Ronan Lyons (Oxford / Daft.ie)

U3A Sutton Baldoyle

October 10th, 2012

First off… What’s happening house prices right now?

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Daft.ie (RPPR) Daft.ie (Asking) CSO

First half of the slides are based around four “stylised facts”

Real estate is a bad investment

The property market is imperfect

Accommodation is a service

Governments can manage the property market

The second half discusses property tax

Context: We’ve seen it all before… Price of Mountjoy

Square townhouse after construction in 1791:

£8,000

Price of Mountjoy Square townhouse in 1849:

£500

Fall: 94%

Real estate is a bad investment

The property market is imperfect

Accommodation is a service

Governments can manage the property market

Outline

But surely…

“Buy land – they’re not making it anymore!”

Mark Twain

This is Amsterdam’s Herengracht…

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Herengracht house prices, 1628-1962

On the face of it, house prices do seem to rise at least some of the time

1628 = 100 – Source: Piet Eichholtz

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Herengracht house prices, 1628-1972

…and rose dramatically 1950-1970

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Inflation-adjusted Herengracht house prices

Correcting for inflation, though, substantially alters the picture

Property stores value – but little more Relative to the cost of living, prices in Central

Amsterdam were no higher in 1975 than in 1875 or 1640

“Stylised fact” (1): over time, house price increases on average match inflation – but don’t beat it

This can be investigated worldwide

The literature on long-run house prices around the world is small but pretty clear on this point – e.g. New York commercial real estate or Boston house prices

In contrast, even savings accounts typically beat inflation

But surely Ireland is different?

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Average house prices in Ireland, 1975-2007

Again, we need to correct for inflation (and add in the post-2007 period!)

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Inflation-adjusted house prices, 1975-2011

The period to 1996 looks familiar!

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Inflation-adjusted house prices, 1975-1996

Our expectations about the future should reflect this

We should only expect house prices to increase the same rate as inflation

This has big implications for those who bought during the bubble (or those who bailed out bubble-era lending)

They can’t expect inflation to eat away their problem – they will have to wait until the principal is paid off to sell their property

It may be the 2050s before prices reach levels seen at the peak

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Potential for house prices in Ireland, 1975-2060

Outline

Real estate is a bad investment

The property market is imperfect

Accommodation is a service

Governments can manage the property market

Economics likes assumptions Assumptions are needed to come up with any sort of

model of the world

Assumptions typically either…

1. Strip away unnecessary detail

2. Simplify a process we don’t understand yet

The danger is when economists mistake a type (2) assumption for a type (1) assumption

Most models in economics generate predictions about the equilibrium…

… but say very little about markets not in equilibrium

“Rational expectations” is a much contested assumption “Rational expectations” means that consumers know

all information and can process it

An alternative is “adaptive expectations”

i.e. people do not process every last bit of information – instead they look at the past and extrapolate into the future

This has very different implications for policy

Property markets exhibit strong tendencies of “adaptive expectations”

We can see this in Ireland over the last ten years

Adaptive expectations lend themselves to bubble-crash cycles Ireland’s crash has been so vicious because it has

ticked all the boxes of the archetypal bubble:

An initial favourable change in conditions (moving from 1980s stagnation to 1990s export-led growth)

Fresh sources of credit to turn the boom into bubble (entering the Eurozone gave Irish banks access to German savings to lend)

Fresh sources of supply (of houses) to suck everyone into the bubble (tax breaks for construction)

Despite this, people did not see the end of the bubble

Source: Analysis of ESRI-IIB Consumer Sentiment Surveys

People also find it hard to see the end of the crash The typical respondent to a survey on the property

market in January 2012 expected house prices to fall a further 10% this year

Just one in six sees house prices being higher in 2017 than they are now

This is only slightly above the number who believe house prices will fall by a further 35% or more during the same period

Outline

Real estate is a bad investment

The property market is imperfect

Accommodation is a service

Governments can manage the property market

Economics is not: “what goes up must come down”

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Average house prices in Ireland 1975-2015

Economics is about: supply and demand Supply is largely fixed

Both generally: in housing markets (compared to other markets) supply moves slowly

And specifically: in Ireland at the moment, very little construction activity happening

To understand where house prices will “land”, we need to understand demand

This is often thought of “in short-hand” as the ratio between incomes and house prices

House prices relative to incomes Between 1988 and 1995, the average house price was

3.6 times household income

Household income in 1990 was 1.15 times average income (compared to 1.33 in 2005)

The ratio in 2005-2007 was over twice this (an average of 7.4)

What if house prices had reflected household income?

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Inflation-adjusted house prices in Ireland

Actual

Income ratio

But the income ratio is a symptom – not the cause Some of the increase

above the dashed line may not be due to a bubble

It may be because Ireland went from a high interest rate environment to a low one

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Interest rates

Pre-1995 average

Post-1995 average

The ultimate value of real estate comes from the service it offers Income multiples also tell us very little about why

house prices vary spatially

Rents matter – even if you are not a renter or a landlord

One of the most important services in a developed economy’s GDP is “imputed rent”

What would an owner-occupier pay in the rental market to enjoy their accommodation?

The ratio of rents to house prices is the fundamental measure of health in a property market

Rents and house prices reflect a huge range of “non-market” services

Figures show the estimated effect of moving a property from 1km away from a particular amenity to 100 metres away

The ratio of rents to house prices is like the “return” on housing Think like an investor: a property that rents for €800 a

month has an annual rental value of €10,000

Knowing that this property has an annual “dividend” of €10,000, what would you buy this property for?

If you had lots of cash, you would compare the return to, say, interest rates on savings accounts

If you were borrowing, you would compare the return to the cost of borrowing

The rent-to-price ratio is closely related to interest rates

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Yield

Interest rateRising house prices in 1996 may have been justified by lower interest rates

Perhaps the real damage was done when yields were pulled down by low ECB rates post-2001

What if house prices had reflected rental yields?

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House prices in Ireland 1975-2011

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Income ratio

Yields

Crystal-ball gazing Asking prices fell by an average of 52% between 2007

and the end of 2011

If asking prices have fallen a further 5% since then and accepted bids are typically 10% below the asking price, then prices are down 58%

The average transaction price now is in the region of €155,000

This is in line with both income multiples and rental multiples…

… but prices won’t actually stabilise until credit returns

Outline

Real estate is a bad investment

The property market is imperfect

Accommodation is a service

Governments can manage the property market

Government can put in place good market foundations Caution: Intervention was part of the problem

As of 2006, the Irish property market the most intervened in among developed economies

In addition to tax breaks for construction and mortgage interest relief, also no annual property tax or capital gains tax!

New intervention has to be aware of the stylised facts of property markets

Three principles will go a long way Sensible land use

E.g. site value tax, which encourages socially beneficial use of land and penalises land banks, derelict sites

Sensible lending

E.g. “covered bonds”: to lend over 30 years, banks must borrow over 30 years – effectively creates culture of fixed rates so Ireland would be less prone to ECB decisions

Sensible borrowing

E.g. improving the “informational infrastructure” – publicly available house price register

Context for property tax Gap between public expenditure and public revenues

added €75bn to national debt 2007-2012 A bigger amount than (even) the banks

Both “spend less” and “tax more” needed unfortunately

With marginal rates of direct and indirect taxation among highest in the OECD, wealth tax the obvious missing link Real estate forms the bulk of wealth in Ireland

Residential property in Ireland still worth ~€300bn

Policy perspective: property tax ‘how’ rather than ‘if ’ Commitments in two Programmes for Government, the National

Recovery Plan 2011‐2014 and Budget 2011

Want to move past Household Charge débacle

Ten Steps to a Property Tax Key points are about

Information

Behaviour

Fairness

Transparency

Step 1: Announce the Choice Put people out of their misery!

Tell people what the system will be

But also tell them:

1. What this was chosen instead of

2. What this replaces

On (1), if not property tax, then 2% higher VAT [or 2% increase in standard rate of income tax]

On (2), a residential property tax should replace 1% stamp duty, 80% windfall gains tax…

Step 2: Finalise the Tax Base For residential property, the tax

base is all land and buildings zoned residential

Land Registry (PRA) contains details on plot sizes and locations for 93% of the country

Supplemented by Geodirectory, Local Government Management Agency, Dublin City Council

Revenue Commissioners, Dept of Social Protection, ESB/Bord Gais for cross-check

Source: Collins & Laraghy 2011

But How?!

Standardised zoning of land (yellow = residential)

So Much information exists already! Myplan.ie already brings

together:

Standardised zoning maps

GeoDirectory

Inventories of unfinished housing, undeveloped residential zoned land

Step 3: Integrate within existing system My understanding of behavioural economics:

Who likes paying €1,250 in one cheque to the Government between Christmas and New Year’s Day?

For PAYE workers, it should be an extra line in the payroll

At-source deduction should be the default – but not compulsory

For others, mostly self-employed, due with their annual returns

These mostly have their own accountant already

Step 4: Self-Assessment Whatever property tax is introduced, informational

infrastructure isn’t in place for a top-down tax

Any property tax will have to be bottom-up (i.e. self-assessment), with auditing

Need information that comes in in Year 1 (the values that will be indexed in future years) to be good quality

Solution: Tax credit (of ~€250) in Year 1 (only) to have property formally assessed by a qualified professional

Step 5: The Checklist A Revenue Commissioner checklist needed to ensure that

all assessors give similar results

Exact contents of list depend on specific tax chosen – SVT needs site-specific features only, full-value needs both

Site-specific features: Size, shape, density according to local development plans, listed

structure on the site

Nearby (dis)amenities (Luas, roads, schools, flood risk, waste facilities, etc.) that may add to (subtract from) value

Property-specific features: Size, property type, number of rooms (of which bedrooms), size of each, number of bathrooms, size of each, number of

outhouses, size of each, BER rating, age of the property, presence of bay windows, presence of double-glazing, converted attic, orientation of the house and gardens (in particular whether south or west facing), number of balconies, utility room, conservatory, under-floor heating, solar panels, fireplace, stove, wet-room, fitted wardrobes, walk-in wardrobes, French doors, high ceilings, recently refurbished, double or triple-glazing…

Step 6: The Deferrals Property tax is not income tax – the motto needs to be:

“no exemptions, only deferrals”

If nothing else, income threshold skews incentives in the labour market, creates a target to “game”

Politics, not economics

Economics would say recycling of properties probably a good thing (family homes inhabited by families)

Candidates for exemptions:

Old-age pensioners (possibly only until 2020?)

Those on low incomes

Those in mortgage arrears (need threshold for this)

Step 7: The Non-Deferrals Tax credits can be used to ensure political fairness and

other social outcomes

An obvious example is tax credits for afforested land

Align social and private incentives

An economic application also (tourism) – helps viability of listed country estates

More pressing debate will be about negative equity

2004-2008 buyers already given income tax relief on their mortgage interest… is this enough (politically)?

Could give same group tax credits (e.g. €5,000 for an individual, €10,000 for a couple) to be used by 2020

Step 8: Auditing Top-down auditing

requires models of real estate values

Oxford-NUIM analysis highlights contours of land value (and like-for-like property values)

Based on an average price over a basket of standardised properties Combined output from a

sales model (ask price) and a lettings model (6% yield)

Methodology Value of property = value of building + value of land

If we know value of a certain property type everywhere, can calculate value of land

Hedonic Price Regression Price for standardised property in every part of the country

Regressions control for measurable property attributes In particular property type and size (measured by bedrooms,

bathrooms)

Square meterage, BER, age would improve the models

Produce an average price for a basket of five standardised properties for each of 4,500 districts in Ireland

Step 9: Local Government reform Will next government simply abolish the property tax?

Its sustainability will be driven by its success – does it help to maintain local services?

Need for (MAJOR!) local government reform Many reports on this sitting on Government shelves

Local government needs responsibility (spending & revenue)

What do local governments do? Education, health, waste, water… libraries & roads?

Do we have too many or too few local authorities? Island has ~6 regional economies – Dublin, Belfast, Cork-

Waterford, Galway-Limerick, Midlands, Sligo-Derry

In Germany, there are 12,000 municipalities (700 for Ireland?!)

Step 10. Local Government autonomy Whatever the exact number of distinct local authorities, for

local responsibility to work, they need autonomy

In Denmark, central government sets minimum possible rate for a local authority (1.6% for site-value tax) Rates vary from 1.6% to 3.4%

What about richer versus poorer areas? Elasticity at work – cheaper areas attract people by having a lower

rate (à la Ireland’s corporate tax rate)

How will redistribution work? Property tax is about funding local services

Consumption tax is about common infrastructure

Income tax is about redistribution

From how to What These ten steps are independent of which particular

property tax system is chosen

What are the choices in property tax? Size-based proposals: major issue is that properties are larger in

rural (less wealthy) areas – potentially regressive

Government has stressed a value-based tax, so there are effectively two choices 1. Banded or %?

2. Full value or site value?

Need only look at experience of the UK to see that bands represent a terrible option Require constant adjustment in annual Budget

Five reasons you’d be mad to choose full value over site value

1. Full-value tax is riddled with perverse incentives

2. Full-value tax struggles with atypical properties

3. Site-value tax hurts speculative land-hoarding

4. Site-value tax shifts the burden from people to land

5. Site-value tax is far easier to assess and to audit

1. Full-Value Tax is riddled with Perverse Incentives If I make my home more energy efficient (say moving from

a C rating to a B rating on my BER), its value increases by roughly 3% Why should our tax system punish someone for boosting Ireland’s

environmental sustainability?

Similarly, if you build an extension over your garage, up goes your property tax bill All you are doing is using your allocation of a scarce resource (land)

better than before

A site-value tax encourages you to use land well Aligns the private cost with the social cost

2. Full-Value Tax struggles with atypical properties Two examples:

1. A listed building on North Great George’s Street Full market value may be €2m - but huge positive externality (on

tourism business)

Site value reflects that use of site is constrained

Equivalent of an in-built tax credit for listed buildings – exactly what you want the tax system to do

2. A country estate on 30 acres, with 25 acres of forest Not often traded – how do you calculate full market value? Include

speculative component?

With site value tax, easy to calculate value of the land

Focus is also only on the residential land – no tax obligation on the forest aligns private and social incentives

3. Site-Value Tax punishes speculative land-hoarding In Year 1 of a site-value tax, two immediate effects in

relation to the supply of residential land Proper understanding of how much of each farm is residential and

how much is agricultural

Dezoning of land still being held speculatively – currently costless to have land residential

Conversely, full-value tax does nothing to stop the type of speculation and land-hoarding that contributed to the last bubble

We will straight away whether there are still decades of lands available – and whether shortages are emerging in Dublin and the other cities

4. Site-value tax shifts the burden from people to land The burden of income and consumption taxes is borne by

people

A full-value property tax has as its unit the dwelling – i.e. the household

The unit being taxed under a site-value tax is the acre: doesn’t affect consumer or labour decisions at the margin

With site-value tax, very easy to shift the tax burden away from people even further with per-person credits Small-scale effects, e.g. four-bed property cheaper for a family with

three kids than a sole occupier

Large-scale effects, i.e. tax shifted from inhabited acre to uninhabited one

5. Last but not least, Site-Value Tax is far easier to do! Site value is a component of

full value – thus, anyone calculating full-value tax has already calculated site value

Checklist for site-value assessment a fraction of the size of checklist for full-value Whether you’ve double-glazing

or not doesn’t affect site value… and arguably shouldn’t affect your property tax bill

What is residential land worth? Estimated site value per acre, by region,

based on basket of five properties

Dublin €840,000 Other cities €335,000 Leinster €150,000 Munster €80,000 Connacht-Ulster €15,000*

What SVT might look like

Property type ED (and decile in country)

Land footprint 2% SVT (Lower bound)

Limerick city-centre one-bed apartment

“Market” ED 5th decile

25 sq.m. (0.6% of an acre)

€24

Limerick city-centre two-bed terraced

“Dock B” ED 6th decile

95 sq.m. (2.6% of an acre)

€52

Limerick suburban three-bed semi-d

“Singland B” ED 5th decile

121 sq.m. (3% of an acre)

€120

Limerick rural four-bed bungalow

“Clonkeen” ED 8th decile

1/2 an acre €400

Limerick suburban five-bed detached

“Ballysimon” ED 5th decile

560 sq.m. (14% of an acre)

€560

An Extended Proposal Or “I want to cut VAT and income tax and still close the

deficit”

Introduce a 10% site value tax on residential property Would raise in the region of €7.5bn – bulk is new revenue

Could then lower VAT and income tax rates to levels more in line with our OECD counterparts

While I’m at it… site-value tax can easily be levied on all types of land Commercial – replace rates, which reward empty premises

Agricultural – rewards productive farmers

Public – internalising costs of occupying a site, would boost local government autonomy

Thank you

Comments, concerns, questions welcome