Rent rate reverses signal trouble ahead
The loss of 900 jobs at Xerox in Blanchardstown over the next two years will put downward pressure on rents in west Dublin. There will be knock-on effects on house prices, though the relationship between rents and house prices has never been straightforward.
According to data from the property website Daft.ie, rents fell 18 per cent between January 2002 and March 2004.
In real (that is, inflation adjusted) terms, rents dropped an astonishing 26 per cent over that period. People may have been complaining about rip-off Ireland, but renting a place to live was relatively cheap.
While rents were plummeting, the prices of homes were soaring. The Department of the Environment reports that prices for new houses jumped nearly 30 per cent over the same period.
The behaviour of rents and house prices saw a sharp decline in the rent-price ratio, known as the rental yield.
In fact, yields on rental property have fallen dramatically over the past decade.
Between 1980 and 1997, yields fluctuated within a narrow range around nine per cent. Yields then began to drop like a stone, as rents failed to keep pace with house prices. Although rents staged a recovery in 2005 and 2006, they continued to be outpaced by prices.
By the first quarter of this year, I calculate that the yield on rental property had slumped to around three per cent.
In recent months, yields have nudged up slightly as rents have accelerated 12 per cent in May from a year earlier -- and house prices have gone south. That said, yields remain below four per cent.
How do we explain the behaviour of rental yields over the past decade? To think about the connection between house prices and rents, it's useful to borrow a framework for studying stock prices. Using this approach, rents in the housing market are analogous to share dividends.
So the price that a property investor is prepared to pay for a house should reflect both expected rents over the next few years and expected capital gains. Continuing the analogy, low-carrying costs -- consisting mainly of mortgage interest payments -- can also justify low rental yields.
At least some of the slump in rents relative to house prices can therefore be justified by the drop in interest rates since 1998, reflecting Ireland's entry into Economic and Monetary Union.
However, the decline in rental yields appears to be much greater than can be explained by interest rates.
This implies that the unusually high level of house prices relative to rents and carrying costs was mainly supported by large expected capital gains.
Put simply, landlords weren't too bothered that rents were low, since they anticipated hefty capital gains on property.
From this perspective, the reversal in rents relative to house prices over recent months is a sign that property investors have come to realise that those rosy expectations are going to disappoint.
Without the prospect of large capital gains, and with interest rates climbing, house prices are now badly misaligned with rents.
Let's consider some hard numbers. According to estimates by the Central Bank and Financial Services Authority of Ireland, rents and mortgage repayments for an average buy-to-let property were roughly equal over the period 1998-2004. Prior to 1998, rents generally exceeded repayments by a small amount.
However, over the past three years, repayments and rents have diverged notably. By mid-2006 repayments were nearly 50 per cent higher than rents and the margin has widened since.
A back-of-the-envelope calculation suggests that even with an interest-only mortgage, mortgage repayments currently exceed rents on a newly purchased investment property.
Daft.ie says average monthly rents in Dublin were €1,400 in May. According to Permanent TSB/ESRI data the average price of a house in Dublin that month was €425,000.
Monthly payments on an interest-only, 100 per cent mortgage on such a property currently amount to €1,800.
Payments are expected to increase nearly €100 per month after the ECB's next interest rate hike in September or October. The investor will also have to pay stamp duty and legal fees of about €38,000.
All told, it is difficult to make the case that houses are still a good investment.
The point is that far from being a reason to be optimistic about the housing market, the recent upturn in yields is in fact a sign of stress. Unless and until expectations for gains in house prices brighten, rental yields will continue to adjust up to more sustainable levels.
One thing is for sure: if house prices are to stabilise around current levels, rents will need to increase sharply. With the economy and employment slowing, it is not clear that there is much scope for that to happen.
Alan Ahearne is a former senior economist at the Federal Reserve Board in Washington DC. He currently lectures in economics at the Cairnes School of Business and Public Policy at NUI Galway
- ALAN AHEARNE
