Is housing still a good investment?

House prices in many European countries appeared to defy gravity during the Covid-19 pandemic, much to the bemusement of analysts. At a time when economies experienced unprecedented turbulence, it seemed incongruous that residential property should have remained so buoyant. However, since then the market in many countries has been negatively impacted by the resurgence of inflation and an abrupt end to nearly a decade and a half of ultra-low interest rates.

Paradoxically, the European housing market appeared to benefit in 2020 and 2021 from the repeated periods of constraints on personal movement and the economic volatility stemming from the tightening and loosening of lockdown restrictions, both in terms of transaction numbers and price levels. The market was seemingly less affected than during previous economic downturns. Many residential property investors remember ruefully the fallout from the 2007-09 global financial crisis, when Spain and Ireland’s property markets went into free fall, admittedly from extremely overheated levels. Only in Germany, Luxembourg and Sweden did markets prove relatively resilient.

In Luxembourg, which had been experiencing a boom in home prices for more than two decades, the pandemic caused little more than a hiccup.

In Luxembourg, which had been experiencing a boom in home prices for more than two decades, the pandemic caused little more than a hiccup. The cost of a house or apartment grew by 135% between 2010 and 2022, according to Eurostat, significantly higher than the EU average of 47%. By contrast, growth in rental prices in Luxembourg increased by no more than 20% over the 12-year period, close to the EU average.

First slowdown in decades

However, since then the grand duchy’s residential property market has experienced its most significant slowdown in decades. According to online real estate listings platform Immotop, the average price of homes and apartments in the grand duchy peaked at €9,208 per square metre in July 2022; by May 2023 it had declined to €8,626, and to €8,464 a year later. Analysts attribute the stalling market to the impact of rising borrowing costs at a time when inflation is eating into earnings.

That marks a significant change; for most of the previous two decades, buoyed by the ‘great moderation’ characteristics of low inflation and interest rates amid steady economic growth and rising earnings, investment in Luxembourg houses and apartments had been a one-way bet. According to the BIL IMMO index compiled by Banque Internationale à Luxembourg, home prices had outstripped the country’s consumer price index since around 2000. Annual average price growth in those years ranged from 4.4% in 2014 to a peak of 14.5% in 2020.

Although analysts have routinely described Luxembourg’s housing market as overheated in recent years, many industry participants still believe that the dip in prices might prove relatively short-lived, and will go into reverse once inflation and interest rates fall back toward the trends seen in the first two decades of this century. With a shortfall of new construction of homes estimated at up to 4,500 a year, demand appears set to continue to exceed supply for the foreseeable future.

Of course, Luxembourg is atypical of European residential property markets – a small, extremely prosperous country whose economy is mostly based on services, closely interlinked with neighbouring regions and where almost half of the national workforce commutes in daily from other countries. These factors endow the housing market with intrinsic buoyancy – which has extended to a lesser degree to neighbouring areas of Belgium, France and Germany.

Impact of inflation

Some of the factors that have influenced the end, at least for now, of the long housing market boom also apply to other European countries. In April 2023 the International Monetary Fund warned in its regional economic outlook of the risk of home price corrections across the continent linked to both the impact of inflation levels unprecedented since the 1990s and the raising of interest rates by central banks to heights also unseen for decades to bring rising prices back under control.

The IMF says downward trends were already visible in some European housing markets, including the Czech Republic and Denmark; in Sweden residential property prices declined by more than 6% in 2022. Although interest rates appear to have passed their peak, housing markets could continue to struggle even if there is no broader financial distress within economies. Even if markets see longer-term inflation risks receding, mortgage lenders have become significantly more conservative. This is also likely to have a broader economic impact by lowering households’ assessment of their own wealth and financial outlook, lowering personal expenditure and acting as a brake on economic activity overall.

Average home prices in the eurozone were down by 1.1% year on year in the fourth quarter of 2023. Luxembourg saw the biggest annual decline at 14.4%.

According to Eurostat, average home prices in the eurozone were down by 1.1% year on year in the fourth quarter of 2023. Luxembourg saw the biggest annual decline at 14.4%, more than double the next largest drop of 7.1% in Germany. The trend was not uniform across the EU; prices rose by 13.0% in Poland, 10.1% in Bulgaria and 9.5% in Croatia.

Vicious circle?

IMF analysts have warned of a possible vicious circle involving higher mortgage loan interest rates, constrained household discretionary spending, an increase in payment defaults and a further drop in the readiness of banks and other lenders to provide finance to would-be homeowners. It says empirical models linking home prices to their fundamental drivers pointed to an overvaluation of between 15% and 20% in most European countries in 2023.

That reflects to some extent the extremely high level of home price growth in some European countries over the past 25 years – 176% between 1996 and 2021 in Sweden, 145% in the UK, 142% in Denmark and 126% in France, according to the Organisation for Economic Co-operation and Development.

But in other countries growth has been much more modest – 31% in Germany (where prices were lower than in 1996 until 2016), 27% in Portugal (where recent growth is attributed to its now-abolished Golden Visa scheme to attract wealthy residents with tax breaks) and just 9% in Italy.

Rating agency S&P Global concluded in 2023 that the long period of price growth appeared to be coming to an end, forecasting a decline – although not a crash – in home prices in most European countries and little prospect of a strong rebound before the end of 2025. However, by January 2024 S&P was reporting an upgrading of its housing price forecasts because of increased resilience across European markets, especially in the UK, Ireland, Spain and Portugal. It says supply factors such as the continuing high cost of building materials have been a key factor in the price resilience of residential property, alongside a rebounding labour market, backlog of home construction and government support.

Steady rental prices

Although residential property construction has been holding up well in some European countries – although not in France, Sweden, Germany or Luxembourg – S&P says construction is a lagging indicator of the housing market, given the length of time between housing starts and completion.

An important factor for residential property investors is that rental values have remained much steadier than purchase prices over the past decade.

An important factor for residential property investors is that rental values have remained much steadier than purchase prices over the past decade. Eurostat says average rents across the EU increased steadily, but not spectacularly, between 2010 and the fourth quarter of 2022 – with growth of just 18%, compared with 47% for home purchase prices over the same period.

What does this mean for property investors? Forecasters suggest that there is little likelihood of a Europe-wide surge in home prices – and therefore of substantial capital gains – on the scale of that in the 2010s, at least in the immediate future. However, a large-scale drop in rental returns also appears unlikely since they have not outstripped overall economic growth in the same way as purchase prices. And a drop in housing sales could push more people toward renting rather than purchasing property, supporting demand.

In the long term, investment in residential property is set to remain popular simply because – eventually – supply and demand factors are likely to bring prices back into equilibrium, and rents can deliver the steady returns that many investors seek. But the days when houses and apartments were a one-way bet appear to be over – at least for now.