In Tallinn, the capital of Estonia, the average price of dwellings was up 10.4% on the year ending in Q2 2011, to €1,033 per square metre (sq. m.) (up 4.9% inflation-adjusted), according to the Statistical Office of Estonia.

Nationally the average price of dwellings was up 10.6% to €703 per sq. m. during the year to end-Q2 2011. When adjusted for inflation, Estonian house prices rose by 5.2% over the same period.

It has been a rough ride. After amazing 37% annual house price rises from 2004 to 2006:

  • In 2007, the average price of dwellings dropped by 1.5% (-9.7% inflation-adjusted)
  • In 2008, house prices fell 18.3% (-24.5% inflation-adjusted)
  • In 2009, house prices dropped 30.5% (-29.1% inflation-adjusted)

After these 3 horrendous years, the house price recovery began in the second half of 2010, and during 2010 the average price of dwellings was up 4.1% (-1.1% inflation-adjusted).

Yet things seem to be moving. Some say construction of at least 10,000 new residential units in Tallinn could begin before the year ends. There were 2,245 dwelling permits granted in the year to Q3 2011, up 21% on last year, according to the Register of Construction Works. In Q1 2011, transactions in Estonia rose by 3% from a year earlier, though they were down 29% from the previous quarter. Why the poor quarterly data? Probably, increasing property prices were slowing buyers' decision-making processes.

But despite rising house prices, strengthening construction and transactions volumes, the travails of the eurozone could yet spook the market. Estonia joined the euro this year after many years of effort - only to find the club in disarray.

The great boom of 2000-2007

Estonia's housing market was in continuous boom from 2000 to 2007. Why?

  • low interest rates
  • low inflation
  • strong economic growth
  • rapid wage increases
  • huge foreign demand for property, especially from other Europeans

Demand for properties in Tallinn reached an all time high in 2006, with foreigners attracted by the city's potential. Tallinn accounted for more than half of all real estate transactions in Estonia.

House prices in Estonia rose by double-digit levels from 2000 to 2007. In Tallinn, the average price of 2 room flats rose by an average of 27% annually from 2001 to 2005. House price growth accelerated in 2006, with prices rising by more than 50% y-o-y.

The average price of 2-room flats in Tallinn rose by 448.7% from 2000 to 2007, in Tartu prices rose 431.5% and in Parnu 440%. Prices of three-room flats were equally impressive, rising 412% in Tallinn, 481% in Tartu, and 471.5% in Parnu.

Meanwhile owner-occupancy rates rose strongly, up from 85% in 2002, to 96% in 2004. The rental market shrank from 12% of households (with 9% privately renting and 3% in social rents) in 2002, to just 4% in 2004.

The house price falls in Estonia in 2008 were among the biggest in the world, rivaled only by Latvia. These falls were in sharp contrast to enormous annual price increases in the past, peaking at an annual price increase of 77.5% during the year to end-Q1 2006.

The fastest mortgage market expansion in history?

The house price boom was supported by a massive expansion of the mortgage market, growing by an average of 62% yearly from 2002 to 2006.

Outstanding housing loans grew from 4.7% of GDP in 2000, to 37% in 2007 (from EEK4.5 billion (€286 million) in 2000 to EEK88 (€5.6) billion in 2007 and EEK 97 (€6.2) billion in 2008).

The mortgage market boom was pushed by:

  • the favorable macroeconomic environment
  • financial market reforms
  • the entry of foreign banks and lower interest rates

At the peak of the boom, banks were willing to provide loans with a maximum lending period of 30 years, and a loan-to-value ratio of 100%.

Interest rate conundrum

One of the factors that contributed to mortgage and house price boom was the pegging of the Estonian kroon to the deutschemark in 1992 and eventually to the euro in 2001. In June 2004, Estonia entered ERM 2 in preparation for the eventual adoption of the euro. Although the kroon is allowed to fluctuate within a 15% band, Estonia preferred a peg of EEK 15.6466 per euro. This led to lower inflation and lower interest rates.

Mortgage interest rates fell from over 10% during the late-1990s, to below 4% between 2004 and 2006. Estonia managed to bring down inflation from 89% in 1992 to the single-digit level of 8.2% in 1998. Between 2002 and 2006, inflation was below 4.5% (an average of 3.3%).

As a consequence of the peg to the euro, interest rates in Estonia followed key rates set by the European Central Bank (ECB). Hence when the ECB began to raise key rates in mid-2005, mortgage rates also increased in Estonia. ECB base rates were gradually raised in 25 basis point steps, from 2% in October 2005 to 4% in May 2007, and again to 4.25% in July 2008.

Clearly these rates were lower than warranted by Estonia's inflation. Yet the monetary authorities have been relatively powerless because the kroon's peg to the euro means the central bank cannot raise interest rates further. Nevertheless there has been a divergence in mortgage rates between euro and kroon-denominated loans, with kroon-denominated mortgage rates rising above Euro rates.

Kroon-housing loan rate volatility

By November 2008, the interest rates for kroon denominated housing loans were at 7.37%, up from below 4% from July 2004 to April 2006. For euro denominated loans, housing loan rates rose to 6.27% in October 2008, from below 4% from November 2004 to May 2006.

These interest rate hikes proved too much for Estonia's housing market to bear and contributed to massive house price falls.

In an effort to ease the credit crunch and economic downturn, the ECB reduced key interest rates. It adjusted the key rate successively from 4.25% in September 2008 to 1% in May 2009, where the rate has remained until now. With this, the euro housing loan rate fell to 3.43% in February 2010.

Interest rates on kroon-denominated housing loans have been volatile since Q4 2008. For instance they fluctuated from 10.04% in October 2009, down to 5.89% in December, up again to 10.02% in January 2010 and down once more to 4.56% in February 2010.

Oversupply

After the break-up of the Soviet Union in 1991, housing construction in Estonia dramatically decelerated. From 1996 to 2001 less than 1,000 dwellings were added to the dwelling stock annually - not enough to meet demand. Most apartments were sold before completion.

In 2001, housing construction started accelerating. In 2007, around 7,200 units were added to the dwelling stock, up from 5,100 units in 2006. Developers have been mainly building suburban homes and luxury apartments, for middle to upper class Estonians seeking to upgrade from their Soviet-era block buildings.

The massive increase in dwelling completions combined with the mismatch between demand and supply led to oversupply, pushing house prices down. Despite the decline in construction activity in 2008 and 2009, the overhang remains, due to the decline in foreign demand.

Constrained rents and yields

The construction of new apartments exerted pressure on rents, which have risen only modestly compared to property prices.

From Q1-2003 to Q4-2007, the average rent for 2 room flats in Tallinn rose 34%, while the selling price rose by 179%. For 3 room apartments, the average rent rose by a mere 10.6%, while prices soared 203%.

Relatively, stagnant rents combined with rocketing prices have lowered rental yields. From around 20% at the beginning of the decade, gross rental yields are now down to around 3% -4% per annum in 2009, according to Global Property Guide research.

Rents can be expected to move ahead now that prices have stalled - because those who would previously have bought are now somewhat more likely to choose to rent. But this has not happened yet:

  • The average rent for 2-room apartments in Tallinn rose 8% in Q4 2009, compared with a 0.4% increase in prices.
  • The average rent for 3-room apartments rose 2.7%, while selling prices fell 0.86%.
  • However the average rent of 1-bedroom units (dwellings with a room and a kitchen) dropped 10.7%.

Economic recession

During the boom Estonia's economy grew at Asian rates, earning it the moniker The Baltic Tiger.

The real growth spurt began in 2000, with 9.6% GDP growth. From 2001 to 2006, Estonia's economy expanded by an average of 8.7% annually, including resounding 11.2% GDP growth in 2006 and 10.2% growth in 2005. In 2007, GDP growth was 7.1%, one of the highest economic growth rates in the EU.

GDP per capita increased from US$4,100 in 2000, to US$15,850 in 2007. Likewise, real wages rose by an average annual rate of 7.5% from 2001 to 2006. Unemployment fell from 13.6% in 2000 to just 4.7% in 2007.

The economy entered recession in Q3 2008 with GDP shrinking 3.3% from a year earlier (after a 1.1% y-o-y contraction to Q2 2008). GDP to 14.1% contraction in 2009. Real wages fell by 5% in 2009 while unemployment surged to 13.8%.

The recession is expected to ease in 2010 with GDP shrinking by 1%. Economic growth is expected to resume in 2011 with a 3% GDP increase. Nevertheless, unemployment is expected to rise to 15.5% in 2010 before easing to 14.7% in 2011.

Economic growth to slow in 2012

During the boom Estonia's economy grew at Asian rates, earning it the moniker The Baltic Tiger.

The real growth spurt began in 2000, with 9.6% GDP growth. From 2001 to 2006, Estonia's economy expanded by an average of 8.7% annually, including resounding 11.2% GDP growth in 2006 and 10.2% growth in 2005. In 2007, GDP growth was 7.1%, one of the highest economic growth rates in the EU.

GDP per capita increased from US$4,100 in 2000, to US$15,850 in 2007. Likewise, real wages rose by an average annual rate of 7.5% from 2001 to 2006. Unemployment fell from 13.6% in 2000 to just 4.7% in 2007.

The economy entered recession in Q3 2008 with GDP shrinking 3.3% from a year earlier (after a 1.1% y-o-y contraction to Q2 2008). GDP to 14.1% contraction in 2009. Real wages fell by 5% in 2009 while unemployment surged to 13.8%.

As the country fell deeper into recession, the government cut spending by about 7.8% in 2009. It kept its income tax rates low, but hiked VAT by 2% to 20% in July 2009. By 2010 Estonian unemployment had risen to 17.3%.

Because of prudent macroeconomic policies, the economy recovered in 2010 with GDP growth of 2.3% and a fiscal budget surplus. In January 2011, Estonia was the first country to join the Eurozone since the financial crisis.

Estonia registered an astounding growth of 7.7% in 2011, mainly due to strong exports. Unemployment fell to 12.5% over the same period.

The average monthly gross wages rose by 5.9% to €839 in 2011 from a year earlier, according to Statistics Estonia. In addition, real wages also showed a slight increase of 0.9% y-o-y in 2011, after declining by 4.9% in 2009 and 1.8% in 2010.

However, in the first quarter of 2012, annual real GDP growth decelerated to 3.6% from 4.5%, 8.5% and 8.4% in the previous three quarters, according to Statistics Estonia. The slower growth can be attributed to the ongoing eurozone debt crisis. However, unemployment fell to 10.8% in Q1 2012, from 13.6% during the same quarter the previous year.

This year, economic growth is expected to slow to 1.9%, according to Bank of Estonia.

In May 2012, Estonia had the highest inflation among the eurozone members at 4.1%, according to Eurostat. Inflation is projected to settle down to 3.9% by end-2012.

Global Property Guide