While Greeks are preoccupied with the so-called bond scandal, involving the purchases of government bonds by social security funds at inflated prices, the European Central Bank (ECB) is preparing to notch its intervention interest rate up to 4.0 percent in early June, reaching a level regarded by some as crucial for the Greek real estate market, an important segment of the local economy. If pundits are right, the ECB is not going to stop its campaign of normalizing its key interest rate at 4.0 percent but will proceed with one or more hikes by the end of the year. Some forecasters even see the official interest rate going up to 4.75 percent in the first half of 2008 from 3.75 percent at present and 2.0 percent at the end of November 2005. This policy of interest rate hikes reflects the strength of the eurozone economy on the back of an upbeat Germany and aims at ensuring price stability by avoiding overheating. The normalization of euro interest rates may make sense, especially in relatively high-inflation countries of the eurozone such as Greece and Spain but may spell trouble for one of the pillars of economic growth in the last decade or so, namely the residential real estate market. Due to a rise in disposable income, the lowest real interest rates in generations, favorable demographics and a change in the housing preferences of many Greeks, the local real estate industry has flourished during this period. Although there are no official statistics, the local residential market is widely thought to account for more than 80 percent of the entire real estate industry, with the rest split between office, retail, shopping centers, logistics, hotel and other sectors. The value of residential real estate property held by households is estimated at more than 1.0 trillion euro, comprising the biggest portion of Greek household wealth by far. This illustrates the importance of the sector to the Greek economy. According to National Bank of Greece estimates, investments in residential real estate, along with its impact on consumption through the wealth effect, added about 1.3 percentage points to annual gross domestic product (GDP) during 2000-2005. However, signs of cooling in the vibrant residential sector are already apparent. House price inflation fell to single digits in 2006 after registering double-digit growth the previous year. The real estate market boomed at the end of the last decade with house prices more than doubling by end 2003. House price inflation decelerated in 2004 before picking up again in 2005. Buyers rushed to purchase property or get building permits in the last quarter of 2005 to avoid paying additional taxes from 2006 onward, following the announcement of gradual increases in the presumptive value of properties on which taxes are calculated and the introduction of VAT on new buildings. By all accounts, house prices in general appear to have stabilized in the first four months of the year and may even have declined slightly in the case of large apartments in prime areas such as the northern suburbs of Athens. The optimists argue this is just a brief stop for the industry after years of extraordinary growth. They contend that supportive factors will once again reassert themselves, leading the market higher. These factors are Greece’s projected rise in GDP growth rates by 3.5 percent or better in the next two to three years, paving the way for an increase in disposable income. The limited supply of suitable land in several large cities, the influx of immigrants, albeit slower than in the past, and the increase in the number of Greek households despite the continuous decrease in the average household size which is now approaching the EU average of 2.2 persons, has also provided support to the residential property market. Larger apartments In addition, more and more Greek households are seeking new, larger apartments in better areas. This reflects the fact that a good portion of the Greek housing stock is old compared to the EU average. Moreover, there has been a pick-up in demand for second homes from Greeks and foreigners alike. Nevertheless, the most important factor in the strong, double-digit growth in mortgage loans since the late 1990s was been the liberalization of the mortgage loan market in 1994 and the sharp reduction in lending rates. This became more obvious after Greece’s entry to the eurozone in 2001 and the easing of the ECB’s monetary policy. Mortgage loans have been growing annually by about 30 percent on average since the mid-1990s, helping underpin demand in the residential market. This is to be expected given the fact that Greek households were not leveraged. Although the Greek mortgage-to-GDP ratio still lags behind the eurozone average, it is much higher than in the past and, even more importantly, it is largely made up of floating rate mortgage loans. Greece’s proportion of variable rate mortgages to the total exceeds 90 percent, followed in the EU by Finland, Luxembourg, Spain and Ireland. Moreover, real mortgage lending rates are positive now, standing at about 1.0 percentage point and are bound to go higher as the ECB keeps raising its interest rates. Real mortgage rates, that is the difference between the nominal loan rate minus inflation, have been negative in the last few years. Although the compression of the interest rate spread has absorbed part of past ECB rate hikes on the heels of bank competition for new clients, banks usually charge the ECB rate or the three-month Euribor rate plus a spread. This is not expected to continue as spreads on new mortgage loans have reached the average eurozone levels. So, Greek households can no longer expect much comfort from this source any longer. Extending the life of the loan could be an alternative and already the average life of new mortgage loans exceeds the 20-year mark according to bankers and real estate brokers. Even so, the prospect of stabilization of the Greek residential real estate industry is likely in the next 12 months or so as the ECB hikes rates to 4.5 or 4.75 percent and the higher lending rates start to bite. Although this is not the end of the world, it is clearly not a welcome development for the local economy.