A Marriage Made in Hell: Housing and Foreign Demand

In the past couple of years we have seen a surge in the effort to obtain demand from abroad. Current Account negative balances, have provoked many discussions, since in a currency union, in order not to have a Balance of Payments crisis, there is a need for having a stable quantity of money in the economy. The apparent solution of boosting the export sector, as Germany has been doing during the Eurozone crisis, is no solution for the long-run as without strong domestic consumption the country is prone to shifts in foreign demand. Yet, in the short run, this dependence on foreign demand appears to be great if demand keeps going up. 

The problem is that the same principle does not hold for housing. Picture the following scenario: a person from country Y buys a very affordable home in country X. It goes without saying that most probably country Y is richer than country X, or at least house prices in the latter are lower than the former. (The rationale behind this is that it wouldn't be easy for someone to purchase a home in a country where prices are much higher than in his own country - unless he or she is very wealthy which is what has been happening in London nowadays). Now, if the house is really affordable, others will also want a piece of the housing, and from the supply and demand law we know, prices will rise in the country.

Is that necessarily bad? The answer is unfortunately yes, most of the times. If the rise in foreign demand occurs during a relatively short period of time (as it usually manifests), then house prices will rise by much more than national inflation rates. The case of Spain is very enlightening:

Yellow line is the price of housing per square meter while the green one is the inflation rate

The first question which arises is why doesn't the inflation rate rise by as much as foreign demand if that is the main driving force behind the increase. The answer to this is inequality, but not in the Piketty sense: it is not that everyone in Spain benefits from the rise in prices. The "representative" Spanish household has no intention of selling its house and living somewhere else just because prices have gone up (I know that many economists believe that this is what "rational" agents would do, but that is not very realistic). It's the land developers who benefit the most from this expansion of prices, which is followed by an expansion in credit as banks see its profitable to lend to them. Money is still distributed along the economy in the form of credit or increased consumption (the rising trend of inflation in the above graph is indicative of this) but not by as much as the rise in property prices.

The second question is why does it matter that much. What most fail to see at the time is that this expansion in foreign demand hurts the nationals by much more than we believe. If the average price in Spain was around 1000 euros in 1997, and a part of the population could not afford to purchase a house, then who would argue that in 2008, when it nearly tripled many less would really afford it. If someone doubts this then the following graph should remove all doubt:

The increase in wages was less than 70%, when house prices rose by almost 180%. House price in 1997 was approximately 14 times the wage index, while in 2008 it was more than 28 times. Foreign demand for housing has an even nastier side: it assists in the creation of a credit bubble as locals have to borrow more money for property purchasing and land developers borrow more as profit opportunities rise. Spain is again indicative of this behaviour as credit rose by more than 400% since 1998, mostly driven by these developments.

So what makes housing so different?

The simple answer is that housing is immovable. You cannot really take a house or an apartment and leave the country as you can do with other types of goods.That makes all the difference since it means that locals and foreigners compete for the same goods. If a producer can sell a banana at home and the same one abroad, then prices are charged accordingly and, if possible, charges foreigners more, given the extra trouble that is required. In the meantime, the producer cannot really charge the foreign price to the local market because there are many other substitutes: buy from another producer, buy an imported banana or buy some other fruit. In contrast, the house is stuck where it is built and there is no local nor foreign substitute for it. In addition, the developer has a very good alternative for local demand: sell it to a foreigner at an inflated price. Which is more profitable? Obviously the latter, and the locals will just have to meet the price if they want to purchase the property.

Thus, simply put, increased foreign demand for real estate is almost always bad news for the locals. The phenomenon has not just taken place in Spain, housing bubbles have appeared in the Netherlands, Greece, Cyprus and even London as it appears nowadays. So next time you hear about rising foreign demand for real estate in your country be wary, very wary.

Housing Bubbles

The data below are from a Eurostat estimate of the Housing Price Index in all EU nations. 4 out the 6 EU countries in trouble (Spain, Ireland, Greece and Cyprus) can attribute all or part of their troubles to a housing bubble and the graph is indicative of this fact. Specifically, in the case of Ireland the rise and fall of housing prices is astonishing. The index which reached as high as 150 in 2007 is now looking to stabilize at about 75.

When beginning this article, I had in mind foreign purchases of housing units in each of the above nations. Foreign purchases, especially in relatively small countries like Greece, Ireland and Cyprus can significantly increase the level of prices, especially in a short period of time. I was only able to find some data for Spain which state that "Property sales made by foreign residents in Spain experienced an increase of 24.7% in the third quarter of 2011". In another article, 8.9% of purchases in Spain was attributed to foreigners. If in a country as large as Spain (with a 46 million population) foreign purchases of real estate can amount to that much you may imagine how much they could amount for in the aforementioned 3, which have a combined population of 16 million.

Compare this to Denmark, where the state law indicates that "Unless foreigners are permanent residents in Denmark and have lived in the country for a period of at least five consecutive years, Danish law states that they must obtain permission from the Danish Ministry of Justice (Justitsministeriet) to buy property. (unless they will use it as a permanent residence)" Even though the law is harsher on foreigners in Denmark than the rest of the Southern nations, we can easily question what it has done to prevent a housing boom in 2007 and 2008. Although the subsequent fall was not as sharp as the one experienced in Ireland, it was approximately like the one in Cyprus, and much worse than the one in Greece and Spain.

Then what is the solution for not experiencing housing bubbles you may ask? The answer is relatively simple: increased taxes in real estate combined with stricter mortgage regulations. Although Denmark's law did not stop the country from experiencing a rapid fall in housing prices, we cannot know what would have happened without it. However, when real estate taxation is high (and I do mean tax paid on the unit's value not transfer costs, lawyer fees and other costs relating to the purchase) less people would be willing to buy a house if they do not intend to live in it. Nevertheless, taxation should be lower for those who are buying their first house, with the purpose of living in it. As young couples are what is driving demand in most nations, with the application of such laws the governments would have taken specific measures to safeguard this demand. 

Also, when mortgage demands are stricter (forcing you to have at least 20-25% of the value of the unit you intend to purchase) demand will be more stable and the banks will face less problematic loans. With demand not rising and falling to extremes, it would be much easier for developers and real estate agents to predict the market's future needs and thus they themselves would be less inclined to fund projects which would take many years to yield profits, straining the banks and the economy. 

Nobody in their right mind could ever propose that bubbles can be left out of the system. Demand will always fluctuate and we can do our best to estimate it. Most likely our estimation will be wrong; and we can surely not expect strange phenomena like hurricane Sandy which caused some USD 71 billion of damages in the states which it hit. Nevertheless, it would also be a shame not to do what is expected of us to make this world less crisis-prone.