The Pandemic Has Driven Demand And Prices To New Heights

Housing markets posted strong activity and price increases in the first half of 2021, pushing European house prices to rise at their fastest pace since 2006. Prices rose by 6.9% on average in the euro area in the second quarter of 2021 compared with the same quarter of last year (see chart 1). European residential property markets continued to recover from the pandemic shock more quickly than the rest of the economy. In most markets, strong demand has pushed transaction volumes above their pre-pandemic levels, lending for housing purchases is more dynamic than in 2019, and construction activity is close to full capacity.

Table 1

Chart 1

Three major factors are driving the strong increase in residential housing prices since mid-2020:

• A large accumulation of savings and reassessment of housing space needs during lockdowns;
• Lower borrowing costs as central banks loosened monetary policy to respond to the pandemic; and
• More acute supply constraints after construction activity was put on hold at the onset of the pandemic.

This has led to some overheating in terms of price-to-income and price-to-rent ratios. Indeed, most markets have reached price-to-income levels not seen since 2007, or even longer in the case of Switzerland, Sweden, and Germany (see chart 2). As a result, more lower income households are being priced out of the markets, putting greater pressure on governments to expand social housing developments, a general trend that has been increasing as a result of worsening affordability.

That said, higher prices have been accompanied by only a relatively modest rise in household debt so far, suggesting that house price inflation is mostly not credit-driven. With more savings put aside, households have been able to put down larger deposits. Borrowing costs have also declined further, with interest rates falling to a new record low of 1.32% for new housing loans in the eurozone in August (see chart 3). As a result, household debt-service ratios remained broadly stable at the start of 2021 (see chart 4). That said, new lending is strong, pointing to new borrowers entering the market.

Chart 3

Chart 4

Supply Constraints Will Continue To Push Up Prices

Looking forward, we expect housing price inflation to have peaked in mid-2021 in most countries. This is because two of the main demand drivers of housing activity--higher savings and loose monetary policy--are likely to fade. In our view, the effect of this will outweigh the third housing price driver, constrained supply.

Accumulated savings are likely to be absorbed over time, as households tie them up in housing or use them for consumption, assuming there are no new lockdowns that overly restrict spending. We estimate that in the six quarters between Q1 2020 and Q2 2021, households have accumulated close to 6% of 2019 GDP in excess savings in the eurozone and 9.4% in the U.K.. This amounts to around 1.7% of the market value of the housing stock in the eurozone and 4% in the U.K. (see chart 5)--an approximate estimate of their likely contribution to housing price rises. The impact of these savings may even be more sizable because they are not evenly distributed and skewed towards wealthier households, which are more likely to be homebuyers (see chart 6). What's more, housing demand has been stronger where prices were generally lower (e.g., outside big economic hubs in second-tier cities, especially in France and the U.K.), as a result of the generalization of working from home. Finally, investor demand, driven by search for yields, remains another contributor to housing prices in an environment of low yields.

Chart 5

Chart 6

At the same, we don't expect further falls in borrowing costs but rather a gradual tightening of monetary policy with the economic recovery. This is likely to limit affordability further, even if income growth starts to rise as employment recovers (see chart 7). This is an asymmetric risk for European property markets. For example, while we don't expect the European Central Bank or Swiss National Bank to lift rates before 2024, the Bank of England is likely to start normalizing its monetary policy stance earlier, given its view that inflationary pressures in the U.K. are greater and more persistent than in the eurozone. As a result, a slowdown in the U.K. property market, which is already under way after the removal of the relief in temporary stamp duty, is more likely to be exacerbated by higher rates than elsewhere in Europe, where rates will remain low for longer.

Chart 7

Nonetheless, even before the pandemic, supply constraints have been one of the main drivers of housing price inflation in many European countries, such as Germany, the Netherlands, Sweden, and Ireland, and particularly in large cities. Even if construction in most countries has now recovered to its pre-pandemic levels of activity, the gap that has widened between housing supply and demand as a result of the first lockdown and restriction on building activity has not been filled. As the construction sector is already operating at full capacity and labor shortages are starting to become a factor preventing expansion, we expect it will take some time for the sector to catch up with demand. Shortages will therefore continue to put upside pressure on prices over the medium term, also, in part, through higher construction costs.

Country-Specific Trends Are Linked To Economic, Supply, And Taxation Dynamics

Aside from all the common drivers of housing demand across Europe, we still observe some differences across countries, linked to their specific economic situation, demographics, and housing taxation.

• In France, interest in housing purchases has mainly occurred outside the capital, while transactions in Paris have not yet recovered to pre-pandemic levels. Price increases have therefore been stronger in the surrounding suburbs or in second-tier cities such as Lille or Lyon.
• In Italy, while the market has finally exited contraction after years of decreasing prices, we see demand dynamics fading. The upcoming taxation reform may lead to some uncertainty in the short term, which could delay some housing investment decisions. In the longer term, a decreasing population profile is likely to continue to weigh on housing demand, although a successful implementation of the reform program could alleviate this trend.
• Low interest rates will continue to prop up housing prices in residential property markets in Switzerland and Germany, which have a higher share of non-owner-occupied homes than elsewhere, as investors look for yields in relatively safe assets.
• In the Netherlands, the stamp duty relief for properties below €400,000 and for buyers under the age of 35 boosted both house prices and the number of transactions. We think the strong pace in price growth is temporary, and housing transactions will slow down given fewer properties for sale, but the tax exemption should still have a permanent impact on house price levels.
• House price growth in Spain last year decelerated to the lowest pace since 2013. Regions with higher growth rates prior to the pandemic, i.e., the metropolitan regions of Madrid and Barcelona, as well as touristic areas, have even seen price declines since last year. The second quarter of this year was a turning point, with growth rates back to solid positive territory, thanks to better-than-expected economic and labor market conditions (extended short-term work schemes limited the surge of unemployment), as well as the outlook for a strong rebound in the tourism sector next year.
• Tourism and foreign buyers will also continue to push up price growth in Portugal, increasingly worsening affordability in the most affected regions.
• In the U.K., the end of temporary stamp duty relief that had fueled house price inflation, is now contributing to a significant slowdown in price growth.