House prices in Europe remain above long-term average and further price declines are likely in particular in markets in Spain, Ireland, the Netherlands, Italy, France and to a lesser extent in the UK. 

Deutsche Bank economists say in a paper published on Wednesday that it has been frequently argued that house prices in the Eurozone follow similar cycles to those in the US, but with a lag of six months to two years - - depending on sample periods and data series. Comparing the long-term development of house prices in the US and house prices in the Eurozone, a remarkable similarity is evident: Since 1970 (nominal) house prices have been rising in both the US and the Eurozone by roughly 500% until their latest peaks in 2006 and 2007, respectively. What is more, in both the US and the Eurozone the house price bubbles have been concentrated in some hot spots: Between 2000 and 2006 house prices in California, Florida and Arizona rose just as strongly as house prices in Europe’s most affected housing markets Spain and Ireland.

However, the papers' authors, Tobias Just and Thomas Mayer, say the downward adjustment in many European countries has not been as strong as in the US. The statistical phenomenon that the Eurozone followed the US in the past therefore suggests that house prices in Europe need to fall further. They say the financial crisis started because many US citizens could not afford their subprime loans any longer. Affordability issues have obviously been crucial. The simple price-over-income index proved to be a good indicator in the past few years.

For both the US and the Eurozone the indicator crossed the long-term average in 2003 and reached new peaks in 2005 (US) and 2006 (Eurozone), respectively, with levels 12% to 18% above the long-term average. However, the regional differences were significant, with price-income ratios topping the long-term average by more than 40% in UK, Spain, Ireland, Finland and the Netherlands.

These figures indicate that further price drops are significantly less likely in the US than for many European countries: In the US, the price-income ratio is already below the long-term average and only slightly above the long-term low. In Europe, however, all analysed
economies (except the usual outlier, Germany) are still far above their long-term low and in most cases are still above their long-term average.

The economists say that of course, this simple house price-income indicator is an inaccurate measure of affordability, as it does not capture interest rate movements. As most households are debt-financing their homes to a large degree, lower interest rates can allow for much higher house prices without damaging the purchasing power of a household. It is therefore useful to calculate mortgage payments over income rather than house prices over income.

Unsurprisingly, this affordability index, representing mortgage payments over income, is significantly below the long-term average in most countries (suggesting a high degree of affordability), given the currently very low interest rates. However, affordability in countries with variable mortgage rate systems may deteriorate quickly when interest rates rise (esp. Spain, Ireland, UK and Sweden). The paper says using a 15-year reference  period, the affordability index would could increase significantly (20-30 %) in the next two years above this 15-year average in many European countries. Houses would then be comparatively expensive compared to the 15-year period.

The economists say price-to-rent ratios still signal sizeable mispricing in Europe. The ratio increased in (almost) all OECD countries between the late 1990s and 2006. With prices falling in most countries and rents remaining comparatively stable, this ratio has almost fallen back to its 15-year average - - in the US a bit more than in the Eurozone. However, they say it is necessary to differentiate between developments in the Eurozone, as the Eurozone indicator has a strong downward bias due to the big weight of Germany in the indicator. In most Eurozone countries the price-to-rent ratio is still more than 20% above the 15-year average and significantly above the longer-term average (35 years) or compared to the long-term lows.

The paper says the biggest supply-side problems remain on the Spanish, Irish and the Finnish housing markets. In UK and Sweden the increase in housing units matched pretty much the additional demand. What might be even more astonishing is that despite the significant drop in residential construction in Germany, this development largely reflects the country’s unfavourable demographics: Not only has growth of completions come down, but growth in the number of households also fell.

The economists say they have looked at a very broad set of indicators for the large sample of 11 OECD housing markets. Not all indicators were pointing in the same direction. But one general conclusion is straightforward: The risk of further house price falls is much bigger in some European countries, especially in Spain, Ireland and the Netherlands, but also in Italy, France, and to a somewhat lesser extent in the UK, than in the US.

OECD housing markets: US, DE (Germany), UK, FR (France), ES (Spain), IT (Italy), NL (Netherlands), SE (Sweden), NO (Norway, FI (Finland) and IE (Ireland).