Wobbly House Prices?

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Illustration: Hein de Kort for Het Financieele Dagblad. See more at https://fd.nl/opinie/1441301/p...

Since the mid-1980s, house prices have risen almost without interruption. The exception of the great financial crisis is almost forgotten. A house one would have had to pay €66,000 for in 1985 now costs €428,000. The ever-decreasing mortgage interest rate was a major cause of this: for a 10-year fixed-rate mortgage without national mortgage guarantee it was 8% in 1985, and only 1.4% last year. Unprecedentedly low. This continuous fall in interest rates has now come to an end. The mortgage banks are massively increasing their interest rates: they have been more than doubled in a few months. What will this mean for house prices?

The logical first thought is that they must fall: higher mortgage rates mean worse affordability: a full mortgage to pay for the average house at the then prevailing price last year resulted in a net monthly interest burden of just over €255, on the basis of the 43% mortgage interest deductibility at that time. At current interest rates, house prices and deductibility, that is about €685. Wages may be rising slightly, but certainly not enough to compensate for the higher interest charges. So it seems that the tide will have to turn: if people simply cannot afford the monthly costs, then house prices must come down.

The first signs of a turnaround are indeed already visible. A turning point in the property market is always reflected first in declining liquidity and only then in weakening prices. And indeed, houses remain for sale a bit longer than they did last year. Last week, the renowned weekly magazine The Economist published an analysis of the interest sensitivity of 20 housing markets in Europe and beyond, based on this reasoning. After Sweden, the Netherlands emerged as the most risky country. Recent research by Matthijs Korevaar of Erasmus University also shows a clear opposite relationship between interest rates and house prices. Frightening stuff.

But things can also go very differently. Yes, nominal interest rates are rising, but inflation has risen even more sharply. So in real terms, interest rates are strongly negative. What does that mean? A house buyer now borrows money at 3.2%. After tax, that is 1.9%. But inflation is 8%, so the real value of the mortgage decreases by 8% in one year. That means the homebuyer is 6.1% better off after that year. And as long as inflation is higher than the interest rate, this financial position improves year after year. That makes it very attractive to borrow a lot, and the easiest way to borrow a lot is by buying a house with a big mortgage. This creates additional demand for owner-occupied homes and can push prices up further.

This scenario may seem far-fetched, but we have experienced it before in the Netherlands, namely in the second half of the 1970s. Mortgage rates then hovered around 9%, with a top income tax rate of 70%, so after tax the interest rate was just under 3%. At the same time, inflation was structurally around 9%, so the real value of a mortgage was falling rapidly. This made it extremely attractive to take out a mortgage and buy a house. The result was an unprecedented boom in the housing market: between 1974 and 1978, prices rose by over 21% per year. The bonanza only ended when monetary policy suddenly became much tighter: interest rates rose rapidly and inflation almost disappeared.

Whether the second scenario will materialize is not certain. The big difference with the second half of the 1970s is that wages were subject to automatic price compensation then, so purchasing power was not directly affected by high inflation and it remained possible to take out a high mortgage while maintaining affordability. That is not the case now. Moreover, we are not (yet) used to high inflation, so perhaps citizens may not fully take this into account when deciding whether or not to take out a loan. But apart from that, the situation today is very similar to the situation 45 years ago. The lesson is that quick conclusions about faltering house prices are premature, especially given the continuing housing shortage. House prices are unlikely to fall until interest rates rise above inflation again.