ÍSB Research’s new macroeconomic forecast, released yesterday, includes a discussion of the housing market. House prices have been rising virtually unimpeded since the COVID-19 pandemic struck. The market is characterised by strong demand pressures at the moment, largely because of the Central Bank’s (CBI) policy rate cuts last year. The policy rate was 3% at the beginning of 2020 and then lowered in increments to 0.75%, where it remained from October until this past May. But the CBI has begun tightening the monetary stance since then, and the policy rate is now 1.25%. Last year’s rate cuts delivered extremely favourable loan terms: mortgage interest rates are low, thereby easing the debt service burden on many mortgages and boosting borrowers’ purchasing power.
Housing market still going strong
House prices have been rising virtually unimpeded since the COVID-19 pandemic struck. The market is characterised by strong demand pressures at the moment, largely because of the Central Bank’s (CBI) policy rate cuts last year. At the moment house price inflation is driven mainly by capital area housing single-family homes in particular. We believe the conditions are in place for a continued rise in house prices in the coming term.
Other factors have also stimulated demand in the real estate market. Real wages have generally continued to rise, and the majority of households are well positioned financially. Last year, in the midst of the Corona Crisis, real house prices rose by 3.5%, well in line with real wage growth, which measured 3.4%. These two variables tend to track one another over time, but this year, house prices have taken a decisive lead. In the first eight months of 2021, real prices rose 6.4%, even though inflation is quite high at the moment. It is quite likely that households held back at first, owing to the uncertainty prevailing at the onset of the pandemic – as often happens in response to any kind of uncertainty. This year, uncertainty has receded, the policy rate is low, households have built up more savings, and wages have risen, prompting many to grab the opportunity and buy a home.
But where is the supply?
Clearly, supply cannot keep pace with the demand that has developed in the housing market. Actually, though, supply has been relatively strong in recent years: in 2020, a record number of new flats – 2,500 – were put on the market in greater Reykjavík. But that situation has changed. In H1/2021, residential investment fell 6.7% YoY, and the contraction in new residential construction looks set to continue. In greater Reykjavík, construction has begun on 1,400 flats during the year, well below the 2020 total, but about the same as in 2018.
As we see it, supply is still far from satisfying the demand currently on display in the market. In our new macroeconomic forecast, we project that residential investment will contract by nearly 7% this year, then grow by 5% in 2022. In 2023, supply will have caught up with demand, and the growth rate will measure around 9%.
Detached housing prices have risen most
For the past three years, flats in regional Iceland have risen faster in price than those in the capital area. At the moment, though, house price inflation is driven mainly by capital area housing – single-family homes in particular. In the first eight months of 2021, detached housing prices in greater Reykjavík rose 10.5% in real terms and condominium prices 6.3%.
Demand for detached housing appears to be gaining steam, and apparently, a fairly large numbers of buyers are taking advantage of favourable lending rates and “trading up”. We believe this spurt in demand is due in large part to the so-called Corona Effect, with increased time at home (including remote working) giving rise to a need for more space.
Nearly half of loans are non-indexed
The composition of household loans has changed markedly in recent years. Before the economic crisis of 2008-2009, very few Icelandic borrowers took non-indexed loans, as they bore such high interest rates. After the crash, however, non-indexed loans became a more feasible option, and more credit institutions began offering them. With the recent drop in lending rates, they have become a realistic alternative for many borrowers. This can be seen in the increasing shift towards non-indexed loans, which now account for nearly 50% of the household mortgage stock.
In our opinion, this will make monetary policy more effective than it would be otherwise. It may cause each individual policy rate hike to have an immediate impact on at least some households. Presumably, there will then be less need to raise the policy rate to cool down the economy than there would be if a large share of household debt were indexed.
What’s next for the housing market?
We believe the conditions are in place for a continued rise in house prices in the coming term. We project that nominal prices will rise by nearly 12% this year; i.e., in terms of the percentage change from the 2020 average. The increase from the beginning of 2021 to the year-end will be somewhat larger, or around 13.5%. New house price index data from Registers Iceland support our opinion. The capital area house price index rose 1.6% month-on-month in August, but we expect a somewhat slower increase in the months to come. As is mentioned above, house prices have risen more in greater Reykjavík than in regional Iceland in the recent past, but the Registers Iceland index covers only the capital area.
We expect house prices to keep climbing in 2022, by just under 7% year-on-year in nominal terms. By 2023, the market will have rebalanced somewhat, with higher interest rates and a larger supply of new flats, and we forecast a 3.4% rise in prices that year.