After almost three years of house price falls, the housing market in Lithuania is finally recovering. 
The apartment price index for five largest cities rose slightly by 0.1% in October 2011 on the same month last year, according to Ober Haus. However, when adjusted for inflation, house prices are still down by 4.4% over the same period.

In Vilnius, the capital city, property prices rose by 3% to €1,208 per sq. m., according to the preliminary figures from Lithuania’s registry office. On a quarterly basis, property prices fell by 0.8% in Q3 2011, after a 2.2% drop in the previous quarter.  House prices in Vilnius are still down  by 39.1% from the peak in December 2007.

On the other hand, property prices in all other cities (excluding Vilnius) rose by 6% y-o-y to Q3 2011. House prices dropped 2.9% q-o-q to Q3 2011.

After registering double-digit house price increases from 2003 to 2007, house prices started to decline in 2008 due to the global crisis.

• In 2008, house prices dropped by 15.2% (-21.8% inflation-adjusted)
• In 2009, house prices plunged by 26.8% (-27.7% inflation-adjusted)
• In 2010, house prices fell by 3% (-6.4% inflation-adjusted)

The average interest rate paid by households for a housing loan denominated in Lithuania litas (LTL) currently stands at 3.6%, down from 6.2% in March 2010. In mid-2011, the average interest rate on new mortgage loans was about 3.4%.

Lithuania’s property market is expected to continue recovering, fuelled by strong economic growth (with projected GDP growth rate of 6.2% in 2011).

Strong GDP growth, low unemployment for 2011

Lithuania’s economy expanded by 6.3% in the second quarter of 2011, fuelled by increased consumption and high foreign direct investments (FDIs).

In 2009, economy shrank by almost 15%, the worst recession in the EU, largely due to the bursting of the property bubble, higher tax rates, the end of cheap money and a huge contraction in exports. After growth of more than 7% annually from 2004 to 2006, GDP growth had reached 8.8% in 2007. In 2008, the economy began to slow, due to contagion from the global financial meltdown.

In 2010, the economy finally emerged from recession with GDP growth of 1.3%.  Now it is continuing to pick up momentum.  In 2011 Lithuania is expected to post GDP growth of 6.2%, according to the Bank of Lithuania.

From January-July 2011, exports rose 38.3% as compared with the corresponding period in 2010.  Foreign direct investment (FDI) increased more than 50% in the second quarter of 2011, compared to the same quarter last year. Specifically, 30 FDI projects were launched early this year, expected to generate LTL5.85 billion (€1.7 billion), according to the Ministry of the Economy of the Republic of Lithuania.  During the year to end-H1 2011, the accumulated FDI in Lithuania increased by 11.7% to LTL37 billion (€10.7 billion).

In September 2011, the annual inflation rate stood at 4.5%, up from 1.2% in 2010, 4.2% in 2009, and 11.1% in 2008.

Unemployment was 15.6% in Q2 2011, a sharp decline from 17.2% the previous quarter. Due to the global crisis, unemployment had risen to 17.8% in 2010, up from an average of 6% from 2005 to 2008.

The government exacerbated the budget crisis

The Lithuanian government compounded its difficulties by actually lowering its income tax rate in the middle of the crisis. Lithuania’s tax rate is now lower than Estonia’s 21% and Latvia’s 26%.

In the mid-1990s, like its Baltic neighbors, Lithuania implemented a flat-tax on personal income. The idea was that a simple and uniform tax is conducive to business and economic growth.

After achieving double-digit GDP growth rates, the flat tax was reduced from 33% to 27% in 2007, and 24% in 2008. Despite the ongoing crisis, in 2009 Lithuania pushed through with a final planned reduction of personal income tax to 15%.

The value-added tax (VAT) was raised to 21% (from 18%; the sale and lease of immovable properties remains VAT-exempt). Corporate taxes were reduced to 15%, down from the standard rate of 20%.

Tax-deductibility on housing loan interest payments was abolished in January 2009, adding to borrowers’ problems. As of early-2010, the mortgage market remained frozen.

Lithuania’s neighbours reacted differently to their budget crises. Estonia abandoned its earlier plan of lowering its flat tax to 18% after 2012 (from 21%) – having introduced a 26% flat tax in 1994, and reduced it gradually.

Similarly in January, Latvia raised its flat tax to 26%. Latvia had lowered its personal income tax rate to 23% in 2009, from 25%.

Large revenue shortfall

Lithuania’s sharp reduction in personal income tax rate was not sufficiently covered by tax increases elsewhere, such as the VAT, and standard corporate income tax was even lowered from 20% to 15%. Income tax collection is relatively stable in periods of economic crises, while VAT collection falls drastically during a crisis, as households and corporations reduce spending. The higher corporate income tax rate has been largely ineffective, since most companies are reporting losses.

Government income and wealth taxes fell in 2009 almost by half from LTL 10.4 billion (€3.016 billion) in 2008, to LTL 5.5 billion (€1.6 billion). Yet despite the VAT rate increase, VAT-type revenues fell from LTL8.7 billion (€2.5 billion) in 2008, to LTL6.6 billion (€1.9 billion) in 2009.

Total government revenues plunged 17%, while expenditure declined by a mere 4.6%. The revenues/expenditure mismatch pushed the budget deficit to 8.9% of GDP in 2009, from 3.3% in 2008, and 1% or less from 2005 to 2007.

Unless the government imposes higher or new taxes and/or reduces spending, the deficit is likely to exceed 9% in 2010 and 2011. The current deficit is way beyond the EU limit of 3.5% of GDP.

Dramatically higher unemployment

Unemployment rose to 15.6% in Q4 2009, and is expected to increase to 16.6% by end-2010, thus undoing the work of the boom years when Lithuania successfully reduced unemployment from 17.4% in 2001, to 4.3% in 2007.

The higher corporate income tax rate may have exacerbated the situation by forcing some companies to shut down.

On the other hand, nominal wages fell by 3% in 2009 while real wages fell by 2%, the first time since 2000. Real wages are expected to fall 6% in 2010 and 9% in 2011.

That crazy house price boom

The average price of old apartments in Central Vilnius rose 275% between 2002 and 2006:

• 2003: prices increased 28%
• 2004: prices increased 29%
• 2005: prices increased 45%
• 2006: prices increased 56%

The average price of newly constructed one-bedroom apartments in central Vilnius rose 162% from 2002 to 2006.

Booms in other cities, a nation mortgaged

Major price increases were also seen in other major cities. In Klaipeda, Lithuania’s third largest city and only seaport, the average price of one-room apartments rose 282% from LTL2,200 (€637) per sq. m. in 2003, to LTL9,000 (€2,607) per sq. m. at end-2007.

Mortgage debt rose from a mere 0.4% of GDP in 2000, to 19% of GDP in 2008, with about 80% of all purchases made with the aid of mortgages, and typically 95% of property value granted in loans.

Rental yields in Vilnius still very low

While prices tripled in Vilnius from 2002 to 2006, rents stayed mostly flat. From 2002 to 2007, the average rent for a one bedroom apartment rose by a mere 18% while the average apartment sale price soared by 197% (from € 1,217 per sq. m. to €3,623).

Despite the crash in prices, rental yields are still low. In August 2009, luxury apartments in Vilnius yielded 4.44% on average, according to the Global Property Guide. Smaller units (30 sq. m.) achieved higher yields at around 6.3%, while slightly bigger units (90 – 200 sq. m.) had yields ranging from 3.8% to 4%. In contrast in 2002, Vilnius yields typically ranged from 8% to 10%.

Interest rates and currency risk

Recently, interest rates on Lithuania litas (LTL) housing loans have increasingly reflected worries about currency risk.

From 2005 to mid-2007, there was not much difference between interest rates on new housing loans whether denominated in litas or in euro. The divergence widened in January 2009 and from mid-2009 they seemed to follow different paths. Interest rates on litas-denominated new housing loans surged to around 10% from April to October 2009, before falling to 6.2% in March 2010, while interest rates on euro-denominated housing loans simply followed the key ECB rate downward.

The litas-dollar peg lasted from 1994 to January 2002 (US$ 1 = LTL4), and from 1999 to 2001, average housing loan rates fluctuated from 8% to 14%. In February 2002 the litas was re-pegged to the euro at €1 = LTL3.4528. Housing loan interest rates declined to less than 6% in 2002, and to less than 4% between July 2005 and May 2006.

The interest rate hikes of 2006-2009 had disastrous effects, as almost all new loans approved between 2004 and Q3 2006 had an initial rate fixation (IRF) of less than one year.

As well as causing distress to borrowers, the interest rate hikes caused the market to shift to Euro. In 2006, only 44% of new loans were denominated in Euro, but from 2009 to Q1 2010, the ratio of Euro-denominated loans rose to around 80% to 90% of new loans. If the litas does disconnect from the euro, the consequences for borrowers would be disastrous.

Deflation takes hold

Similar to other countries with currencies pegged to the euro, Lithuania has surrendered its ability to raise interest rates to control inflation. To be able to maintain the peg, interest rate movements set by the European Central Bank are mirrored in Lithuania.

From 1999 to 2003, consumer prices in Lithuania barely increased, with average annual inflation of only 0.38%. Inflation then accelerated, reaching 11.1% in 2007, the highest level in a decade.

In November 2007, the government passed the Fiscal Discipline Law which mandating that starting 2008, the annual fiscal deficit cannot exceed 0.5% of GDP. However, the deficit still reached 3.3% of GDP in 2008.

The sharp economic contraction in 2009 pushed down inflation to 4.2%. Lithuania is expected to experience deflation of 1% in 2010 and 2011.

The government plans to keep the deficit back to 3% of GDP by 2012, a highly ambitious plan.

Half-completed buildings everywhere

During the 1980s, when the country was still under socialism, more than 20,000 dwelling units were constructed annually.

Completions dropped to less than 5,000 annually between 1998 and 2003, leaving a huge, pent-up demand.

As the economy gathered steam, housing construction accelerated:

• In 2004-2006 dwellings completions rose to an average of 6,700 yearly
• In 2007, there were 9,286 completed dwellings
• In 2008 dwelling completions rose to 11,286, the highest since 1992
• In 2009, completions dropped to 9,400 units due to the economic crisis.

In 2009, completions dropped to 9,400 units, due to the economic crisis.

The number of unfinished dwelling units is alarming. From 2005 to 2008, 15,000 dwellings were authorized annually - around three times the number of completions. While some authorized dwellings may never have gone beyond the drawing board, the amount of ongoing construction in Lithuania, especially Vilnius, suggests that many are still being built – but are not yet finished.

The drop in construction activity was also reflected in the drop in the number of dwellings authorized; from 19,229 units in 2007 to 15,928 in 2008 and 7,553 in 2009. The number of dwellings completed and authorized is expected to fall further in 2010.