HOUSING MARKET –
CLASSIC BUBBLE OR “JUST” SWOLLEN HOUSEHOLD BALANCE SHEETS?

By Steen Bocian, Director of Department, Danske Bank

ECONOMY: Danish house prices have been appreciating at a record rate. The past year alone has seen prices increase on houses by some 24%, on apartments by 31% and leisure property by 20%. Such a pace of growth has not been seen since the mid-1980s, and when corrected for inflation real growth is at a more than 50-year high.

Naturally such strong price growth gives rise to concern about just how sustainable the trend is – especially in light of developments over recent quarters when house prices have continued to climb with undiminished vigour despite interest rates heading up. And, indeed, attempting to reconcile the development in house prices with underlying economic conditions is presenting us at Danske Bank with an increasing challenge. Back in the first quarter of 2005 the gap between actual house prices and what our model could explain was around 9%. A year later this gap has risen to all of 25%. That said, house prices being 25% higher than our model can explain is not the same as saying house prices are 25% too high. Our model has, in fact, a number of well known inbuilt weaknesses. In particular, our model fails to take account of the impact of interest-only loans on house prices. There is now no doubt these loans, which were introduced in October 2003, have been a contributing factor to the surge in house prices. Factoring in the effect of interest-only loans suggests –albeit with considerable uncertainty – that house prices nationwide are around 10% higher than what economic conditions can explain.

Interest rates
An imbalance on such a scale is not normally something that would be associated with a classic bubble. It should also be remembered that there is considerable uncertainty connected with setting the “true” value of a house. For example, asking three different estate agents for an estimated sales price on a property can very well result in a spread of more than 10%.

But just because a classic bubble is not present in the housing market it does not mean that prices cannot fall. If the economic situation changes, then a drop in house prices definitely cannot be ruled out. With no changes on the horizon for property taxes and favourable prospects for growth in the Danish economy, then interest rates will play a key role for prices in the coming years. A sharp rise in interest rates could send house prices lower. However, there are no signs from the financial markets to suggest that this will happen. Rather, interest rates are expected to rise gradually, which will help slow the housing market to a more normal pace. In fact there is already much to suggest that the housing market is beginning to lose a little steam. Some of the first signs of a slowing housing market are a drop in the number of transactions and an increasing supply of properties for sale. And this is precisely what is happening at the moment – the number of transactions has now fallen 10% from its peak, while the number of properties for sale has risen 25% since it touched bottom. House prices are often slow to react to such developments, as sellers are unwilling to cut prices much once their property has been put up for sale and, in addition, the market to some extent is guided by past price trends.

Tax-free wealth gain
While housing prices have soared this year, the housing market has in fact been on the up since hitting bottom in 1993 in the wake of the government’s economic stringency programme (the “potato diet”), tax reforms and rising interest rates. Over the past decade the average homeowner in Denmark has enjoyed a tax-free wealth gain of DKK 1 million, while homeowners in the capital have seen their housing assets swell by almost DKK 2.5 million. This means that the average Dane is now richer than ever before – even excluding the increase in housing equity, the net wealth of Danes has been on the rise for some time. Pension savings, in particular, have been surging, although this has to be seen against the backdrop of what has been happening in the housing market, as increasing housing equity has to some extent been converted into higher pension contributions. More money being channelled into pensions, combined with rising house prices, has resulted in a considerable increase in household borrowing, though not so much as to threaten net wealth.

There is no doubt that household balance sheets have swollen over the past many years: pension and housing wealth has been rising sharply while, on the liability side, debt has also surged. Put another way, Danish households have taken on a greater economic risk than earlier. Thus hefty interest rate hikes could squeeze the value of household assets, while debt servicing costs going up would increasingly eat into household budgets. Moreover, a substantial portion of household assets are illiquid and thus cannot easily be drawn on if budgets begin to tighten. However, this does not alter the fact that the economic situation of Danish households is – in general – robust.