specific segments, which can go in very different directions. So whilst the market as a whole stagnates, prime property at a reasonable price might sell well, as seems to be happening in some areas. For more information on this see my recently article ‘Segments are the key to understanding today’s property market’.