Accuracy Talks Straight #5 – Industry insight
Is real estate at the peak of its cycle? The Paris example.
What should we think of the stability in Parisian residential property prices, despite the public health crisis?
Since March 2020, the Covid-19 pandemic has shaken up the global economy, bringing about changes in numerous sectors, including residential property, in particular.
This public health crisis is behind a change in economic paradigms that have been in place since the 2010s. The eurozone is currently facing a significant increase in inflation, which reached 5.2% in May 2022, a level unseen since 1985. Access to mortgages for individuals is gradually becoming more difficult.
However, despite this context and in contrast to previous crises, the price per square metre of existing housing in Paris has not experienced any significant decrease; in fact, it has remained relatively stable.
In this situation, two opposing theories have come to light: one the one hand, some consider that the consistent rise of existing housing prices in Paris is justified by its unique nature, the City of Lights, which shelters it from economic cycles; on the other hand, some worry about a property bubble in the capital that is on the verge of bursting.
WHAT DO THE FIGURES SAY?
According to the Parisian notary database, the price per square metre of existing housing rose from €3,463 to €10,760 between 1991 and April 2022, an increase of around 3.6% per annum on average. Inflation over the same period stood at around 1.8% per annum on average, according to Insee. In short, the value of a square metre in Paris grew on average twice as quickly as inflation. In the graph below, we can observe the curve representing the actual increase in property prices per square metre in Paris versus a curve representing the 1991 price per square metre subsequently inflated each year using the Insee inflation rate.
This graph highlights two observable phases:
• In the period from 1991 to 2004, the actual price per square metre remained below the 1991 Insee-inflated price. Property prices grew significantly in the period prior to 1991 then underwent a major correction of around 35% between 1991 and 1997. Only in 2004 did the actual Parisian property price curve exceed the Insee-inflated curve.
As a reminder, 1991 marked a high point in the cycle, completing an upward phase of speculation by property dealers in Paris, and the beginning of what certain experts would call ‘the property crisis of the century’.
• In the period from 2004 to 2022, the actual price per square metre grew massively, much more quickly than economic inflation: +5.0% per annum on average for the actual price versus only +1.8% for inflation. There is therefore major disparity between the development of residential property prices in Paris and the average increase in standard of living.
Moreover, it is worth noting that between 2020 and 2022, the price per square metre in Paris did not experience any major fluctuation, in contrast to previous crises (1991 or 2008).
The first quarter of 2022, however, sees the return of significant inflation, with no repercussions on the actual property prices at this stage.
Is this due to increasing demand?
Many defend the following theory: demand for Paris is growing, whilst supply is limited, which has resulted in the constant rise in prices per square metre, no matter what stage of the economic cycle is prevailing.
The demographic reality is not quite so categorical. In 1990, Paris had a population of 2.15 million; this grew to 2.19 million in 2020, with a peak of 2.24 million in 2010. Further, since 2021, the city’s population has been falling to reach 2.14 million in 2022. Indeed, some Parisians, finding the health restrictions rather trying, decided to leave inner Paris for the inner and outer suburbs or other regions of France altogether.
The trend to leave inner Paris can also be seen among the households that returned from London following Brexit.
This declining trend comes hand in hand with an increase in demographic pressure in the rest of the Ile-de-France region (excluding Paris). The departments in the inner and outer suburbs have seen their population grow from 8.5 million to 10.3 million people between 1990 and 2022.
Therefore, since 1990, Paris has experienced a relatively stable demographic dynamic, even starting to decline from 2021. We can conclude then that demand does not seem to be behind the significant rise in the actual prices of residential property in Paris.
Is this due to decreasing supply?
In Paris, transaction volumes are higher during periods of increased prices (between 35,000 and 40,000 transactions per annum), whilst these volumes fall significantly during periods of decreased prices (25,000 to 30,000 transactions).
It seems high time to put an end to a common misconception: a fall in the volume of properties for sale does not automatically increase prices.
The economic reality is different: when prices are high, property owners are more inclined to sell their property, either to crystallise a capital gain or to undertake a buy–sell transaction (incidentally, often in the reverse order) because they have confidence in the market. Conversely, when prices are shrinking, the market seizes up. Property owners delay as much as possible their potential sales waiting for better days.
This leads to the following conclusion: the classic economic mechanisms of supply and demand simply cannot explain the historical growth in residential property prices per square metre in Paris.
These price dynamics should really be considered as ‘contra-economic’: supply grows in volume when prices increase; supply falls in volume when prices decrease.
When concentrating our analysis on the recent public health crisis, we can observe that transaction volumes decreased in the Parisian market. Indeed, the residential property market in Paris experienced a dip from the first lockdown, falling from 35,100 transactions per annum to 31,200 in 2020 to return to 34,900 in 2021. This change can be explained in particular by the specific structure of the lockdown, with investors unable to complete the purchasing process for residential property (visits, meeting with the notary, move, etc.).
When the strict public health measures were lifted, the property market was able to recover quickly.
WHAT ARE THE CONSEQUENCES OF THE COVID-19 CRISIS ON THE RESIDENTIAL PROPERTY MARKET IN PARIS?
For some investors, the change to our way of life due to the public health measures – remote working and leaving Paris – was to lead to a fall in Parisian property prices, or even to a bursting of the property bubble comparable to that of 1991.
Marked by the successive lockdowns and discouraged by the more difficult conditions to obtain a mortgage, people could have started a mass exodus from Paris, resulting in a fall in residential property prices in the city.
We can see in the graph below that the public health crisis appears to have had little impact on the price per square metre in Paris. Prices have flattened, or slightly decreased, but have not fallen below the bar of €10,000 per square metre on average.
WHAT ARE THE REAL DRIVERS EXPLAINING THE INCREASE IN RESIDENTIAL PROPERTY PRICES PER SQUARE METRE IN PARIS?
As we cannot use demography and standard economics to explain the long-term increase in prices observed, what are the variables that really can explain this sharp increase?
To answer this question, we have built a multi-variable regression model using a long historical series (1990–2022), which comes to the following conclusion:
Since 1990, the development of residential property prices per square metre in Paris can be explained ‘entirely’ and ‘mathematically’ by two financial variables.
To put it simply, this means that it is possible to explain—and potentially predict—the price per square metre of residential property in Paris with an extremely high degree of accuracy using only two financial variables.
– For those familiar with such techniques, our multi-variable regression model reached a correlation index (R2 ) level of 94%1.
The first variable involved is the following:
– Variable 1: the spread between the French 10-year OAT rate and Insee’s inflation rate.
As shown in the graph below, taken in isolation, this variable
In simple terms, this variable represents a borrower’s interest rate adjusted for economic inflation, that is, the net real interest rate for the borrower.
This variable thus makes it possible to take into account the attractiveness of the resources available to the borrower to acquire a residential property.
The spread highlights the impact of French 10-year OAT rates in the development of property prices per square metre. Indeed, when the French 10-year OAT rates fall, the borrowing capacity of an individual borrower rises significantly. For example, if an individual borrower’s rate decreases by one point (100 basis points), his or her borrowing capacity increases by approximately 10%. But the Parisian property market incorporates this component in the development of prices per square metre. The fall in rates enables a rise in borrowing capacity for buyers but not in terms of the number of square metres that they can buy. The market absorbs any increase in borrowing capacity in the price per square metre.
Furthermore, this variable takes into account the effect of inflation on the property market. The year 2017 marks the beginning of a scissor effect between the French 10-year OAT rate and inflation. Interest rates remained stable whilst inflation picked up significantly. For the first time, the spread (10-year OAT – inflation) became negative, meaning that for the first time, individual borrowers could borrow at negative net real rates.
The scissor effect has intensified since 2018, bringing about the continued rise in residential property prices per square metre in Paris between 2018 and 2020.
But since 2021, the striking rise in inflation coupled with the stable low base rates have been behind a financially untenable spread. This spread has developed from (0.6)% in 2020 to (3.6)% in 2022. Over the same period, prices per square metre have started to decline just as the rise in the cost of living has accelerated.
The current intention of the European Central Bank (ECB) to increase base rates in order to curb inflation should gradually attenuate this historic scissor effect. But prices per square metre of residential property in Paris appear to have begun a noteworthy decline.
The fall in spread is not the only or even the best driver explaining the historical increase in prices per square metre in Paris.
The second historical variable is the following:
– Variable 2: the size of the ECB’s balance sheet.
– Taken in isolation, this variable explains the price per square metre with an R2 of approximately 94%. It itself is highly correlated with the first variable, owing to the coordination of decisions on the development of the ECB’s monetary policy for these two variables.
This variable highlights the consequences of the quantitative easing policy implemented by the ECB on the valuation of financial asset classes, including Parisian property.
To enable the members of the Eurogroup to face various economic crises (including the public health crisis), the ECB put in place in 2009 an ambitious quantitative easing policy, similarly to the Fed, with the aim of ensuring the stability of the euro by injecting a vast quantity of currency into the market.
The supply of this monetary mass to banks and the maintenance of low base rates are behind the historical rise of residential property prices in Paris.
Based on our analyses, it is possible to correlate the historical development of prices per square metre in Paris with the size of the ECB’s balance sheet at 94%.
The graph below presents the development of the ECB’s balance sheet, showing its consistent growth since 2009. This strong growth is the fruit of the implementation of unconventional monetary policies to respond to the crises felt by the Euro-system in 2009, 2011 and 2020. By massively acquiring public and private debt on the European market to serve the refinancing demands of banks, the ECB has created favourable financing conditions in the eurozone in a context of crisis and very low interest rates.
Since 2009, the ECB has implemented two ambitious net asset purchase programmes: the Asset Purchase Programme (APP) and the Pandemic Emergency Purchase Programme (PEPP). These programmes are behind an unprecedented increase in the size of the ECB’s balance sheet.
However, though we can observe another doubling of the ECB’s balance sheet between 2020 and 2022, the price per square metre of property in Paris has slightly fallen, compared with a considerable increase over the period from 2011 to 2021.
This is a major break in the trend.
Over the long-term historical period, we have observed that the development of prices per square metre in Paris is highly correlated with the monetary policy of the European regulator, in particular via two variables: the spread (10-year OAT – inflation) and the size of the ECB’s balance sheet.
Between 1999 and 2020, a mathematical formula makes it possible to predict with a high degree of relevance the development of prices per square metre in Paris. In short, it suffices to listen to the European Central Bank and to anticipate and model its decisions.
But the years 2021 and 2022 have been marked by a drastic change in macroeconomic indicators.
Inflation has returned to levels not experienced since the 1970s (5.2% in May 2022), which disrupts the spread rate.
Similarly, the ECB’s decision to put in place a massive debt purchasing plan in the context of the public health crisis led to the doubling of its monetary balance sheet, with no particular effect on the price per square metre in Paris.
The two variables that were the drivers of the rise in prices since 1999 can no longer explain the development of the price per square metre of residential property in Paris from 2020 onwards.
The model is broken.
This likely marks the beginning of a wait-andsee period that could lead to a fall in both volumes and prices per square metre (versus inflation).
What remains to be seen is how long the property investor of 2020 will have to endure this market correction and whether Parisian property will play its role of a safe haven investment as it did during the inflationist period of 1970.