The strong price momentum in major European housing markets is likely to cool over the next few years amid declining affordability, rising interest rates, and high inflation. However, strong household balance sheets accumulated during the COVID-19-related lockdowns, as well as an influx of refugees from Ukraine, should sustain housing demand and continued, but slower, price growth. Price dynamics accelerated in the second half of 2021 in nine of the 11 countries we cover in this report--sharply so in the case of the Netherlands, Spain, and Ireland (see chart 1). Prices also continued their sustained rise in Belgium, the U.K., and Sweden. On average, in our sample of 11 countries, housing price inflation exceeded 9% in the second half of 2021, up from 6.7% in the first half. What's more, housing prices not only rose faster in absolute terms, but also faster than household income--despite a robust labor market. In most markets, prices also rose faster than rents, which are largely regulated. This continues a long-term decline in affordability (see chart 2).

Chart 1

Chart 2

The Normalization Of Monetary Policies Will Cool Demand

A confluence of factors is currently keeping demand for housing high: record high levels of employment, rising wages, and forced savings accumulated during the lockdowns, along with now widespread working-from-home practices. Households are also still benefiting from years of accommodative monetary policies, which culminated in the emergency measures taken by central banks at the time of the pandemic. All this has boosted household wealth until recently (see chart 3), by increasing the present value of financial assets and real estate and keeping debt service low. As a result, household wealth net of debt has increased by half a year of income since the end of 2019 to reach 7.5 years of income by the end of 2021--an all-time high. Most of this saving has been by wealthier households and, thus, potential homebuyers.

Chart 3

Still, while some of these demand factors are still at play, it is likely to be dulled by monetary policy normalization now under way at a faster pace than expected some months ago on the back of persistently high inflation (see "Implications Of The ECB's Policy Normalization For Interest Rates, The Balance Sheet, And Yields," published June 9, 2022, on RatingsDirect). Higher interest rates could lead demand for housing to cool down. We expect the European Central Bank to lift the policy rate to 1.5% by the end of next year, the Bank of England to 2% before pausing, and the Swiss National Bank to 0.75% (see "Economic Outlook Eurozone Q3 2022: Inflation Dulls The Post-COVID Bounce," June 27, 2022). That said, as consumer price inflation and GDP growth are forecast to slow down in the years to come, we do not expect long-term yields to rise much beyond the levels they reached in early June. Banks are not signaling a sharp tightening in credit standards for housing loans. What's more, construction costs are increasing faster than consumer prices. This is because the sector is running at full capacity, the price of construction materials has increased considerably, and energy standards for new homes have been tightened. This suggest that despite possibly slightly higher nominal rates on mortgages, real mortgage rates (i.e., deflated by construction cost inflation) will remain negative in the years to come (see charts 4 and 5). Monetary policy normalization is therefore likely to cool down, but not abruptly stop demand for housing.

Chart 4

Chart 5

A Higher Cost Of Living Will Likely Delay Some Housing Investment

High inflationary pressures are also likely to somewhat cool housing demand by squeezing consumers' purchasing power. Consumer sentiment has deteriorated on the back of price pressures, with households noticing a deterioration in their ability to save. While this may be less of an issue for higher income households, which are generally more active in the housing market than lower income households, it's likely to act as a drag on housing demand, especially in 2023, as wages take some time to catch up with inflation.

Moreover, it also suggests that landlords may find it harder to raise rents at a time of rising debt-servicing costs. This could weigh on their rental yields. For markets where the search for yields has been a big impetus of investment in the low interest rate environment (such as Switzerland and Germany), this could reduce investor demand for housing, especially as long-term yields now offer higher returns.

Refugees From Ukraine Add To Housing Demand In Some Countries

The war has caused many people in Ukraine to leave the country and seek new home abroad. The UNHCR recorded almost 5.5 million of individual refugees from Ukraine by the end of June 2022. The longer the conflict lasts, the more likely it will be that the flow of refugees will continue and that refugees will stay longer in their host towns. While neighboring or nearby countries logically receive more refugees than the others, the inflow is also sizable in some countries we cover in this report . Already 860,000 Ukrainians have fled to Germany, 140,000 to Italy, and 120,000 to Spain. Such inflows represent a sizable share of the domestic population--about 1% of the population in Germany, for example, adding to demand for housing (see chart 5).

As such, even if demand for housing slows down, the supply shortage remains high in many markets where price increases have been more pronounced (such as the Nordics and Germany). Supply-chain bottlenecks and longer delivery times have been other barriers to construction activity, exacerbating the lack in supply.

Chart 6

On balance, the combination of higher interest rates in nominal but not in real terms, strong household balance sheets, and displacement of people due to war, does not point to a hard landing for the European housing market. We therefore expect prices to cool down next year and further in the years to come.

Table 1

Country-Specific Trends

• In France, housing prices have risen much faster outside Paris. This is because workers are reassessing their need for space as working from home has become more widespread and more choose to live in second-tier urban centers.
• In Italy, the housing market recovery path is continuing after a long period of correction following the financial crisis. While demographics will remain a drag on housing demand in the long term, the strong recovery of the labor market is underpinning households' demand for real estate. However, interest rates have risen faster in Italy than in the most eurozone countries, pointing to a slower increase in prices as affordability worsens.
• In Switzerland, investors are reassessing yields generated by housing investments in the context of rising capital costs at a time when long-term interest rates are offering higher returns. That said, household demand for individual family homes continues to surge, especially outside the big cities, making those homes less affordable for most.
• Germany will continue to see sustained house-price growth, as we do not expect supply to catch up with demand over our forecast horizon. Demand pressures are exacerbated by immigration, notably refugees, while supply-chain disruptions weigh on supply. Energy efficiency regulations are set to make construction or renovation more expensive, thus pushing up prices further. The gap between house price growth in major cities and the rest of the country is likely to narrow. Demand for owner-occupied housing is slowing due to worsening affordability, combined with the need for more space. At the same time, investors, who focus on city real estate might turn away from the housing market as the bond market becomes more attractive.
• In the Netherlands, house-price growth rocketed in 2021 at nearly 19% on the previous year. This was to a large extent driven by demand for owner-occupied housing, especially by first-time homebuyers under 35 who benefitted from an exemption of the transfer tax. Higher savings and regulation on lending standards for dual earners has driven up purchasing power. Conversely, the market became less interesting for investors due to an increase in the transfer tax, contributing to decelerating price growth in an overheated market.
• House-price growth in Spain accelerated in 2021, especially in coastal regions and less urban areas, as homebuyers look for more space. The metropolitan region of Madrid, by contrast, has seen among the slowest pace of growth. COVID-19 infection waves in 2021 weighed on house purchases by foreigners, some of which might return this year, therefore limiting the deceleration in price growth.
• House prices in Portugal accelerated in 2021, owing to strong demand. Supply is not able to keep pace with increasing demand, in spite of increased construction. Lisbon and tourist hubs are seeing notably strong house-price growth, fueled by buy-to-rent demand for tourism and foreign buyers. Both factors should prevent a fast deceleration in house price growth over the medium term, despite worsening affordability for local buyers.
• In Belgium, house price growth remained fairly stable in 2021, as people sought more space and their purchasing power increased due to excess savings during the pandemic and the desire to secure mortgage loans at low interest rates. In an already largely owner-occupied housing market, new regional regulations on registration rights benefitted homebuyers at the expense of investors, further increasing their purchasing power.
• In the U.K., house prices will remain supported by the large amount of savings accumulated during the pandemic, especially by higher-income households. Housing will also remain an attractive option to preserve wealth in an environment of high inflation for those who can afford it, which should support demand to some degree. Overall, however, affordability has deteriorated markedly over the past two years and has now surpassed levels just prior to the global financial crisis, which will limit price growth in the medium term. On balance, we expect a soft correction towards the pre-pandemic trend.

Related Research

• Implications Of The ECB's Policy Normalization For Interest Rates, The Balance Sheet, And Yields June 9, 2022
• Economic Outlook Eurozone Q3 2022: Inflation Dulls The Post-COVID Bounce, June 27, 2022