A bubble ready to burst or safe as houses?

DO property investors know more than the economists? It seems like a reasonable question to ask as the property market settles in for another bullish run in 2006.

House prices look set to rise by another 15% this year, having slipped by 3% less than 12 months ago.

In Dublin prices are pacing ahead at the rate of 20%, raising fears that investors are going to get badly stung, with rental income increasingly failing to cover mortgage repayments as the interest rate outlook hardens.

In a cautionary note to punters, Rosa White, economist with Davy Stockbrokers, makes the point that rental yields are well down with speculators and others are doing well if they are getting a 2% yield.

Contrast that with the 3.5% available from bonds or the potential returns available from smart equity investment and the case can be made that those pinning their hopes on property are seriously misguided.

Rents have fallen, with many investors now forced to supplement mortgage repayments on second homes by significant amounts as rents fail to meet mortgage repayments.

If, as feared, the European Central Bank (ECB) decides to push rates up another 1% within the next 12 months, the pressure will be on thousands of investors, young couples and others, fresh to the market, who have no other ambition than to own their own home.

However the interest rate bears may have over-interpreted positive indicators on the German economy as a trigger to a sharp hike in ECB interest rates.

On Thursday ECB president Jean Claude Trichet suggested markets may have jumped the gun.

In what some analysts called a less “hawkish speech” than before, Mr Trichet suggested interest rates “are expected to stay at historically low levels over a long period of time”.

His remarks were prompted by weaker-than-expected German retail sales, down 0.6% month on month in February but up a modest 1.1% year on year.

In another blow to euro recovery expectations, reports in the Italian press suggest official growth forecasts for Italy will be revised down to 1.3% from 1.5% for 2006, with the deficit forecast revised up to 3.8% of GDP against 3.5%.

Those figures do not point to a boom in the euro economy which will struggle to reach 2% growth on average in the coming years, according to best estimates to hand, and suggest interest rates may not rise as high as some have indicated over the next 12 months, which would take some pressure off overstretched borrowers.

But irrespective of the interest rate outlook, Mr White says net property yields of 1.5% in Dublin were ridiculous when compared with a risk-free rate of 3.5% on 10-year gilts.

For fair comparisons, it was better to compare residential property to a similarly risky asset like the ISEQ index, which has an earnings yield of 7%.

For him, investors must be extremely bullish about rental growth to justify record valuations being given to residential property in Dublin. “To us, this looks like boundless optimism,” said Mr White.

His words of caution are timely, given ECB rates will rise in the months ahead.

On the flip side of those arguments, however, since April 2001 house prices nationwide have risen by 52% on average.

As a result, thousands who have bought into the market for capital gain have already achieved their aim, and with the bulk of the money borrowed to enhance their property portfolio, they have done seriously well.

In his words of caution Mr White also questions the view that capital gains are the driving force of the buy-to-let market and not the rental income.

That was unsound investment advice because traditionally house price valuations are tied to rental income people can expect from letting them out.

If the current trend continues and rent yields continue to fall, house prices should also fall, he claimed.

Meanwhile house prices continue to defy gravity as the latest house price projections for 2006 clearly demonstrate.

With housing demand destined to average 55,000 a year indefinitely, investors will be loathe to check out of the boom conditions that continue to deliver very strong capital growth.

While it cannot go on forever, the fall from grace of equities since the dotcom bubble has contributed to the search for alternative retirement savings and to date, the housing market has justified billions invested in it.

Time will tell who made the right judgment call.