How overvalued is the Spanish real estate market?
Several measures can be applied to reach a realistic appraisal, but the most telling is the rent-yield model. Suppose that you buy a property for €1,000,000. At a 5% risk-free rental you would expect a revenue of €50,000 euros per year plus a risk premium, so let’s say a rent of €60,000 per year, or €12,000 per month. However, a property costing €1,000,000 in Barcelona or Madrid is impossible to let out for more than €6,000 per month. According to this model the Spanish real estate market is overvalued by as much as 50%. The correct purchase price of the property should have been €500,000. Anything above that price is a discounted expectation of a future increase in value of the property.

Why is Spanish real estate significantly different from other countries?
There are three main peculiarities:

1. The national preference for ownership. Spaniards in general do not like being tenants; they feel a strong need to own their homes. Accordingly Spain has the highest home ownership rate in Europe.
2. The conservative tradition among wealthy Spaniards to invest not in the stock market but in “ladrillo” (bricks).
3. Real estate taxes and maintenance costs are among the lowest in Europe. This encourages investors to keep housing units empty, without tenants, which are to some extent seen as a problem due to Spain’s complex legal system.

These factors distort the rent-yield valuation and drive down the accepted yield for buy-to-let properties. Investors, until recently, became so convinced about the sustained rising value of property that very few have considered letting out.

Why did Spanish Real Estate values rise in such a spectacular way between 1999 and 2008?

1999 - 2004 Supply in the construction sector is inelastic in the short run. Building is a slow process, with barriers of municipal bureaucracy, especially in Spain. In 1999 a series of factors started to make a real impact on demand. D(1999) Immigration: approximately six million immigrants entered Spain between 1999 and 2007. Even if the vast majority of them didn´t initially buy properties, they contributed to the housing market by renting. The influx of wealthy northern Europeans attracted at the time by relatively low property values The low interest rates The starting up of low cost airlines The economic boom, and the interdependency of the boom in the construction sector and the general economy The influx of black money: the construction sector has always been a safe avenue for money laundering The divorce rate soared between 1999 and 2007, creating extra demand for housing for one of the ex-spouses The increased labour market for young workers made it possible for the under- 30s to leave the parental nest and buy their own apartments

2004 - 2007 From 2005 onwards the construction boom gained speed and the supply curve started moving to the right In 2007, the peak year, Spain built as many housing units as the UK, France, Italy and Germany together The banks granted mortgages whose monthly repayments amounted to 80% of the buying couple´s joint income. In other European countries the banking standard is to never give a mortgage representing more than 40% of the borrowers´ joint income. This lax mortgage approval pushed up demand even further

2007 - 2009 Sales started to slow  down seriously in 2007, due to over-supply and fear of higher interest rates In 2008 the banks practically stopped giving unsecured mortgages and the market ground to a halt. Prices stayed hard but few transactions were made Interest rates rose from 2.8% to 4%, making monthly repayments some hundred euros more expensive In 2009, prices are starting to tumble; published statistics tend not to faithfully reflect the real fall in prices, and the fall is accelerating

Several factors on the demand side converged over a few years, together creating a surplus demand that inevitably led to a phenomenal price increase.

1. The number one factor has undoubtedly been immigration: Spain received approximately five million immigrants between 1999 and 2007. If not for this major wave of immigration and its attendant higher birth rate, the Spanish population would have decreased to 38 million instead of growing to 46 million, where it stands today. Bear in mind that Spain in 1999 had the OECDs lowest birthrate, at 6.9 births per 1,000 inhabitants.
2. Immigrants started renting and buying in poorer areas, in housing estates around the big cities, thus affording the Spanish seller the opportunity to move to a more attractive area, where the seller there was also enabled to move up the property ladder. Thus, immigration created a rapid chain reaction within the housing market and an unprecedented boom for realtors. After the market crash in 2008, more than 70% of real estate agencies disappeared.
3. An unprecedented economic boom, largely fuelled by the construction sector, raised the spending power of millions of Spanish families, enabling them to buy new-build properties on the coast or a new apartment in town. The phenomenon of interdependence arose, whereby one sector fed the whole economy, and the economy was feeding only this sector.
4. With the currency change to the euro, Spanish mortgage rates were set by Euribor plus 0.3% . The record low interest rates in Europe from 2003 to 2005, which were set chiefly to reactivate the German economy, had a huge effect on the Spanish real estate market.
5. Banks did not properly inform borrowers about the possibilities of changing interest rates and changing economic conditions in general. They merely pointed out that the mortgage takers had to pay the current quota (principal plus interest), without informing them what the quota would be if interest rates doubled.
6. The banks granted mortgages for up to 80% of a couples joint disposal income. Comparable terms in Sweden are around 30%.
7. The influx of wealthy northern Europeans with deep pockets, who increasingly bought properties on the Costa Del Sol, and also became interested in Barcelona. According to a famous study made a few years ago in Germany, 10% of Germans would like to live in Spain if they had the means to do so.
8. Another new trend is that not only pensioners from abroad are coming to live in Spain. Professionals in their thirties and forties, many with families, decide to change their lifestyles largely due to the digital revolution. Skilled individuals can continue working in the same position at the same company doing the same job, but from Spain.
9. The low cost carriers have totally changed the economic reality for areas such as Tarragona and Girona, neighbouring low cost airline hubs.
10. Black money continues to be a very important factor in the Spanish economy in general and especially so in the construction sector. The facilities to launder money through investments in building projects are well known, and especially common in southern Spain.

Why didn’t constructors react more rapidly to satisfy the growing demand?
It wasnt until 2004 that construction picked up in a serious way. The bureaucratic process in Spain regarding building permits and land use reclassification is extremely slow.

How did the supply side react to absorb the new demand?
Until the boom, output had been approximately 400,000 housing units per year, sufficient to satisfy domestic demand during normal conditions. Between 1999 and 2007, around six million immigrants arrived and the Spanish economy was soaring. From 2004, housing production went up to 800,000 units per year. The record year was 2007, when over a million units were produced, at just the same time as the demand from immigration was dropping, the economic boom started showing worrying signs of slowdown and sales of new-build housing ground to a near standstill.

What is the current situation?
In December 2008, in the whole of Spain, only 165 new-build housing units had been initiated. The construction sector has collapsed. Spain’s unemployment rate is nearing 20% and will probably hit 25%.
In March 2009 there were 1.2 million unsold, newly constructed housing units. The bulk of transactions made at present are in distressed assets being sold to investors. Everybody else is waiting for the market to go down 30% or more. Which might happen, or might not. In any event, distressed stock will increase in value, and the banks will take over more and more of these assets.

Why hasnt the Spanish real estate market gone down farther than it has?
Prices are sticky downwards. Sellers have patience, regional mobility is low, and very many apartments are owned by wealthy Spaniards who are not particularly concerned if the market plunges.
For political reasons the Spanish government and its statistical institutions tried to hide the obvious crisis until after the general election in 2008.
The foreclosures departments of the banks try to avoid flooding the market with reclaimed apartments. The strategy is to convert unsold, newly constructed apartment complexes into rental, with very little success. The banks are afraid of a drastic and widespread slump in the market, something that would create “negative equity” for many of their clients, whose mortgages could typically be for 40% more than the underlying value of the property.