House price rises halt as Denmark’s economic recovery falters

 Denmark annual house price change graph

Strong house price increases in Denmark in early 2010 were not sustained in the second half. Weaker economic growth, combined with banking sector problems, hit the housing market.

After rising by an average of 2.6% every quarter between Q4 2009 and Q2 2010, the average price of owner-occupied flats in Denmark fell 1.4% during Q3 2010. Nevertheless, the average owner-occupied flat price was still 6.6% higher than a year earlier, according to the Realkreditrådet (Association of Danish Mortgage Banks), at DKK18,404 per sq. m. (€2,468 per sq. m.).

In Copenhagen, the average price of owner-occupied flats was DKK23,190 (€3,110) per sq. m. in Q3 2010, up by 12.3% from a year earlier, but virtually unchanged (-0.9%) on the previous quarter. During each of the past three quarters, the price of flats in Copenhagen rose by an average of 4.25% quarterly. 

The average price of single-family houses in Denmark was DKK11,989 (€1,608) per sq. m., up by 3.4% from last year, but 0.4% down on the previous quarter.

Movements in the housing market generally mirror the overall economy. Denmark’s overall GDP growth for 2010 was around 1.9%.   GDP growth slowed to 1% annualized in Q3, and though official Q4 figures are not available, growth is expected to slow to less than 1% in the final quarter.

Problems in the banking system led to the lowest net mortgage lending in 10 years, according to the Realkreditrådet.  On February 6, 2011, Amagerbanken became the latest bank to collapse, due to losses from high-risk in the real estate loans, aggravated by the financial crisis and currency speculation.  It was Denmark’s eighth largest bank in terms of deposits and lending.

Since the onset of the global financial crisis in 2008, 11 financial institutions in Denmark have failed and been placed under government receivership. Net lending has been trending down since 2007.  In October last year, blanket guarantees on senior debt and deposits expired. 

Nevertheless, the overall financial system remains stable, according to the central bank.

“The Danish financial sector as a whole is assessed to have sufficient capital and liquidity to meet the outlook for the Danish economy” said Nils Bernstein, governor of Danmarks Nationalbank. 

End of a house-price cycle

Denmark Owner occupied House Prices graph

Denmark has experienced three house price cycles during the past three decades:

  • The first cycle began in 1972. Though house prices slightly dropped after the 1973 oil price crisis, they recovered immediately and continued rising until 1979. From 1972 to 1979 nominal house prices rose by 96%. Finally, the second oil price crisis struck in 1979, leading to an 11.3% fall in house prices between 1979 and 1982.
  • The market recovered in 1982. Prices rose by 88% between 1982 and 1986. From 1986 to 1993, the housing market stagnated with property prices falling by 20% (33% in real terms).
  • The latest cycle began in 1993 and prices peaked between 2006 and 2007. By end-2006, average prices of single-family and terrace houses and owner-occupied flats were almost 250% and 360%, respectively, higher than in 1993. Low interest rates, the introduction of new mortgage products combined with favorable economic growth pushed property prices up. Since the peak during Q3 2006, the price of owner-occupied flats has declined by 26.1% (-29.9% when adjusted for inflation). The national price of single-family and terrace houses peaked during Q3 2007, and has declined by 12.4% (-15.7% in real terms).

“Balanced” mortgage market

Denmark Outstanding Mortgage Credit Lending graph houses properties

The Danish mortgage market operates under a “balance principle.” Mortgage banks, the only financial institutions allowed to conduct mortgage loan and bond activities, are supervised by the Danish Financial Supervisory Authority (DFSA). They act as the direct link between borrowers and investors, and are specialized lenders by implementing all loan functions within the same bank. The DFSA strictly requires mortgage banks to hold at least an 8% capital base.

Before issuance of mortgage loans, banks adopt a strict and conservative approach in determining the value of the loan by assessing the borrower’s capability to service the loan and taking all possible risks in determining the amount of loan issued. This significantly reduces interest rate, foreign exchange, and prepayment risks.

Issued mortgage loans have a maximum loan to value (LTV) of 80% for residential properties. To fund the loan, banks issue mortgage bonds. The strict legal framework of the “balance principle” requires mortgage bonds to match the value and terms of the corresponding mortgage loan the bank is funding. The framework has provisions limiting the currency, interest, and liquidity risks of bonds.

Moody’s rates the bonds in the Aaa-Aa2 level, and in the history of the mortgage market, no default on bonds has occurred. Aside from the security of the bonds, they are attractive to domestic and foreign investors and hedge funds because of the low transaction costs and the high liquidity of the bonds. Nevertheless, investors still incur prepayment risks.

Mortgage banks are responsible for the collection of loan payments, as loans remain on banks’ balance sheets until their maturity. Thus, banks incur credit risks, if either the borrower defaults on the loan or the value of the property doesn’t match the outstanding amount of the loan. In the event that a borrower defaults on his loan, immediate foreclosure and forced sales of the property is implemented.

The strict regulations of the mortgage market limit the risks shared between bond-holders and mortgage institutions, create transparency, and offer investors security. This helps the continued growth of the mortgage market despite tough macroeconomic conditions.

The system has allowed the mortgage market to grow constantly bigger than the Danish economy, from 102% in 2004 to 120% in 2008.

Outstanding lending grew 7.6% in 2008, after growth of 11.7% in 2005, 10.2% in 2006, and 9.8% in 2007.

As of March 2009, total outstanding lending amounted to DKK2,201 (€295) billion, up 7.1% from a year earlier.

Flexible for borrowers

Denmark Mortgage Credit Institutes Lending by Type graph houses properties

The mortgage market issues loans to borrowers capable of servicing their loans. Borrowers are generally well-informed and critical because they base the type of loan they choose on the interest rate developments and use whichever payment option is financially beneficial.

The system offers borrowers flexibility in paying back loans. When interest rates increase, buyers can pay for the loan by buying the corresponding bonds trading at market price and delivering them to the mortgage banks. They can also refinance to another loan to pay for the existing loan, despite having longer pay terms. On the other hand, when interest rates fall, borrowers can refinance their fixed-rate mortgages (FRM) with adjustable-rate mortgages (ARM) and still earn capital gains.

A due on sale clause in a loan contract means that borrowers have to pay their loans in the event the property has to be sold. This clause isn’t attached in Danish mortgage loan contracts, as borrowers can transfer the remaining loan to the new owner, or can buy back the bonds. This is especially beneficial to borrowers who experience situations where house sales are involved.

This payment system discourages borrowers from defaulting their loans, as they remain liable for the payment of their loan if they default.

The market share of ARMs has risen quickly since 2000, especially during the period when interest rates were falling from 2003 to 2005. Only 9% of the total mortgage value was ARM in 2000, while 81% were FRMs. In 2006, the share of ARMs had risen to 52%, while the share of FRMs had shrunk to 44%.

When interest rates rose between January and October 2008, homeowners refinanced to pay their previous loans, reducing their remaining debt despite longer term payments. When interest rates began to drop in November, borrowers shifted to adjustable-rate mortgages (ARM). By end-2008, the FRM share further declined to 42%.

In 2009, homeowners are taking advantage by shifting from FRMs to ARMs. The first quarter saw more than 80% of homeowners who took new loans preferring ARMs over FRMs, according to a report by Morgenavisen Jyllands-Posten, a leading Danish newspaper. By the end of 2009, ARM share is expected to increase.

Falling new supply and sales

Denmark residential properties sold graph

Around 75% of all residential property sales in Denmark are one-family houses. Sales of one-family houses declined 12.2% in 2006, and 2.9% in 2007. Sales of owner-occupied flats, the second most sold residential property category, decreased 17.8% in 2006, and 16.4% in 2007.

With homeowners expecting the economic situation to worsen, disposable income is either being saved or used for increased consumption in other areas, according to Realkreditrådet.

Denmark dwellings completed graph residential houses properties

Residential completions dropped 15.8% in 2008 to 24,129 units, as finance providers were reluctant to finance residential projects, according to Sadolin and Albæk, a real estate consultancy firm.

Multi-dwelling house unit completions dropped most, falling by 35.9% from 2007, to 6,752.

Completions of detached and semi-detached houses declined by 4.8% and 7.6%, respectively, during the same period.

Denmark house construction permits graph properties

Issued construction permits declined in 2008 by 38% to 14,533, the lowest number of issued permits since 1996. Permits for multi-dwelling and semi-detached houses declined the most, declining by 54.4% and 52.1% respectively, while permits for detached houses declined by 30.6%.

Recession

Denmark mortgage and interest rates graph houses properties real estate

In 2008, Denmark became one of the first countries in Europe to formally enter recession. The economy contracted by 1.14% in 2008, a reversal from 1.65% GDP growth in 2007.

In March 2009, Denmark’s unemployment rate rose to 3.2%, with the total number of unemployed rising to 90,000. In February and March alone, almost 11,000 workers were laid off. The unemployment rate is expected to reach 4.5% in 2010.

The construction industry was specially severely affected, with a 225% rise in the number of unemployed construction workers, according to the Cartel of Unions in the Building, Construction, and Wood Sectors (BAT).

Denmark’s inflation rate increased to 3.4% in 2008, up from 1.7% in 2007. But the IMF expects deflation in 2009 and 2010.

Lower interest rates

Danish interest rates adjust when the European Central Bank (ECB) adjusts its interest rates to maintain Denmark’s fixed exchange rate policy with the euro. This prevents the depreciation of the Danish Kroner when the interest rates of the ECB adjust.

The official lending rate of Danmarks Nationalbank fell to 1.65% in May 2009, a decline of 385 percentage points since October 2008. The decline in interest rates is in response to the ECB further lowering its interest rates to 1%.

Mortgage rates generally move along the same direction as the interest rates of the Nationalbank. In March 2009, effective mortgage rates had fallen to 4.18%, from 6.76% in October 2008 - the lowest rates since March 2006.

Crippled, complex rental market

Denmark’s housing market is fundamentally distorted by misguided social policies. The private rental market is strongly pro-tenant (see Landlord and Tenant section). Rents are non-responsive to market forces because there are five different forms of rent control, depending upon the age of the building. Private sector rents are regulated based on historic costs, and there is a huge social rental sector.

The result has been to discourage the private rental sector. More than half (51%) of the 2.5 million households in 2008 are owner-occupied. The rental market comprises about 47% of the housing stock, while other categories comprise the remaining 2%.

Only rental dwellings constructed after 1991 are exempt from rent control (less than 1% of dwelling stock, or about 10,000 to 15,000 units). Approximately 60% of all private rented dwellings were built before 1940, and only about 11% were built after 1980. In fact, rather few new private rental dwellings are now being built.

Although there has been a slight decline in owner-occupancy in favor of social housing, this is due to the rise of single person households.

Owner-occupied dwellings, which cater mainly to families, receive generous benefits from the government. Aside from mortgage tax relief, house owners are also entitled to a standard deduction for home maintenance. About 21% of households in Denmark receive housing subsidies from the government, the highest rate in the EU.

One way to revive the housing market could be to deregulate the rental market. Rapid price increases in the past, combined with strict rent controls, have led to low rental yields in Denmark. Average rental yields in Copenhagen typically range from 4.2% to 5.5%, according to Global Property Guide research.

Soften the recession

To ease the effect of the recession on the financial sector, the Danish government has implemented two stimulus packages.

  • The October 2008 package guaranteed bank deposits and unsecured bank debts due to risky commercial loans, and created a fund to wind-up insolvent banks and to prevent more banks from declaring bankruptcy. Mortgage banks are specialized banks that do not take deposits, and thus, are not part of this package. The package mainly caters to savings banks.
  • The January 2009 package offered up to DKK 100 (€ 13.4) billion in loans to strengthen the capital base of financial institutions. Mortgage banks were included in this package despite raising their capital base. They can receive up to DKK 25 (€ 3.35) billion. The package aims to serve as a safety net to mortgage banks in the event capital injection is needed.

In March 2009, the Danish government secured majority support for tax reforms, raising top tax bracket threshold, and abolishing the middle income tax rate of 6%. This potentially boosts individuals’ disposable income.