At some point there will be a reckoning on house prices
Supply and demand may rule the market but there are many classic signs of a speculative bubble
This week my attention turns to a subject that I always approach with trepidation – house prices.
I argued in 2003 that the housing market was becoming dangerously over-valued and that at some point average prices would fall by about 20pc. I made my prediction too early. Prices continued to rise. But by 2007 they had indeed started to fall. From peak to trough, national average prices fell by 20pc and they even fell sharply in prime central London.
I am returning to this subject now because both people actively in the market and economic policy-makers are concerned about the extent to which a new bubble could be developing.
If it is then, when it bursts, a new period of financial and economic instability could lie before us.
The initial danger is that, as interest rates go up, borrowers find that they cannot afford their mortgage payments. They would then cut their spending, leading to an economic downturn. Further effects would follow from the resulting damage to banks as many of their loans turned sour. And falling house prices would clobber wealth and confidence.
The indications as to whether or not this is a realistic danger now are mixed. On the consoling side, mortgage lending is low and average house prices are still below their previous peaks. Moreover, the proportion of first-time buyers’ incomes that they have to spend on mortgage payments is just below the long-term historical average, implying that mortgages are readily affordable.
True, prices in London are well above their previous peaks but London is a separate country – a combination of the world’s playground, work hub and bolthole. It dances to a different beat.
Yet this consoling picture starts to seem less convincing when you look more closely.
My favourite measure of long-term value, the ratio of average house prices to average incomes, is currently standing at about 6.3, below its recent peak of 7.5pc but still in line with the previous peak reached in the boom of 1989. The fact that prices are not yet back to the recent bubble’s peak is hardly reassuring.
The affordability measure is seriously flawed because it reflects the effects of interest rates. These are currently at all time lows. Even though, in my view, they are unlikely to rise very soon, at some not too distant point they will rise. A Bank Rate at 3pc would imply mortgage rates of 5pc. That would be devastating for many borrowers.
Furthermore, the proportion of income taken by mortgage payments for an initial borrower is not the same as the proportion taken by a mortgage over its lifetime.
In the bad old days, when they took out a mortgage, many people borrowed up to the hilt, confident that over time their incomes would rise sharply, in line with general inflation, while the mortgage payments would remain the same. Accordingly, however difficult things might be at the beginning, before long the burden would become easily bearable.
Not anymore. Because of low inflation, pay is not rising so fast and accordingly the burden of mortgage debt is not being eroded as quickly. So mortgage affordability at a given level for initial borrowers does not amount to the same thing that it used to.
The fact that property prices in the rest of the country have not increased as much as they have in London is not consoling. London prices usually lead. If the rest of the country is not yet in boom mode that may merely reflect the usual time lag.
Whenever I opine on this subject people write in to tell me that I do not understand: this is simply a matter of supply and demand. As an economist, of course, I have never thought of this. It is true that in a small island with limits on the availability of land for building and a growing population, property prices are bound to be relatively high and to rise over time.
But that does not justify the current real level of prices or the current rate of increase. Interestingly, over the past 15 years the rate of house-building has been above the rate of household formation.
Sharp changes in market prices are always caused by changes in demand. There are a number of indications that this is true now.
First, the ratio of rents to house prices is low. If there were an absolute housing shortage you would expect to see rents bid up along with house prices. Indeed, over the past 15 years, the ratio of average rents to average incomes has fallen sharply.
Meanwhile, since 1965, whereas house prices have risen more than 50 times, equity prices have risen by only 35 times.
If the explanation for the UK’s housing market strength is the UK’s own peculiar supply situation, how does this square with the fact that, as the IMF has recently warned, the same phenomenon has been witnessed across a range of countries, including Sweden, Canada, Australia and Belgium. The common feature all these countries share is very low interest rates. The particularly UK factor is the Government’s “Help to Buy” scheme.
The market has recently been showing many of the classic signs of a speculative bubble: middle-class parents saying that if they don’t help Johnny or Sarah to buy a flat then they will never be able to afford one: and people happy to leave property idle because “its value only ever goes up”.
I am waiting for one of my favourite stories to resurface, that is the Knightsbridge garage/cupboard/walk-in wardrobe going for £1m.
Meanwhile, because of the UK’s ludicrous system of taxation and the history of large gains on houses, millions of properties are under-occupied as people think that it suits best to hang on to as much property as possible.
The UK’s property market is an unmitigated disaster – born of misguided public policy, reinforced by the worst sort of short-term politics, of which “Help to Vote” is the most egregious recent example.
At some point soon there will have to be a reckoning. This is not to say that someone planning to buy a home to live in should desist. There are all sorts of pecuniary and non-
pecuniary advantages to owning your own home and there is more to life than money. But anyone who thinks that residential housing currently presents an attractive medium-term investment needs to have their head examined – and their finances.
