For the best part of two years homeowners in the Baltic states have been riding on the crest of a property market boom. In Riga, where price growth has been particularly spectacular, standard block-house apartments have more than doubled in price from just over $250 per square meter at the start of 2002 to nearly $600 by the middle of 2003.
In Tallinn and Vilnius prices have climbed to similar levels, though at a slower pace. Apartment prices in desirable city centres and land prices in areas close to the capitals have shared in this boom. Naturally, such spectacular price developments have raised questions. Is residential property overvalued? Are recent price developments sustainable, or are we in a "bubble" that could burst at any moment?
These are important issues. For the typical owner-occupier in a market economy the value of his house or apartment represents by far the biggest part of household wealth. For this reason the residential property market, much more than the stock market or the foreign exchange market, is where ordinary people are most directly touched by the workings of a market economy.
In the Baltics the privatization of state-owned dwellings has led to rather a high share of owner occupation: just over 80 percent in Latvia and more than 90 percent in Estonia and Lithuania. These are very high figures compared with the EU average of 63 percent. In the EU only Greece, Spain and Ireland have owner-occupation rates in excess of 80 percent. In Germany it is 43 percent, in Sweden 60 percent and in the U.K. only 71 percent. These figures suggest that households in the Baltics may be especially vulnerable to developments in the residential property market.
How can we identify the presence of a bubble in the housing market? Analysts in countries with long established housing markets look at several indicators. One is the ratio of property prices to incomes - this may be thought of as an indicator of affordability. Another is the so-called price/earnings ratio, which measures house prices relative to rents: The higher the ratio of prices to rents the more likely that property market valuations are feeding on themselves rather than being determined by the underlying value people derive from living in property. In other words, the higher the ratio, the more likely the market is to be overheated.
Needless to say, application of these indicators to the Baltic states is fraught with difficulties, but the bare figures make interesting reading. In Riga in 2003 the affordability ratio reached 7.5 - i.e., it took 7.5 years of gross income to purchase an average blockhouse apartment. In Tallinn the affordability ratio was close to 5 and in Vilnius about 6. For comparison, in the U.K., where this is a long established indictor, the historical average has been around 3.25, and a ratio of 5 is regarded as signaling a crisis.
Developments in the P/E ratio also suggest Riga - where the P/E ratio has risen by about 20 percent since the start of 2002 and by 40 percent since initial development of the secondary market in 1998 - as the most vulnerable of the three capitals.
Although the indicators point to a bubble, identifying its presence and actually predicting when it will burst are two very different matters. Turning points are notoriously difficult to predict, and even when the turning point comes, it may be difficult to identify at once, as housing bubbles tend to deflate rather than burst dramatically. Thus the U.K. bubble of the late 1980s was followed by 14 consecutive quarters of falling prices, and in Japan the deflation has lasted for a decade.
Typically the "bursting" of a bubble needs a trigger. What is likely to be the trigger in the Baltics? By its nature a trigger has to be unanticipated, so could it be the very event that has been driving much of the euphoria, namely EU accession? Many people have been enticed into the market for both apartments and land in the belief that prices will rise after accession.
But is there any basis for this belief? It is hard to see why. Property prices in the EU 15 remain widely divergent after more than a decade of the single market.
In fact, as people move west in response to liberalized labor markets, demand for housing is also likely to switch. In London real estate agents are anticipating a migration induced rental boom!
If the London analysts are right, people who bought here in anticipation of still higher prices after May 1, 2004, will be disappointed and the disappointment will feed back into demand, and then to market activity, and finally to prices. Perhaps?
Alf Vanags is director
of the Baltic International Centre
for Economic Policy Studies (BICEPS).