Algarve Property Market Outlook for 2016, and review of 2015

Algarve Property Market Outlook for 2016, and review of 2015Every year in December we reflect on the past year and provide an outlook for the property market in the year ahead, 2016. As expected, trading conditions for real estate have improved over the past 12 months.

Looking back we can say that the market bottomed out in 2013/2014. During this period transaction volume steadily increased but property prices remained weak for most of this period.

However by the end of 2014 we saw some price improvement which continued more broadly in 2015 making this the first time in 6 years that vendors started to benefit from the recovery too.

In addition the overhang of unsold, newly built properties is getting smaller by the month. Supply and demand is more balanced, however in some property/price categories supply is drying up fast. For instance, it is becoming very difficult to find villas with a pool below the Euro 300.000 threshold.

The construction of new properties is also picking up, albeit from a low base and includes previous approved developments which were put on ice due to the crisis but also complete renovations of old properties/ruins in town centres. This is a positive sign in light of a moderate economic recovery in Europe.

In Europe we are still very much at the beginning of a new credit cycle. When compared with the USA we are miles apart. Despite provisions for bad loans over the past years, European banks exposure is twice as big compared with banks in the USA according to figures recently released by the European Banking Authority. The figures show that approx. 6 % of European loan books are impaired, with only 3% in the USA.

However, some banks are better capitalised and are gaining market share in the Portuguese market for mortgages. The recovery in new mortgage origination by banks in Portugal confirms the beginning of this new credit cycle. There is a clear distinction in activity between the better capitalised banks versus the weaker ones. Actually, some banks have seen the volume of new mortgages in 2015 triple versus 2012 and are gaining market share. As a result interest rates have come down too. Only a year ago spreads were around 4% over Euribor, now they are down to between 1,5 and 2,5% depending on which financial institution you use to apply for a mortgage. This spread is to be added to the 3 or 6 month Euribor rates, which are currently in negative territory. This extraordinary situation is due to the quantitative easing (QE) program of the ECB. And there is more good news to come in 2016. We expect competition between banks to intensify leading to a further narrowing of spreads. To put this in perspective, before the start of the financial crisis banks were charging between 0.5 and 0.9% over Euribor.

As the Algarve is a melting pot of cultures and has always attracted buyers from all over the world, it is important to watch how other economies are performing when analyzing trends in property prices.

The big themes for 2016 that could have a negative impact on the property market are a slowdown of economic growth in Europe, deflation and the need for further strengthening of banks balance sheets. To start with the first, the recovery in economic activity has been very moderate and as such disappointing.

One would have expected a more robust economy after the great recession. The inflation outlook is weak, which is what the ECB is focussing on. The ECB is way off the 2% inflation target. The slowdown of global economic growth is not helping either and the ECB assessment is that there is risk to the downside.

Hence, it is well anticipated that the ECB at the next meeting in December will not only extend the length of the QE program but also the monthly volume in order to add further support to Europe's economy. The current program runs until September 2016 and is likely to be extended by another year. In other words, interest rates are staying low for longer.

QE and low interest rates have had an effect on the currency too. Of all major currencies, the Euro has been the weakest in 2015. This may well continue in 2016 as the world?s two big central banks are heading in opposite monetary policy directions.

In addition, the Euro zone GDP will start to benefit from the following tailwinds:

- Low energy prices
- Easing of credit conditions
- Weaker currency
- Fiscal policy

Fiscal policy is likely to turn stimulative in 2016 for the first time since 2010. There has already been slippage on government budgets in several countries including France, Italy, Spain and Portugal. With a left wing coalition now back in power ruling Portugal, the likelihood is that anti austerity measures are being reversed. Hopefully budget rules will be obeyed as fiscal recklessness was the root cause leading to Portugal's bailout.

Debt to GDP is still very high at 130%. When Portugal signed up for the bail out program, the Troika (ECB/IMF/European Commission) demanded structural reforms. However, little progress has been made on this front and the newly elected government is keen of undoing some. Portugal exited the 3 year bail out program in 2014 and is no longer required to negotiate with its lenders.

If economic growth is used as a measure of success, then Portugal underperformed when compared with Ireland (another bailout country) where in the first half of 2015 the economy grew by 7%. Expected GDP growth for 2015 and 2016 in Portugal is respectively 1,7% and 1,7%. For Ireland this is respectively 6% and 4,5% and for Spain these figures are expected to come in at 3,1% and 2,7%. Portugal's underperformance is nothing new. For decades it has not been able to reach it potential.

The issues hampering economic growth in 2015 are likely to be the same in 2016; a slow judicial system, inefficient public administration (e.g. hidden unemployment), restrictive labour regulations and a lack of competition in some sectors.

But the single biggest risk to the local economy and recovery in real estate is also the one that has brought more visitors to the Algarve. During 2015 there has been an increase of vacationers who would normally have gone elsewhere. Due to political instability and in some cases the risk of terrorist attacks they have chosen to spend their holiday in the Algarve.

Beauty is in the eye of the beholder, you have to be there to experience the beauty of the Algarve. Once here, some will consider purchasing a 2nd home or becoming a resident.

Programs like the Golden Visa and the NHR (Non-Habitual Resident) continue to be successful in attracting foreign buyers and we expect this to be no different in 2016. Especially the latter as more and more people from Northern Europe will learn about this program and the benefits. The NHR program is a scheme for individuals who have not been a resident in Portugal during the past 5 years.

Once an individual has been granted the NHR status, he or she will be exempt from income tax (work, royalties, pension, interest and dividend) for a period of 10 years. This program in combination with an undervalued property market is an attractive proposition for many foreigners who like to capitalize on a recovery in property prices while having a 10 year tax holiday. The market benefits more from this type of buyer versus flippers, as they have a strong incentive to hold on to their property during this 10 year period.

The local lodging legislation was changed at the end of 2014 which made investment in real estate more attractive, especially in a low interest rate environment. The new legislation requires owners who rent out their property on a short term basis to holidaymakers to register at the local tax department as a business activity.

The advantage of this so called simplified regime, is 85% of rental income is automatically considered as expenses. In other words, you are only taxed on 15% of your invoiced rental income. There is a flat tax rate of 25% percent, which results in a final rate of 3.75% of total rental income. This compares favourably with the tax rate on savings. Moreover, the rental returns also compare favourably with gross yields varying between 5 to 8 percent depending on the type of property, location and marketing.

To summarize, despite change in government and economical challenges we expect 2016 to be a good year for real estate. In 2015 property prices have increased on average by 5%. We anticipate a further recovery in property prices in 2016 and would not be surprised if by this time next year prices on average were to be 7 to 9 % higher. If correct, the market would still be approx. 30% below the previous high of 2008. Furthermore, we expect new construction to pick up steam in 2016.

Over the coming 12 months it is likely that the balance between supply and demand chances gradually in favour of vendors and thereby ending a buyers market which lasted for 6 years. As a result the new construction hitting the market can be easily absorbed. In addition, we believe banks will continue to strengthen their balance sheets in 2016 - something we always considered to be a process and not an event - which has already lead to a more liberal approach by better capitalised banks towards the issuance of new mortgages and a reduction in the spread.

There is a good chance for a further reduction in spread as competition between banks for customers will heat up. Foreign buyers of property in Portugal continue to enjoy a double whammy in 2016; a weak Euro and depressed property prices. In addition to this for some the icing on the cake is the Non Habitual Resident program. For those who consider the purchase of a property, it is not getting any better than this.

W: www.landandhousesalgarve.com