Housing market is cooling down

For the third consecutive year, the annual house price change has been lower than the previous year. The price index for 13 main metropolitan areas in Italy rose by 6.3% (4.2% in real terms) in end-2006. This is lower than the 10.6% price increase in 2003, 8.7% in 2004 and 7.1% increase in 2005.

The housing market has been in an upswing since 1997, after a long period of recession in the mid 1990s. House prices have appreciated by 90% (57% in real terms) from 1998 to 2006.

The recent slowdown of house price growth is largely attributed to the increase in mortgage rates. Households are sensitive to minor changes in interest rates because about 87% of mortgage loans are floating or fixed for only one year; less than 10% are fixed for ten years or more. From its record low of 3.47% in September 2005, the mortgage interest rate for one year fixed loans rose up to 4.93% in Feb 2007.

The economic performance slightly improved in 2006 with 1.9% GDP growth, higher than the average rate of 0.7% from 2001 to 2005. The unemployment rate declined from 7.8% in 2005 to 6.9% in 2006. Real wages rose by 1.8%, after average 2.8% annual wage increases from 2001 to 2005.

Rent controls, tenancy restrictions

Italy's rental market has been rapidly shrinking. In 1993, 74% of all dwellings were owner-occupied. In 2003, 83% were owner occupied, the highest increase in owner-occupancy recorded within the European Union (EU). The proportion of rental dwellings has fallen from 25% in 1993, to 16% in 2003 (other forms of tenure comprise about one per cent).

The tax treatment of residential property biases the market towards ownership. There is mortgage interest relief and capital gains tax exemption and, in addition, imputed rental income is taxed using a very low value assessment.

Demographics also play a role. Most renters are young, single people, while older people are more likely to purchase their own house. Italy’s population is aging, and a typical homebuyer is in the 34-54 age-range.

Still unattractive

The 1998 rental law continues to make private renting unattractive. The standard contract enables free negotiation of the initial rent, but commits the landlord to a four-year contract and gives the tenant the option of a four-year extension. Rents can only be increased annually by 75% of the cost of living index; i.e. if the inflation is 2% then you can only increase your rent by 1.5%.

Though landlords try to incorporate expected inflation into initial rents, rents have failed to keep up with inflation since the mid-1990s.

While house prices have been growing at an average rate of 8.1% from 1999 to 2006, rents grew by an average of only 2.7% over the same period. In 2005, rents rose by only 2.4%, lower than the 2.8% increase in 2004.

With these restrictions, rental yields in Italy are generally low, at 3% to 5%. Apartments in the historical centre of Rome yield 3.7% - 5.3%, while similar apartments in Florence yield slightly higher returns, ranging from 4.8% - 5.8%.

Because of the restrictions on rent increases, most landlords prefer to ‘frontload’ the fixed rents of long rental contracts to take account anticipated future rent increases, inflation and capital value appreciation. Frontloading, in turn, artificially raises rents for new contracts. Due to the rental cost-push effect, households opt for owner-occupation given favorable conditions.

In conclusion, house prices will continue going up, but not as impressively as in the past few years. On the other hand, rents are structurally sticky. Unless the provisions in the Rental Act of 1998 are repealed, buy-to-let investment will not be a real option in Italy.