The Estonian Economy. Macro Research. Housing market risks diluted. Macro Research - The Estonian Economy. 8 July, 2016.

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1 Macro Research 8 July, The Estonian Economy Newsletter Housing market risks diluted The surge in supply has almost halted price growth Construction sector investments low Real estate prices relative to income stay below 12-year average Price it is all about demand and supply In the first quarter of, price growth of apartments in Estonia almost came to a halt due to increased supply. Even though 6, dwellings have been added in Tallinn in the last five years, the ratio of individuals per dwelling has been on the rise. In Tartu, the second-biggest city in Estonia, the situation is less tense. Price pressure has been fiercer in Tallinn and the difference between price per square meter in Tallinn and Tartu has increased from 5 to 35 euros. In the second quarter of, annual price growth accelerated to 1.8%, a notch up from first quarter result of.7%, but in general, the market has stabilised, whereas the median price has a clear trend downwards. Due to increased supply and sale adverts of newer dwellings, competition has pushed down the prices of newer apartments, making them more attractive. As interest rates are low and newer houses have lower maintenance costs, the extra a customer has to pay to cover the price difference with a loan has decreased to a marginal value. Low investments in the construction sector The drop in the prices of new apartments is good news for potential clients, whose income has grown substantially and now exceeds real estate price growth. Wages have grown in the construction sector as well. This, combined with lower sales prices, has hit investments of construction companies. Is the price of real estate too high? Apartment prices are closing in to the level of the real estate boom in nominal terms, they are only 12% lower on average. The situation is not even close to the conditions of the real estate boom when prices are compared to income. Prices relative to income have recovered from the bust that followed the boom and stay below the 12-year average level. In fact, they even dropped in the first quarter of. Whereas in the average worker needed to pay 2.5 times the average net salary to buy one square meter of apartment space, he/she now needs only 1.7 average net wages in a given region. We expect that this year the prices of real estate will stay relatively stable. Low interest rates continue to support demand for dwellings and lending growth. The amount of started construction projects should keep up the necessary supply of new dwellings. 18 Construction of dwellings, 2Q moving average Siim Isküll Economist , siim.iskull@swedbank.ee Construction permit Construction started Use permit July 8, Please see important disclosures at the end of this document Page 1 of 5

2 24 25 Housing markets risks diluted Last September, we wrote about housing market risks as the growth of dwelling prices was one of the fastest in Europe. We forecast that a surge in supply would ultimately slow price growth. It has been ten months since, and the annual price growth of apartments almost came to a halt in the beginning of this year. The current edition of Estonian Economy checks the pulse of the Estonian housing market. Price it is all about demand and supply The price growth of apartments in Estonia has almost come to a halt. In the second quarter of, annual average price growth in Estonia and Tallinn was 1. and 1.8% accordingly, a notch up from first quarter result of.7%. The growth of transactions has slowed as well, and the market in general has stabilised. On average, only 2% more deals were made in the second quarter than a year ago. Differences across regions are noticeable e.g. in Tartu, the second-biggest city in Estonia, price growth in the second quarter was. whereas in Pärnu. The price of a dwelling is ultimately determined by demand and supply. Construction statistics reveal that the number of issued use permits for dwellings in Estonia has been on an upward trend since. The last four quarters have brought nearly 4, new dwellings to the market, and at the moment there are about 2 dwelling development projects in the sales phase, nearly half of them in Tallinn alone. The increase on the supply side is clearly visible (see front-page graph) Apartment prices, EUR per m2 Estonia Tallinn Tartu Pärnu Source: Estonian Land Board Tallinn, dwellings by year of construction Before % % The demand for new dwellings is highest in and around bigger cities like Tallinn and Tartu. Tallinn makes up, by transactions, about 4 of the Estonian housing market.; therefore, it is a good proxy for assessing real estate developments in Estonia. According to the population/housing census and construction statistics, there are currently about 2, dwellings in Tallinn. Its population of 423, individuals puts, on average, 2.1 inhabitants into one dwelling. In, this figure stood at 2.7 inhabitants per dwelling. The growth in population more or less matches construction volumes, and the building of 6, dwellings during the last five years has been justified. In Tartu, the number of inhabitants per dwelling has, contrary to Tallinn, decreased from 2.2 in to 2.4. This difference is also being mirrored to prices. In the difference between price per square meter in Tallinn and Tartu was 5 euros whereas now it has reached 35 euros. The price pressure in Tartu has been less intense, partly because there is no such shortage of dwellings. About two-thirds of dwellings in Tallinn were built during the Soviet era, between 1961 and 199. The construction quality of these buildings is quite low, resulting in higher maintenance costs due to payments into renovation funds and lower energy efficiency. Combined with the low-interest-rate environment and rapidly increasing wages, this makes an increase in supply of new apartments understandable. July 8, Please see important disclosures at the end of this document Page 2 of 5

3 Tallinn, EUR/m 2 by construction year 7% 6% Tallinn, apartments for sale, % total stock % 1 5 3% 2% 1% 2.1% 1.6% 1.8% % 2. Source: Estonian Land Board , KV.ee Currently, about 3 of the apartments offered for sale in Tallinn were built after. That is about 6% of the total stock built after. Looking at the stock of Soviet-era apartments, only 1% are for sale. Therefore, the price competition is more fierce for newer apartments, and this is also reflected in price statistics by year of construction. The prices of newer apartements have decreased or been stable, whereas prices of older apartments have continued to grow. The gap between newer and Soviet-era apartments has decreased substantially during the last year. A newer apartment is only 2 more expensive than a Soviet-era apartment. In March of last year newer apartment was 43% more expensive. As newer apartments are more energy efficient and have lower maintenance costs, the increase in monthly cost that a consumer has to pay extra in order to cover the price difference with a loan and move into a newer apartment has been reduced to a marginal value. Low investments and profit in the construction sector The drop in the prices of new apartments is good news for the consumer, whose income has, in the meantime, grown substantially. In the first quarter of, annual gross wage growth reached 8.1%. Real estate price growth had been higher than wage growth for a long time, but in the last two quarters, wages have grown faster than real estate prices. This has made new apartments more affordable, and, so far, despite the drop in price, the construction companies have continued to keep up the supply. Wages have grown in the apartment-building construction sector as well. This has driven up labour cost, but the overall price index has even decreased a bit because the prices of building machinery and materials have dropped. This has contributed somewhat to lowering new apartment prices, but the profits and investments of construction companies in total (construction of buildings, civil engineering, and specialised construction activities) have taken a hit as well. Investments share in the profit of construction companies has fallen to a record-low level of 1.8%. 18 Construction price index, =1 2 Construction enterprises, % in turnover Total Building machinery Labour force Building materials Investments Labour cost Profit July 8, Please see important disclosures at the end of this document Page 3 of 5

4 The situation of construction companies does not differ much from other sectors that face the same problem of low investments and decreased profit. In the long run, more investment is needed, and, instead of cutting profits even further, there will be an increase in construction prices sooner or later, which will ultimately push up real estate prices. So far, competition on the market has favored the consumer. Is the price of real estate too high? Apartment prices are closing in to the level of the real estate boom in nominal terms. In Tartu, the average price per square meter is higher than in the peak of. In Estonia as a whole, Tallinn, and Pärnu, prices are still 12%,, and 31% lower than the peak, respectively. Comparing nominal prices can be misleading. In order to have a better overview, the price needs to be compared to income in a given region. During the peak of the real estate boom, 2.5 times the monthly salary was needed to buy one square meter of apartment space in Tallinn or Tartu. In, the same could be bought for just 1.2 monthly salaries. At the moment, relative prices are highest in Tartu, where an average employee needs 1.7 times the monthly salary to buy a square meter of apartment space. Considering the rapid increase in wages, the situation is not even close to the conditions of the real estate boom. Prices relative to income have recovered from the bust that followed the boom and stay below the 12-year average level (longest available time series). In fact, relative apartment prices even dropped in the first quarter of. 3 Apartment price relative to net wage 9 Housing loans % 7% % 3%.5 1 2% 1% -1 Estonia Tallinn Tartu Pärnu Source: Estonian Land Board, Statistics Estonia Annual growth (lhs) Source: Bankf of Estonia Interest rate (rhs) The stock of housing loans increased at the relatively modest pace of 4.2% in the first quarter of. This increase can be considered rather modest compared with annual growth of 5-8 during the boom years. The six-month Euribor, commonly used for mortgage interest rates in Estonia, has been negative since November of last year. Following the British referendum results, which have increased the uncertainty of the European economy even further, it is less likely that this rate will rise above zero any time soon. This year, the prices of real estate will stay relatively stable. Low interest rates continue to support lending growth, and the amount of started construction projects should keep up the necessary supply of new dwellings. Siim Isküll July 8, Please see important disclosures at the end of this document Page 4 of 5

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