An alternative view to the recent construction boom

Why are we seeing all this construction going on around us? A fair question to ask.

A popular reply would include a mix of finger pointing towards the Planning Authority for issuing building permits, the developers for building property, and ultimately the government for not stopping construction.

Beyond the rhetoric, there are numerous factors in play. One of them is the increase in the number of workers from outside Malta that contributed significantly to the demand for more dwellings. Another factor that added to the momentum is the schemes announced by the Government in recent years, including first-time buyers’ scheme and reduced stamp duty. The pre-COVID economic boom can be added to the list. But still, these do not explain the entire story.

An additional factor that rarely, if ever, gets mentioned is the role of interest rates. Interest rates are the rates at which money can be borrowed, or if viewed from a different angle, the opportunity costs of money. It’s the cost of ‘spending’ money. Thus, the higher the rate, the more money a borrower must pay back. Alternatively, the higher the rate of interest, the higher the opportunity cost of spending money, either in investment expenditure (irrespective of how one defines it) or consumption. It then follows that when the interest rate is lower, people are more likely to borrow money or spend what they have.

There is some evidence to suggest that when interest rates fall, the Maltese, in general, tend to turn to property as a store of value and a way of “making good use” of their savings. This largely stems from the widespread belief that real estate is as good as gold. This relationship emerges rather clearly from the Chart below.

When interest rates fall, Maltese tend to turn to property as a way of making good use of their savings.

The first years of 2000 were characterized by relatively high interest rates and relatively low increase in the supply of dwelling – around 4000 per year. Construction picked up significantly the closer we got to the euro changeover in 2008. One needs to remember that during that period, a lot of cash entered the system also thanks to schemes for registration and tax amnesty that allowed residents to repatriate funds placed offshore in contravention of the Exchange Control Act.

The negative relationship between the increase in dwellings / construction and interest rates seems to have re-established itself soon after the changeover with construction remaining subdue until 2014. Once the interest rates declined below 2% in 2016, the construction activity started to increase. The increase in dwelling units reached an all-time high during 2018 and 2019 with almost 13,000 new units added to the stock each year.

Still, interest rates do not tell the whole story. An additional factor in the attractiveness of putting money in the local real estate is the perceived lack of alternative investment opportunities. It is well known that there is a degree of reluctancy to explore investment opportunities outside Malta, mainly due to a combination of risk aversion and a lack of financial sophistication. Traditionally, investment outside the local markets was primarily in fixed income assets such as good quality corporate bonds.

A glance at the average yield on a good-quality corporate bond indicates that these declined from 8% in the early years of 2000 to around 3% in the last few years, as seen in the chart below. Such a drop rendered returns from the local rental market even more attractive. The latter very much alive driven mainly by non-Maltese joining the labour supply and short lets reflecting new trends such as AirBnB. In a way, real estate became increasingly viewed as a superior substitute to a fixed income asset (perpetual bond), with income from rent mirroring a coupon payment.

The marked activity in construction noticed over the last few years might well be the result of an environment of low-interest rates, low yields and high GDP growth. Out of three, two are completely exogenous.

Going forward, it is difficult to foresee how the market will develop over the next few years. It might be that the peak is already over. It would be also interesting to see how the market will react following the increase in supply of units and whether it will ‘re-adjust’ its attractiveness of real estate as an investment asset vis-à-vis interest rates and corporate yield.

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