Professional Documents
Culture Documents
Property Market
by Maria Woods1
ABSTRACT
While most research and analysis have tended to focus on the Irish residential market, it could be argued that developments in
the commercial property market have greater consequences for the stability of the Irish financial system. This may be especially
true in the light of international experience regarding recent financial crises in developed economies, the results of stress-testing
exercises and the current historically high share of commercial property-related lending to private non-financial corporates.
Over the period 2003 to 2006, there was a large increase in capital values in the Irish commercial property market without a
correspondingly large increase in rents. Consequently, income yields on all types of commercial property reached very low levels
in 2006. Of additional concern, from a financial stability perspective has been the rapid rates of increase in lending for commercial
property-related purposes during the same period. This paper investigates whether these trends are unique to Ireland, and considers
the extent to which the growth in commercial property values can be explained by fundamental factors. It addresses these issues
by examining recent trends in capital values and income yields on Irish commercial property on a historical and international basis
and finds that nominal income yields have followed a general downward trend since the mid-1990s. In common with the Irish
experience, robust capital growth combined with relatively static rental growth has been a feature of other commercial
property markets up to 2006. Additionally, over the last decade, yields on European commercial property have declined
significantly.
The occurrence of very low-income yields is puzzling in light of developments in property market fundamentals, such as vacancy
rates and rental values. The application of some simple discounted cash-flow techniques suggests that capital values may not be
fully explained by fundamental factors. It is possible however, that other factors, both domestic and global, have created a new
regime of lower income yields by increasing the pool of investors and increasing investor demand generally. This paper also
discusses a number of these factors.
1
The author is an economist in the Monetary Policy & Financial Stability Department. The views expressed in this paper are the personal responsibility
of the author and are not necessarily held by the Central Bank & Financial Services Authority of Ireland or by the ESCB. All remaining errors and
omissions are the author’s. The author would like to thank colleagues within the CBFSAI for invaluable assistance in completing this paper.
16
60
14
50
12
10 40
8
30
6
20
4
2 10
0 0
PL UK CA DE ZA IT IE* PT LV NO ES 1999Q4 01 02 03 04 05 06 07Q2
Source: IMF and author's calculations
Note: * Commerical property figures are estimated for Source: CBFSAI
Ireland. Figures include lending to both resident and non- Note: Refers to all credit institutions.
resident sectors. Lending to the public sector is also included.
It is extremely difficult to benchmark Irish banks’ A sectoral decomposition of private-sector credit shows
exposure to commercial property-related lending against that lending to Private Non-Financial Corporates (PNFCs)
international comparators, as definitions of commercial currently comprises the largest component of total
property loans vary greatly between countries. However, private-sector credit. The majority of this lending to
Chart 2 makes an attempt by drawing upon the PNFCs is for commercial property-related purposes.
International Monetary Fund’s Financial Soundness Additionally, between 1999 and 2007, the share of
Indicators, which were compiled for end-2005. This chart PNFC loans extended for commercial property purposes
ranks countries according to the share of total loans to has more than doubled (Chart 3). By 2007 Q2, the
both resident and non-resident sectors that can be exposure to commercial property reached almost 70 per
attributed to commercial property-related advances in cent of PNFC loans, while the equivalent share in the
2005. Among this grouping, Ireland is estimated to be in United Kingdom was approximately 42 per cent6.
fifth position5. Since 2005, Ireland’s ratio has continued Moreover, commercial property-related lending has
to grow, reaching approximately 12 per cent in the first been the main driving force behind the recent robust
quarter of 2007. annual growth in lending to Irish PNFCs. Although the
international trend has been for a decline in bank debt as
While property-related lending is important for all banks, a major source of funding to PNFC’s, Irish non-financial
the focus of such lending can vary by bank. Only a small corporates remain reliant on bank loan funding as non-
number of institutions however, have a significant bank financial markets are not well developed. Between
proportion of their property-related loans tied to the 2001 and 2005, loans accounted for approximately 30
commercial property market. The majority of Irish per cent on average of total liabilities for Irish non-
mortgage lenders have a property loan portfolio financial corporates (CSO, 2007).
that is more equally distributed between residential
5
This is the broadest measure of Irish commercial property loans, as data on the sub category real estate activities were not available. It was proxied
by the category real estate and business activities.
6
Taken from the Bank of England statistical release ‘‘Analysis of bank deposits to and lending from UK residents’’. To compare with Irish results,
commercial property loans are defined as the sum of advances for construction and real estate.
Mortgage
2.0 Source: Kearns et al., 2006
Note: Data are weighted average over period 2006-2008.
Commercial Data are cover ratios-the value of provisions to the value of
non-performing assets.
1.5
7
For full results of the 2006 exercise see Kearns et al (2006). In this exercise banks were asked to assess their balance sheets in the context of
economic projections over the period 2006 to 2008. At the time of the exercise, these projections were based on forecasts contained in the CBFSAI’s
Quarterly Bulletin No.1 2006 and extended to 2008. The results from these projections formed the baseline scenario. Two hypothetical adverse
shocks — one severe and the other milder in nature — were also applied to the baseline results.
8
The cover ratio is the value of provisions to non-performing assets.
Firms 80 77 84 75 59 58
of which:
—Construction 5 8 — — 13 14
—Real estate business 16 30 75 50 16 12
Households 15 20 7 11 21 25
9
Over the course of the crisis, the share of non-performing loans that could be attributed to the real estate sector fell. A possible reason suggested
by the authors is that some of these non-performing loans may have been converted into real estate holdings by banks.
5
3.1 Long-Run Trends in Aggregate Capital Values
0
From 1970 to 2006, the average annual increase in
-5
capital values was approximately 9.3 per cent (Chart 6).
Capital values increased by a maximum of 28.9 per cent -10
10
Furthermore, charting the period 1971 to 2006 highlights
5
the extreme cyclical volatility of the Irish commercial
0
property market (Chart 7). Relatively higher volatility
-5
combined with cyclical deterioration implies that credit
-10
risk may be higher on loans secured by commercial
-15
property. Gavin (2000) finds that, in comparison with the
-20
residential property market, the commercial property
-25
market is much more volatile and follows the economic
Real GDP Real capital values Real new residential -30
cycle with greater amplitude. During the economic
-35
slowdown that followed the first oil price shocks in 1973,
1971 74 77 80 83 86 89 92 95 98 01 04 06
real capital values fell by almost 30 per cent in 1975.
Source: Jones Lang LaSalle, CSO, DoEHLG and author's
Residential property prices by contrast, fell to a low of calculations
minus 0.6 per cent during these years. Although the
divergence between the two sectors has not been as
marked since that period, capital values generally tend
to correct by greater amounts during a downturn. In recent years, there has been robust growth in
Furthermore, the coefficient of variation10 for the commercial capital values in many countries. As can be
commercial sector was 6.0 between 1971 and 2006 seen from Chart 8, Ireland significantly outperformed its
compared with an equivalent figure of 1.8 for the European counterparts in terms of capital growth across
residential market. all commercial property sectors in 2006. In Ireland,
10
The coefficient of variation is the standard deviation adjusted by the mean. Higher values imply greater variation.
15
20
0
15
-5
10
-10
1985 89 93 97 99 01 03 05 07 Q3
5
Source: Jones Lang LaSalle
Note: Data are bi-annual from 1985 through 1996 and
quarterly from 1997 to date.
0
7 per cent 8
5 6
4
4
3
2 2
0 0
1984 86 88 90 92 94 96 98 00 02 04 06
Real equivalent yield
-4
More recently, a moderation in annual rates of capital
1984 86 88 90 92 94 96 98 00 02 04 06
appreciation which began in late-2006, combined with
the continued modest recovery in rental values, has Source: SCS/IPD, Jones Lang LaSalle and CSO
reduced the gap between the two series. By September
2007, the absolute divergence between capital growth Unfortunately both of these measures of income yields
and rental growth has fallen significantly to 3.4 cover a very short time frame. During this time, Ireland
percentage points. underwent significant economic transformation - from
the very depressed 1980s to exceptional growth during
As a result of this divergence, yields on Irish commercial the 1990s. Therefore, a longer time series of yields is
property are currently at low levels regardless of which necessary to benchmark current levels. Chart 13 looks
definition is used (Chart 11). Furthermore, yields have at the prime yield on all commercial property between
been following a downward trend since the mid-1990s. 1969 and 2007. The long-run average over this time is
The equivalent yield on Irish commercial property 5.8 per cent. Since 1998, Irish yields have fallen below
reached historic lows in 2006. The equivalent yield is this average.
defined as the rate at which the expected future income
13
These yields may be slightly misleading, especially if set during a boom phase. Although rent levels used are still subject to review, the fact that
rents are generally sticky downward implies that in a subsequent downturn, initial yields may be above market yields.
4
10
3
8
2
6
1969 71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 Q3
8
The occurrence of low yields on Irish commercial
property reflects an international trend. Over the last 6
decade, yields on European commercial property have
also declined significantly (BOIPB, 2007). In 2006, robust 4
capital growth combined with relatively static rental
growth was also a common feature of other international 2
commercial property markets. In its Financial Stability
Report 2006(2), Sweden’s Riksbank highlighted the 0
possibility of increased investment risk in the commercial 1980 83 86 89 92 95 98 01 04 07
Source: Key Market Indicators 2007 Q1, Jones Lang LaSalle and author’s calculations.
Note: 29 major European cities were used. Cities were chosen that had information covering both yields and vacancy rates.
The prime net initial yield is used and is defined as the initial net income at the date of purchase, as percentage of the purchase cost (including
both acquisition costs and transfer taxes).
Average annual
return (%) 13.672 16.755 10.209 17.174 10.40 19.60 6.440
Variance 523.094 554.794 142.533 148.336 46.62 59.59 4.922
Sharpe ratio 0.014 0.019 0.026 0.072 0.085 0.221 —
Source: Investment Property Databank, Irish Stock Exchange and author’s calculations.
17
This applies to projects over \150,000.
18
This rate applied to projects over £60,000.
19
Information on both reports taken from the Department of Finance‘s Tax Strategy Group‘s Paper No. 05/18.
http://www.finance.irlgov.ie/documents/tsg/2006/tg1805.pdf.