Is there an asset bubble in the Dublin housing market?

The housing market in Ireland is notable for its cyclical nature. House prices increased by 150% between 1998 and 2006 (Lyons, 2012). Between 2006 and 2012, prices decreased by 53%, and since then prices have increased by 46%. One of the reasons put forward for the crash was the availability of credit. The imperfections in the credit market have been an area of concern for many years. A study carried out by Murphy (2005) found that the user cost has both a negative effect on the price of houses and the capability of leading to bubbles. Other factors that can lead to the existence of bubbles are imputed rents, investor rationality and the cost of capital, market values and intrinsic values. Residential property prices increased by 9.4% in early 2017, and house prices in the capital rose by 8.7%. The cost of apartments grew by 9.6% over the same period. In Ireland, demand and interest rates play an essential role in the determination of property price movements. This study was developed with the aim of ascertaining whether there is an asset bubble in Dublin’s housing market.* Using case studies and interviews with professionals in the property sector, it analysed the current Dublin property market and the association between present market prices and intrinsic values. The main objectives were to discover new facts and verify and test important facts regarding property asset bubbles in Dublin’s housing market.

Interviews
The results of the interviews reflected the perceptions of professionals within the Dublin property sector. It was clear that participants did not see any bubble present within the current Dublin market. Also, most asserted that no speculative bubble was taking place. However, others believed that bubbles were only present at some sites.
Most of the participants agreed that Brexit might have an overall negative effect on the Irish economy, with some believing it was too early to ascertain whether Brexit would generate upward pressure on Dublin rents. In relation to whether rents will continue to increase if pressure zones are lifted, or whether they will begin to cool, one of the participants asserted that the market was at an early phase of its current property cycle. Most of the participants agreed on the rental growth rate. Regarding supply challenges in the Dublin housing market, most of the responses indicated that the market structure was not the issue, and that developers are focusing on office developments, which achieve higher returns, but also that adequate office supply could be reached by 2019-2020. The participants believed that developer costs remain high due to developer input costs, and that margins are tight. All participants believed we are not close to the peak of the cycle, an indication that prices will continue to increase. The respondents asserted that there was no chance of another property crash in the foreseeable future. The study concluded that professionals within the property sector believe that there is no property bubble present within the Dublin housing market. The interview participants determined that this is due to stricter lending criteria and lack of cheap credit.

Case study

The research also included a case study, which used the Gordon Growth Model to determine the intrinsic value of the average property in Dublin’s housing market. Professor Myron Gordon developed the Gordon Growth Model, which is used to determine the fundamental value of stock, based on the future sequence of dividends that mature at a constant rate. The formula used to determine the stock value using the Gordon Growth Model is as follows:
Asset value = D / (K-G)
Where:
D = Expected dividend per share one year from now
K = Required rate of return for equity investor
G = Growth rate in dividends
I applied this formula to the Dublin housing market using the average market rent as a proxy for imputed rent:
Intrinsic value of Dublin houses = D / (K-G)
Where:
D = Imputed rent
K = Discount rate
G = Growth rate
Inputs were sourced from the Residential Tenancies Board (RTB) and Residential Property Price Register, respectively. The average rent (imputed rent) in Dublin during 2016 was €1,300 per month (€15,600 per annum). The average residential sales price in Dublin in 2016 was € 405,466.
It is more difficult to determine the discount rate. The data range was obtained through qualitative interviews with professionals within the property sector and estimated at between 7% an d 8% (McHugh, 2017). However, this represented minimal risk. For increased risk, this would be raised to double-digit figures (McHugh, 2017). Therefore, the discount rate ranged from 7% to 10%. It was assumed that the average growth rate would remain in line with the pressure zone restriction of 4% until the restriction is lifted in 2020. The growth rate was concluded in the qualitative interviews to range from 4-6%. Each scenario was then entered into the model. Based on the research, it was deemed necessary to use several scenarios to incorporate the full range of estimated discount rates and growth rates.
By comparing the average sale price and the intrinsic value, I would be able to determine whether the intrinsic value was below the average sale price and, therefore, whether a price bubble was present in the market. An analysis using the Gordon Growth Model indicates that when the growth rate remains at 4% and risk remains low, there is no asset bubble present because the intrinsic value of the average property is €718,841,which is above the average sale price at €405,466. According to evaluations made for the case study, it was clear that intrinsic value plays an integral role in ascertaining whether a bubble is present. Moreover, when supply and demand do not match, there is a strong tendency for a bubble to occur. It is clear from the growth model that there is no property bubble present in the Dublin housing market. However, if rent pressure zones are reintroduced in 2020, and an increased risk drives the discount rate to 10%, a property bubble will be present.

Risk of a bubble
The Gordon Growth Model shows that if the risks associated with the Dublin property market increase to 10% or above, and pressure zones remain in place, a property bubble of 3% will be present. With the current supply issues in the Dublin housing market, coupled with high demand, the average property price in Dublin is likely to continue to increase, which would further increase the gap between the average house price in Dublin and the intrinsic value. This model is based on assumptions and provides insights into whether a bubble exists in the Dublin housing market at the time of writing (April 2017). The author believes that there is a lack of in-depth knowledge of the technical definition of real asset bubbles, discount rates and asset bubble models in the market, and the area would benefit from further study.

Calculating the intrinsic value of an average Dublin house

Example: Scenario 1

Average house price in Dublin in 2016: € 405,466

Average rent in Dublin in 2016: €15,600 pa

Assumptions:
Growth rate: 4% up to 2020, 6% in 2021

Discount rate: 7%

Calculation of projected rent

Note: a formula is applied for today’s value of future income after application of growth and discount assumptions.
2017: €15,600 2018: €15,163 2019: €14,737
2020: €14,324 2021: €14,191
Total projected rent receivable 2017-2021: €74,015

Formula for calculation
Intrinsic value of a Dublin house = D / (K-G) plus projected rent received

Where
D = imputed rent K = discount rate G = growth rate
D: Imputed rent is calculated in 2021 without discount (so €15,600 x 4% per annum, plus 6% in 2021) = €18,601. This is multiplied by the assumed future growth rate of 4% so €18,601 x 1.04 = €19,344.78 Note: It is assumed that growth will remain at 4% in each year after. This is why you need to apply 4% to find D. So the formula for D is: F(1+G) where F is year 2021 income.

K is assumed as 7% for this scenario.
G is assumed as 4% for this scenario.
So calculation of intrinsic value for 2021 is: €19,344.78 divided by 0.03 (0.07 minus 0.04) = €644,826 plus projected rent received of €74,015 = €718,841

*This article is based on a dissertation completed for the Bachelor of Science in Valuation Surveying at Dublin Institute of Technology.

Lisa Cassidy
Asset Manager, Sigma Retail Partners

 

 

 

Bibliography

Cassidy, L. A study of asset bubbles and the possibility of a bubble within the Dublin housing market. Dissertation. Dublin Institute of Technology. Bolton Street, 2017.

Conefrey, T., FitzGerald, J. Managing Housing Bubbles in Regional Economies under EMU: Ireland and Spain. ESRI Working Paper 315, 2009. [Online] [Accessed January 3, 2017] Available at: http://www.esri.ie/UserFiles/publications/20090925111751/WP315.pdf.

Kelly, M. The Irish Credit Bubble. UCD Centre for Economic Research Working Paper Series, 2009. [Online] [Accessed January 3, 2017] Available at: http://www.ucd.ie/t4cms/wp09.32.pdf.

Kim, K.H., Renaud, B. The global house price boom and its unwinding: an analysis and a commentary. Housing Studies 2009; 24 (1).

Lyons, R. Ireland’s Property Market: How did it come to this and where to next? Challenges Facing the Irish Economy, 2012.

Woods, M., O’Brien, E. Estimating misalignment in Irish commercial property prices. 2015. [Online] [Accessed January 3, 2017] Available at: https://editorialexpress.com/cgi-bin/conference/download.cgi?db_name=EEAMannheim2015&paper_id=1981.

McGreal, S., McCord, M., McIlhatton, D. The Northern Ireland housing market and interconnections with the UK and Irish housing markets. Housing Finance International 2011; 26 (1): 28-34.

McHugh, J. Personal communication, 2017

Murphy, A. Modelling Irish House Prices: A Review and Some Results. mimeo, December 2005. [Online] [Accessed January 4, 2017] Available at: http://www.nuff.ox.ac.uk/Users/MurphyA/Irish%20House%20Prices.zip.

Patrick, P.F. Are Irish House Prices determined by fundamentals? 2015. [Online] [Accessed January 6, 2017] Available at: https://www.ucc.ie/en/media/academic/economics/documents/research/wp04-01.pdf.

Power, T. et al. Financial Management. Gill and MacMillan, 2009.

Sierminska, E., Brandolini, A., Smeeding, T.M. Comparing Wealth Distribution across Rich Countries: First Results from the Luxembourg Wealth Study, in Household Wealth in Italy. Rome: Bank of Italy, 2008.