The Economics Division of the Department of Finance has signalled that only radical government measures can fix the chronic shortfall of housing supply in Ireland.

The department’s February 2023 Economic Insights bulletin expresses the view that the narrowing of the yield differential between residential investment in Ireland and alternative asset classes may weaken the supply of much needed urban housing.

In the analysis of DoF economists Martin Erskine and Dr Gerard McGuinness, the recent increase in interest rates has worsened a pre-existing viability problem.

According to the duo: “Build-to-Sell apartments have in general been unviable for years, with Build-to-Rent output partially compensating. Increasing viability problems in that sector now pose a significant headwind to the ramping up of housing output in the near term.”

In order to curb inflation, the ECB raised interest rates by 50bps in July, 75bps in both September and October and a further 50bps in both December and February.

In Association with

The main refinancing rate has now risen from zero to 300 bps in just six months, with a further 50bps increase announced for March.

The DoF economists believe that interest rates will have a dampening effect on housing demand and prices. The pace and degree at which this occurs is likely to depend on the speed of pass-through from the banking system to households.

Due to the on-going supply-demand imbalance in the Irish housing market, the impact in the short-run of higher rates is likely to be limited.

Fundamental demand drivers are illustrated by the consistent gap between mortgage approvals and drawdowns for home purchases.

While slightly lower more recently, c.14% recently on a four quarter moving sum basis, “the gap still represents a clear indicator of insufficient market supply”, says the DoF bulletin.

Acknowledging that fundamental drivers of demand will remain robust, thereby limiting the potential for a fall in property prices, this does not mean that a fall in prices could not happen.

The DoF bulletin notes recent research by the Central Bank showing that both inflation and mortgage repayment rises could lead to distress levels among households rising by one quarter to a third with disproportionate increases in risk for lower-income, rural and older mortgage holders.

“The impact will grow the higher rates rise,” say Erskine and McGuinness. “However, the low starting point, elevated savings rates, low levels of household debt and the existing levels of excess demand should place a floor on demand and prices.”

As part of the Housing for All policy, it is envisaged that 80% to 90% of funding required for housing will be secured from private sources.

DoF concludes that higher interest rates will have obvious implications for the cost and availability of such financing, and that Build-to-Rent projects may be particularly affected by rising rates.

The department economists explain: “Forward commit deals are pre-sale arrangements in which an institutional Build-to-Rent investor agrees to purchase a development from a developer before it is built.

“Such transactions have been a driving force behind the increase in high density output in recent years and in their absence, only a small minority of the apartments that have been built recently would have been built.”

Risk free return

The increase in interest rates is likely to alter the risk-reward calculation in Build-to-Rent investments, as the gap has narrowed between the risk free return offered by government bonds and returns from residential investment.

“Other factors such as the perceived complexity and inconsistency with planning applications; the prevalence of judicial reviews; the equalisation of specifications between Build-to-Rent and Build-to-Sell units; and the negative public perception of such investors, all lower the relative attractiveness of investing in Irish property with knock-on implications for housing supply, rents, competitiveness and the macro-economy,” say Erskine and McGuinness.

Michael McGrath’s in-house economists are advising the Minister for Finance that high development costs which result in the unviability of projects are a key blockage to increased housing supply, and that recent increases in costs represent a cyclical deterioration of a structural problem.

The DoF bulletin comments: “A housing system that is reliant on low interest rates and high rents for the majority of its urban output is neither desirable nor sustainable.

“Unless a significant reduction in costs is achieved the market will struggle to produce the scale of urban housing needed to satisfy demand.

“As monetary policy normalises, there appears to be no alternative to a comprehensive programme of supply-side measures that radically reduces the cost of residential development.”