European property developers may see some light at the end of the tunnel. Easing inflation and mortgage rates will help stoke housing demand. A strong and resilient labor market should also help restore home buyer confidence.

However, in France, the chance for a faster recovery has proved elusive because of higher household indebtedness, the end of a government tax incentive, and budget woes that are impeding support for property developers.

For Spanish developers, we see a brighter trajectory. Developers will benefit from their ability to pass on costs, and lower household debt will help sustain demand.

Lower Rates And Resilient Labor Market Are First Steps To Demand Recovery

Lower mortgage interest rates will gradually revive demand for new homes in France and sustain it in Spain. The European Central Bank (ECB) has lowered its policy rates, which has triggered lower mortgage in Spain (3.3%) and France (3.7%), as of June 30, 2024.

We expect the ECB deposit rate to reach 2.50% in 2025 and remain at this level toward 2027 (versus 4.00% in 2023). We believe long rates should remain broadly at the current level toward 2027. Real estate affordability should improve from a year ago, allowing developers to launch more projects and increase volumes.

Both countries should benefit from strong job markets in 2024-2025 (with unemployment remaining low in France and decreasing in Spain) and higher disposable incomes, which would support the demand for new housing.

In France, recovery may be slower due to political and economic uncertainties, which could weigh on purchasers' decision to engage in newly developed housing. Developers in France also face more challenges with real estate affordability.

On the other hand, demand in Spain demand will remain strong due to lower mortgage rates and a stable job market and economy. We expect prices to moderate as affordability tightens following previous cumulative increases in price.

Table 1

Construction Costs Remain Elevated And Will Constrain A Faster Margin Recovery

As demand recovers, the capacity of homebuilders and developers to increase volumes and prices will help offset higher costs for land and construction, thereby restoring margins.

We expect the cost of building materials to remain high, despite easing from high price increases in the past 18 months. Prices of raw materials prices, such as cement, increased 40% in 2022 and remain still 40% higher today versus 2021. Despite the higher cost base, construction activity, fueled by recovery of public infrastructure projects financed through Next Generation European (NGEU) Funds and economic growth in Europe, remains high.

Resilient construction activity supports demand for raw materials sustaining current high prices, which we expect to remain around current levels over the next two years on the back of sustained activity.

This could continue to affect developers' profits and consequently their credit profiles. Developers will need a strong recovery in demand to launch new projects that are both, affordable for buyers and profitable at the current higher cost base.

Developers in Spain face hurdles with labor shortages and higher construction costs, but to a lesser extent. They have managed to offset some cost spikes through price increases. We anticipate that margins will remain at about 10%-15% as inflation eases to 2.1% in 2025 from 3.0% in 2024 and price increases moderate.

High raw material costs will still affect developers' margins in both markets, although less so in Spain where developers can offset the higher costs and wage inflation through higher prices.

Chart 1

Space Optimization, Simpler Projects, Lower Costs Will Be Key To Profitability

Profitability may still be limited due to high input costs. To recover margins, developers need to focus on optimizing space and simplifying projects in a challenging price environment.

To address this, they are focusing on optimizing space, simplifying projects, and finding cost efficiencies to create affordable yet profitable offerings.

To minimize buyers' costs, some stronger developers provide loans to customers at more attractive terms than traditional banks. In France, developers may also increasingly develop products that are eligible for a law enabling purchasers to minimize their acquisition costs by buying the built portion only and renting the ground over a very long period (to a government-related financial institution). This scheme (Bail Réel Solidaire) is mostly designed for densely populated areas and to help people with lower incomes buy homes.

While we expect demand to increase, production volumes may remain low as developers struggle to meet demand while maintaining sustainable profitability ratios.

There are also increasing requirements for energy performance and sustainable materials in construction. However, we doubt there will be a compromise on these standards to save on costs due to increasingly stringent regulation.

Governments Aren't Helping Developers Correct The Supply-Demand Imbalance

In France, the dismissal of the Pinel scheme, the last version of a long-dated tax incentive to buy newly built residentials, will end in 2025. Today's budget constraints mean there may be no immediate new housing plan or new significant tax incentives to buy newly built residentials. While all political parties recognize the shortage of housing, particularly in big cities, the government's room of maneuver to tackle the issue in coming months appears limited.

In Spain, the issue of housing affordability is fanning social unrest. While the government may implement stricter regulations and rental caps to address the rent affordability issue, but success may be limited. Only Catalonia has applied rental caps, which has reduced investment and new supply, worsening the supply-demand imbalance. Streamlining planning permissions and building permits would help increase the supply of new homes and balance the demand in major cities.

There is a growing housing agenda in Europe, including the U.K. government's plan to build 1.5 million homes in five years. The strategy involves setting housing targets for councils, streamlining planning, and incentivizing homebuilders.

However, the tough market conditions (namely elevated interest rates and construction costs) in the U.K. have led to more failures among smaller homebuilders over the past two years. Concentrating on a few outstanding players may not be ideal as it could lead to output saturation and price drops. Rapid construction acceleration could drive up labor and material costs, not to mention the upfront investment required.

Spanish Developers Adapt, French Developers Face Harder Time Passing On Inflation

Spanish developers have shown greater resilience in passing on inflationary pressures to final buyers through price increases, despite rising interest rates. This has allowed them to protect profitability and production volumes.

In contrast, French developers' margins are lower, leaving them with less headroom to absorb cost increases. They have struggled with supply-side challenges, including high construction costs and land prices, which have constrained their ability to restore production volumes while maintaining profitability.

Lower Household Debt Supports Spanish Buyers

Inflationary pressures and rising mortgage rates have had different effects on housing demand in Spain and France. In France, mortgage interest rates have risen to 3.7% as of June 30, 2024, from 1.2% at the beginning of 2022. In Spain, they have risen to 3.3% from 1.8%. In response, the French market saw a decline in transaction volumes and prices, whereas the Spanish market remained resilient.

Spanish households benefited from healthier balance sheets, a strong job market, and wage growth, which helped them cope with higher mortgage rates and maintain their ability to purchase homes.

In contrast, French households faced greater vulnerability due to higher debt burdens, eroding affordability and their ability to buy new homes. Spanish households have lowered their indebtedness since the 2008 recession, which has increased their consumption and investment capacity.

Demand from international buyers for newly built residentials is proving stronger and more resilient in Spain, supporting developers' sales.

Table 2

The French and Spanish markets, like many in Europe, face similar demand and supply dynamics, with a shortage of housing in major cities. Key factors have led to increased demand for homebuilders and rising prices. These include red tape, delays in supply, and growing populations in big cities, and a continued shrinking of the average household.

However, the sudden increase in interest rates and cost inflation have coalesced to buffet developers. An abatement in inflation and lower financing rates should help improve the situation, although uncertainties remain.

Chart 2

With the support of low financing costs, prices for new homes in Spain have been more resilient to increasing interest rates since 2022 compared with French prices. Spanish prices have recorded sustained growth of 8.7% in the past 12 months to Sept. 30, 2024, even though mortgage rates have remained comparatively high at 3.3%.

Chart 3

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Spanish households' lower levels of debt allowed them to handle higher financing rates by keeping their mortgage loan-to-values low, which protected their affordability. This enabled developers to maintain their profit margins by raising prices to offset rising costs.

Chart 5

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In France, high loan-to-values (LTVs) contributed to a decline in affordability for households, making it harder for them to cope with increasing interest rates. This led to a plunge in demand for new housing, resulting in sharper price corrections.

Additionally, the phasing out of the Pinel scheme--which provided fiscal support for buy-to-let investors--by the end of 2024 further reduced housing demand. The end of fiscal stimuli, along with uncertainty about new schemes, hurt French developers. As a result, they had to rely on institutional investors to absorb unsold properties, leading to price reductions of about 15%-20%.

Consequently, French developers have scaled back land acquisitions and new project launches to historic lows due to constrained demand from individuals, who are facing affordability issues, and elevated costs for developers.

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Chart 9

Supply-Side Shock Inflames Costs

The cost of building materials jumped in 2022, remaining 30% to 40% higher than in 2021 in both Spain and France. Russia's invasion of Ukraine by Russia in February 2022 led to a surge in energy prices, affecting energy-intensive materials such as cement, glass, tiles, and aluminum. Although energy prices have dropped since 2023, building material prices have stabilized rather than decreased.

In France and Spain, stricter environmental standards for building energy-efficient dwellings have increased costs. This is due to the use of less polluting materials such as wood, bi-sourced materials, or so-called low-carbon concrete, which often cost more. This trend has affected both countries, although to a lesser extent than Central and Eastern European countries.

French developers face lower profitability and efficiency due to high labor costs and a shortage of skilled construction workers. The unemployment rate fell to 7.3% in the second quarter of June 2024, from 10% in 2015. Despite this, turnover and talent scarcity persist, particularly for positions such as carpenters, machine operators, and building engineers. This can lead to delays, quality issues, and increased costs.

Additionally, the French minimum wage has risen by 15% from early 2021 to early 2024, further adding pressure to recruitment efforts. In contrast, Spain has a minimum wage that is 19% lower than France, which eases labor cost pressures for developers. Its unemployment rate stood at 11.7% in June 2024.

Land Availability, Cost Add To Pain Of Low Construction Starts

Land availability and cost are material factors for developers in both France and Spain, representing 20% to 30% of overall project expenses. Local planning regulations limit the use of undeveloped land, leading to higher prices for available land and preventing cost reductions. In France, obtaining building permits is challenging due to restrictive zoning laws, political agendas, and election cycles.

From January to July 2024, the number of residential building permits was for 14,704 units. This is 13% lower than the monthly average of 16,939 over the past four years and 24% lower than the average of the previous local political mandate (2014-2020). This has occurred at a time where pressure on new construction has never been so high, creating uncertainty for both buyers and developers. This uncertainty hinders project launches and raises concerns about potential changes in selling conditions.

Chart 10

In France, sales of newly built housing units have decreased in the past 24 months. However, institutional investors and government-related housing entities have helped by purchasing developers' inventory.

In contrast, Spain has maintained development activity due to strong demand. This has resulted in a low construction start rate in France, affecting future housing supply. French developers are more vulnerable as they historically have lower profit margins compared to their Spanish counterparts--typically 5%-7% versus 10%-15%--leaving less room to absorb cost increases.

Spanish developers have adeptly passed on costs to buyers, while French developers face hurdles due to lower affordability and high input costs. Overcoming these obstacles to ensure sustainable growth and stability is crucial to production volumes and the sector's capacity to contribute to resolving the housing demand-supply imbalance.

Writer: Lex Hall

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