Housing Slump or A Great Divergence?

House prices in many European countries have been falling since last Summer. That also holds for the Netherlands: an average house cost €407,000 in the fourth quarter of 2022, 9.2% lower than the peak in the second quarter. It is the first time since the great financial crisis that Dutch citizens are experiencing falling house prices. A logical question is whether house prices will fall further.

The first thought is that they must. Higher mortgage rates mean worse affordability: the interest burden for a given loan amount has doubled, and while wages are rising in nominal terms, they certainly do not go up enough to compensate fully for the higher interest charges. If buyers simply cannot pay, house prices must come down further until a new equilibrium will be reached.

But if we look at housing through the lens of an investor, and at affordability through the lens of a rental tenant, things look a little different. Institutional investors evaluate assets based on present value calculations. The outcomes of these calculations hinge on two main issues: cash flows and the rate used to discount them. Since mortgage interest rates have gone up, discount rates have followed. If nothing else would change, that would lower the values of rental housing portfolios. However, rental cash flows are not likely to stay as they were. In many countries, including the Netherlands, housing rents can be indexed to inflation or the wage rate, so nominal rental cash flows may go up with inflation, and that would give an upward push to the values of rental housing.

The key question is which effect is stronger: the dampening effect of the increased discount rate, or the stimulating effect of the increased rental cash flows. The answer depends on the relative growth of the discount rate and the cash flows. If the discount rate goes up more than the rent growth, rental-housing values will fall, but if the rents grow more than the discount rate, values may actually increase. Interestingly, the latter may well be the case.

For now, the growth in Dutch nominal wages and consumer prices is higher than the growth in the interest rate. If rents would indeed be indexed to the general wage level, there would not be a problem with affordability either: people would just be paying the same rent in real terms.

So in the short run, the increase in inflation – and therefore possibly in rents – outstrips the increase in the discount rate. However, that in itself is not enough to increase the present values of rental housing: present value calculations are made over a long horizon, so the question is whether the inflation remains higher than the discount rate for a longer time. That is less easy to judge, but it seems that inflation is already more persistent than most pundits expected.

Recently, John Cochrane from Stanford University (in his famous Grumpy Economist blog) posted the graph below. It shows the trajectory of US inflation, as well as the consensus market forecasts of it, with the forecasts starting in May 2021, for about one year out. This graph tells a very clear picture: the consensus was consistently wrong, underestimating how far inflation would rise, and predicting a quick reversal to pre-2021 levels that did not materialize. Although this graph refers to US inflation, the story in Europe is much the same.

US Inflation: actual and consensus forecasts


Source: The Grumpy Economist 2022, https://johnhcochrane.blogspot...

With a graph like that in mind, it is not very tempting to predict inflation, but my conclusion is that it may stay high for longer than markets currently think. In time, this would likely imply increasing nominal rents, which would put upward pressure on the values of rental housing.

However, we currently do not observe higher values of rental housing in the market. On the contrary, we see decreasing appraisal values to the tune of approximately 5-10 percent, and transactions of shares in unlisted Dutch residential real estate funds at similar discounts. This is not surprising, since these appraisals and property deals are based on the same consensus forecasts of inflation as shown in the graph.

In time, however, even experts learn, and if inflation stays high, expectations will be adjusted upwards, affecting the rental cash flows in the discounted cash flow models used to value rental housing. This would likely create a weakening of the link between rental housing values and transaction prices for owner-occupied homes. But this has happened before. Ambrose et al (2013) show that house prices and rents can diverge for long periods, even decades. Such an era may be now upon us.