The foundations of Spain's property market are looking increasingly shaky, and a sell-off in the sector just a few short weeks ago may well be a sign of more troubles ahead, analysts say. "The grounds for the panic were real enough and it will probably happen again, " said Charles Dumas, director of Lombard Street Research. "The Spanish housing market has had it." April's 3% slide in the top stock market index, the Ibex 35, was led by a sell-off in real estate companies, construction firms and mortgage lenders. The property sector bore the brunt of the declines. Real estate investment firms Grupo Inmocaraland Inmobiliaria Colonialboth fell more than 10% in a single day, as shares of Costa del Sol developer Astrocwere slammed by worries about valuation in a sector driven to record levels by deal speculation.

And a recovery remains elusive.

The property sector has lost about 8% since April as investors continue to fret about a glut in the supply of housing and rising European interest rates, while the Ibex 35 and construction sector have both gained about 2%. The banking sector remains flat.

Valuations high

Even after selling off in April, Spanish real estate stocks have risen by about 120% since January 2005, while the Ibex 35 index has climbed by around 60% in the same period. Shares in developer Grupo Inmocaral, which recently merged with Inmobiliaria Colonial to form one of Spain's biggest real estate companies with a market capitalization of more than 5.5 billion euros ($7.3 billion), rose more than 71% from a low of 2.53 euros in June last year. Larger peer Metrovacesa, which is valued at just over 8 billion euros ($10.6 billion), has seen its shares more than triple in value since 2002 to stand at just over 80 euros last week. Stock market valuations have risen as the Spanish economy has strengthened.

Spanish GDP grew by 3.9% in 2006, as house prices rose by 9.1%. The housing market accounted for about 10% of GDP in Spain that year, fueled by strong demand from investors both inside and outside Spain. The Organization for Economic Cooperation and Development said at the end of May that it's expecting Spanish GDP to grow by around 3.6% in 2007 and 2.7% in 2008. The OECD also said a sharp correction in the Spanish property market is the main risk to healthy economic growth as residential construction accounts for such a high share of GDP. "The Spanish housing sector is oversized, representing almost 10% of gross domestic product in 2006," economists at Goldman Sachs concurred in a recent note to clients.

Rates, demand pose risks

Interest rates also represent a great risk. The European Central Bank, which sets rates for the 13 countries that use the euro, including Spain, has raised rates eight times in 19 months to the current level of 4%. The tightenings have been in response to strengthening growth in the euro zone, mostly in Germany. The ECB recently intimated that it will probably continue to raise European rates this year, while investors have also recently stopped hoping for a rate cut in the U.S. Rates in Britain are also seen rising. Buyers around the globe, including those in Spain, are clearly watching these developments as they decide how much debt they can handle. Many property buyers have taken advantage of recent low rates to buy up assets, especially houses.

Demand is another potential minefield.

Construction rates in Spain are running at roughly 800,000 new homes a year, noted Lombard Street's Dumas, against demand for around 600,000 homes. That's more than the total number of homes constructed in Italy, France and Germany combined. "Spain has more homes per 1,000 head of population than any other country in Europe and they continue to add to it, resulting in record levels of household debt," said Dumas. Both houses and apartments are being built right across the country in urban and coastal regions to meet demand from inside and outside Spain. Apartments are being constructed in the cities for the local population and intra-country commuters, and on the southern coast for holiday makers, said Alexander Vaughn, a partner at Lucas Fox estate agency in Barcelona. Owners from outside Spain are from the U.K, and Ireland, as well as Northern Europe and the U.S.

IPOs shed light on sentiment

Just how investors are feeling about the sector can, perhaps, be seen in the performance of listings on the Madrid exchange. Property investment firm Realia Business, for example, was forced at the beginning of June to lower its initial public offer price to 6.50 euros a share vs. a previous range of 7.90 euros to 9.70 euros a share. The final price valued the company at around 1.8 billion euros. "The IPO has been launched just as the market is questioning how sustainable property-sector growth may be and how a soft landing may be managed," noted Javier Hombira, an analyst at Spain's Ahorro Corporacion Financiera in a note to clients. "This has resulted in a somewhat cool market reception for the IPO."

Hoping to avoid a slump

The best scenario for the Spanish housing market would be a continued, gentle softening. House price inflation peaked at almost 20% two years ago before moderating to growth of 7.2% in the first quartet of 2007. Analysts believe that if this trend continues, the market may avoid a sharp correction. "We expect (the housing market in Spain) to downsize gradually, dragging down GDP growth at the end of 2007 and into 2008," said the Goldman Sachs economists. Even if GDP does decline somewhat, it's still expected to rise by an average of 3.6% in 2007, which is "hardly a weak number," they added.

Observers also note marked differences within the Spanish property market itself, meaning slump in one area doesn't necessarily mean a total market. " Everyone tends to lump the Spanish property market together," said Lucas Fox's Vaughn. Although coastal areas in the south are having problems in terms of sales right now -- mainly due to oversupply - the same can't be said of Barcelona, which is the country's second-biggest city. 'The market is holding up well in Barcelona," Vaughn said, adding that prices are expected to rise by between 5% and 7% this year. Still, it's below the 10% rise in Barcelona property prices last year, and Vaughn concedes that the market has softened slightly. "In 2007, the market's not as fierce as it was. Properties may be taking a bit longer to sell," he said.

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