At the beginning of this year, house prices still held up better than most had expected. But the pandemic residential real estate boom in Europe is now over, and nominal price growth has entered a phase of sustained correction, in our view.

Even before European central banks started to hike in earnest, home price dynamics appeared unsustainable, not least because housing affordability in most of the geographies we cover deteriorated significantly over the pandemic years. With interest rates now even higher, pressure on house prices has increased and will intensify further as higher benchmark rates continue to pull up average mortgage rates over time.

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Yet, we continue to expect a sustained decline in European house prices, rather than an outright collapse. A host of mitigating factors are at play. Key among them are the delay with which higher policy rates feed through to household finances, the continued strength of labor markets, improving real household incomes, and large excess savings built up during the pandemic. Structural factors that should help contain price declines are endemic housing shortages and shrinking household sizes due to population aging. Finally, lenders are still willing to lend and have the capacity to do so, albeit at now significantly higher costs.

By the end of this year, nominal house prices in most of the countries we cover in this report will have seen year-on-year declines. In most geographies, these declines will be sustained through 2024. Our expectation of a sustained correction does not necessarily imply its magnitude will be moderate. In fact, we expect sizeable peak-to-trough adjustments of about 12% for Germany and the U.K., 11% for Sweden, 10% for Ireland, and about 8% for the Netherlands and Portugal.

Some Special Cases

There are some notable exceptions. In Italy, the government's subsidies for energy efficiency upgrades triggered a strong rebound in demand earlier this year, which will fade progressively until mid-2025. As a result, the correction in Italy will occur with a delay and will be less pronounced. In Switzerland, the interest rate environment remains benign, with little excess inflation to fight for the Swiss National Bank (2.2% in Switzerland versus 6.1% in the eurozone and 7.9% in the U.K. currently). Switzerland is the only country in our sample which will likely avoid outright price declines, although we still expect a significant slowdown in house price growth this year and next.

Sweden is a special case because the correction there started much earlier, was swifter, and has now mostly run its course. Moreover, for regional comparison reasons, we are committed to forecasting OECD price indices. For Sweden, this index displays less variation in both upswings and downturns than other indices used locally. As a result, the 11% peak-to-trough decline that we forecast for Sweden may appear understated in comparison.

It is also worth noting that, unlike Ireland, the U.K., and Spain, many European housing markets emerged from the global financial crisis without a crash and that the magnitude of the adjustment we expect for them now is greater than it was then.

The Mortgage Rate Shock Takes Time To Play Out

Even as inflation is easing due to falling energy prices, fundamental inflation pressures proved more persistent than central banks anticipated at the time of our January report. This is especially the case in the U.K., where tightening was more aggressive and where the Bank of England base rate, which is currently at 5.0%, could reach 5.5% in August. We also think that the European Central Bank could lift the deposit facility rate to 3.75% later in July, 25 basis points higher than we previously thought.

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The impact of much tighter credit conditions is already visible across economies, including housing markets. Mortgage rates on new loans have shot up in line with benchmark rates, and lending all but collapsed across many geographies largely due to depressed demand. Banks had also tightened credit standards somewhat during the second half of 2022, for reasons other than rising costs. It helps that the tightening came from extremely favorable levels and that there are currently also no signs of more major tightening ahead. Generally, lenders are still capable and willing to extend credit for home purchases, albeit at higher rates. However, demand and, hence, lending should remain muted at best until 2025 when central banks will have eased rates and prices will have adjusted. Even then, borrowing costs that are higher in real terms will moderate the revival in demand.

Higher rates on new mortgages lead to a decline in demand and put downward pressure on house prices. Yet, it is higher payments on existing mortgages and the resulting squeeze on household budgets that will determine how much reluctant or distressed selling will occur. A high degree of distressed selling would, in turn, raise supply substantially and could vastly exacerbate the downward pressure on prices--a key factor in housing market crashes.

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In that sense, it is good news that there is still quite some time to go before benchmark rate levels fully feed through to household budgets. This is due to the fact that during the ultra-low interest rate regime of the past 15 or so years, many European mortgage markets that were previously dominated by variable-rate deals have pivoted significantly to fixed-rate contracts. New fixed-rate contracts over 2015-2019 accounted for at least 50% of deals on average (with the exception of Portugal and Sweden) and in many cases much more. A point in case is Spain, where the share of newly originated variable-rate mortgages in the total fell to 25% in 2021, from over 80% in 2011.

A greater share of fixed rates may have complicated matters for lenders, depending on the funding structure, but should generally be beneficial to housing market stability, especially in view of the continued strength of European labor markets.

Mortgage Markets Differ Across Europe

Even so, there are significant differences across geographies that will determine how, exactly, higher interest rates transmit to the housing markets in our sample. These differences relate, for example, to the share of fixed versus variable rates as well as to the shares of different maturities within fixed rates contracts. All else being equal, the transmission of higher market rates is swifter if the maturity of outstanding loans is shorter. This applies, for example, in the U.K., Portugal, Ireland, and Sweden, where rates are predominantly variable or fixed for relatively short periods. In Belgium, with its almost exclusively long maturities, the absorption of higher rates should be generally smoother, more drawn out, and less pronounced.

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Moreover, differences in the levels of benchmark rates used to price mortgages of different maturities may play a significant role in determining the magnitude of the pass-through, in particular against the background of currently inverted yield curves, where short-term rates are higher than long-term rates. Geographies with predominantly long maturities should see less of a rise in average borrowing costs.

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There are other factors that will determine the transmission across geographies. For example, in countries with a large share of outright home ownership, such as Italy or Spain, the transmission will likely be more muted on aggregate, barring confounding factors. Conversely, the transmission should be swifter in countries with a relatively large share of renters, as rents are pushed up by yields and retrospective inflation adjustments. In many of these jurisdictions, however, existing significant regulations of the rental market will limit the pace of rent increases.

A New Rate Regime

There is still some uncertainty about how much further central banks will tighten, as more data on core price pressures comes in. And because the impact of the much tighter monetary policy on the economy unfolds with a considerable lag, there is significant uncertainty about when and at what pace central banks will ease again. But in any case and barring a major negative global shock, we now seem to have left behind the ultra-low interest rate regime of the past 15 or so years and have moved back to a more normal one, with important implications for costs of funding the housing market.

Indeed, most interest rates, even central bank rates, will turn positive in real terms from next year, and borrowers will no longer enjoy an inflation premium. Real rates will remain positive even when the European Central Bank and the Bank of England ease rates down to equilibrium levels of about 2.5% in 2025, after inflation has returned to target. And long after that, central banks will still be propping up long-term yields as they continue to slim their balance sheets. Mortgage holders and potential buyers will be facing higher real costs of borrowing that take a larger share out of their budget and moderate demand for the foreseeable future. This is one of the reasons why we do not expect a strong rebound in house prices after the correction has run its course.

Less Support From Institutional Investors

The period of ultra-low interest rates and the search for yield benefited institutional investors in residential real estate (RRE), and, as a result, their role in European housing markets grew significantly during that time, especially in geographies where prices looked comparatively attractive (in particular in Germany). That impetus is now diminished substantially. While the impact on activity of institutional investors is likely asymmetric, on balance, we expect subdued activity and, hence, less support for European house prices from that sector than in recent years.

Some RRE investors might face debt servicing challenges, if they are not already, amid rising risk aversion, higher funding costs, and the risk of capital declines. However, there also remains a decent degree of support. Where smaller investors exit the market, this creates opportunities for larger ones to scale up if they can afford to. Residential real estate also remains an attractive asset class for diversification, in particular as prices fall and become more attractive. There is even anecdotal evidence that some larger businesses, whose main activity focus is outside of the sector, for example in retail, are moving into housing to diversify their revenue stream.

A particular area of support comes from the rental market. Rents should continue to rise in the longer term on the back of both higher interest rates and robust demand even if regulation in some markets prevents rent hikes in the short term. In the same vein, the build-to-rent sector remains relatively attractive, which in the medium term will be helped by falling construction and maintenance cost inflation, even though cost levels are currently still high.

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A Construction Slump Adds To Legacy Housing Shortages

Supply shortages, when measured in terms of housing needs, have characterized European housing markets for years, due to still growing urbanization and a lack of land, impediments from regulation and excess red tape, and ever rising urban tourism in many key European cities, among other factors.

This is still the case and has been exacerbated by population growth due to two major waves of immigration in recent years, which raised housing needs even more. The intermittent spurs of activity we saw from mid-2020 largely constituted a rebound from activity losses in early 2020, and construction activity has subsequently slowed down again. Geographies where the construction sector is not yet experiencing a recession may well enter a recession further down the line, in our view. Limited new output will add to historically persistent shortages and provide some fundamental support to house prices.

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Indeed, higher funding costs and nascent concerns over both weaker demand and price declines are now translating into weaker activity in the construction sector, while the lack of materials in the wake of earlier global supply chain issues does not appear to limit construction activity anymore.

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Construction cost inflation looks to continue to come down rapidly. While this would typically support construction activity in normal times, the outlook of declining house prices will likely limit the impetus.

In fact, the decrease in construction cost inflation might itself contribute, to some degree, to falling home prices even if output remains constrained. This downward cost push might be at play in particular in Germany, where underlying demand for housing appears to be more robust than elsewhere, not least because of strong population growth in recent years, which resulted from a sizeable intake of refugees.

Strong Labor Markets Help Mitigate The Correction

The picture of European housing markets today is very different from typical housing market crashes, which are characterized by widespread job losses that cause a significant degree of distressed selling at a time when there is little to no demand. That was notably the case in the wake of the global financial crisis, when, in addition, limited supply of credit exacerbated the situation as lenders rebuilt their balance sheets.

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Households will still have to face increasing pressure of mounting mortgage costs on their budgets, but, as discussed earlier, at a slower pace than in previous downturns. The continued strength of the European labor market constitutes a second, significant layer of resilience that we consider in our forecast. Labor markets have weakened recently, but from a position of extraordinary strength. While we expect unemployment will continue to rise, a year or so of broadly stagnating economic growth in Europe will be insufficient to change the picture dramatically, in our view.

Moreover, there is a sizeable portion left from the significant excess savings the household sector as a whole accumulated during the pandemic years. Those savings can serve as buffers to absorb the mortgage shock, or they can be spent on home purchases once prices and interest rates have become more affordable again, helped by improving real wages. Yet, these mitigating elements will mostly apply to households with higher incomes that are also less sensitive to interest rates. Young professionals will continue to struggle, especially in geographies where the rental sector is less regulated, such as the U.K., and where higher rents will likely offset most, if not all, benefits from higher returns on savings. As a result, those types of households will have less opportunities to get on the housing ladder.

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Related Research

• Industry Top Trends Update Europe: Homebuilders And Developers, July 18, 2023
• Industry Top Trends Update Europe: Real Estate (REITs), July 18, 2023
• Economic Outlook Eurozone Q3 2023: Short-Term Pain, Medium-Term Gain, June 26, 2023
• Economic Outlook U.K. Q3 2023: Higher Rates Start To Bite, June 26, 2023
• European Housing Prices: A Sticky, Gradual Decline, Jan. 11, 2023