Investors in the property bonanza may have to find room for regret
08-04-2015
The housing market is unpredictable, but even more dramatic upheaval may be on the way, says Roger Bootle
Housing prices are unpredicatable at the best of times
Housing prices are unpredicatable at the best of times Photo: GETTY
By Roger Bootle
I am always reluctant to opine on house prices – they are extremely difficult to predict. Moreover, if you are the bearer of bad tidings, you tend to get a pretty rum response. In this regard, I have form. A decade or so ago, I predicted a 20pc drop in average house prices. By contrast, the market carried on rising and I “enjoyed” a response that was beyond rum. Yet although my timing was awry, the market did eventually drop by about 20pc, and by more in real terms. I know that I should be fearful, but it is time to peer over the parapet again.
After its drop, the market staged a remarkable recovery. Although the rate of increase of average house prices has fallen back from last year’s rate of 9pc-12pc, prices are still rising.
Moreover, most people expect them to carry on rising more or less indefinitely. Most people may be right. But I fear they might not be.
If you look at the percentage of a new mortgage borrower’s income spent on mortgage repayments – a measure often regarded as a gauge of “affordability” – you find that, on average, it is about 40pc, which is in line with the average experience since 1970. So no worries there. But hold on. Surely property should be reasonably “affordable” when official interest rates are at a record low of 0.5pc?
My favourite housing market indicator is the ratio of average house prices to average earnings, or HPE. Admittedly, this has been a pretty lousy forecaster of movements in house prices over the short run. But it is a good gauge of medium-term value. It is currently standing at 6.9, only slightly down from its record peak of 7.5. Its peak value in the previous house-price cycle was 5.5. The long-term average is 4.3. In London, things are even more striking – the HPE ratio has continued to rise sharply.
Of course, this indicator needs to be interpreted rather than just followed blindly. Several factors have probably raised the HPE ratio. The population has grown substantially, while the rate of new building has been low. Second, the multiple of a borrower’s income that banks will lend has risen substantially. Third, the rise of the buy-to-let sector has introduced umpteen owners who are not driven by the HPE ratio, but rather by prospective rates of return.
Mind you, on the other side of the demand and supply equation, the Government now seems to be serious about boosting housing supply.
The key question concerns what will happen when interest rates rise. Admittedly, I suspect that they will not rise until next year, and when they do, the pace of increase will probably be modest. But you should beware of placing too much store by this happy prospect. When rates first rise and people contemplate the prospect of continued rises for some time into the future, this will be in marked contrast with the past several years. Moreover, although most analysts are forecasting only a modest rise in rates, we should all be prepared for the unexpected.
Admittedly, some 85pc of recent mortgages have been at fixed rates. People taking out such mortgages will not feel the effects of higher interest rates for some time. The impact of this, however, will be to draw out the process over a number of years, rather than to reduce the required scale of adjustment.
Second, mortgage lenders are now forced to hold more capital against home-loan lending, and their lending practices are overseen and limited by the regulators. Accordingly, mortgage rates stand further above official interest rates than they used to. Given this wedge, it can be argued that official interest rates will not need to rise as far as they used to in order to deliver a given level of mortgage interest rates. Yet achieving a certain level of mortgage interest rates is not the only objective of monetary policy. It may well be that before too long the MPC will want to use interest rates to restrain the rate of inflation, whatever that implies for mortgage rates.
The residential property market often displays considerable momentum. Prices can carry on rising further than a reasonable assessment of economic fundamentals would suggest. This is partly because the market includes a strong element of speculation. Recently, Asian investors have been buying new apartments in London off-plan. Simultaneously, a good deal of property is kept empty, acting as a passive investment or a home for “funk money”. Meanwhile, it is common for single people and older couples to hang on to much more space than they “need” because property supposedly is a good investment.
Over and above this, the widespread expectation of future price increases leads to behaviour among ordinary market participants that, for a time, is self-fulfilling. How can young people manage to afford the apparently ridiculous prices for even the most modest accommodation in London? Of course, many can’t. But for those who can, frequently the answer is that they receive support from the Bank of Mum and Dad. And that bank is one of the few financial institutions that is not regulated at all. Its directors are encouraged to behave this way because they think that Jack and Jill will never be able to afford to own a property unless they get on to the “ladder” very soon. And that makes their investment supposedly a one-way bet.
But believers in “ladders” should beware of snakes. It has frequently been argued that the extended period of ultra-low interest rates has created damaging distortions in the economy. The greatest of these distortions is likely to have been in the housing market.
Of course, we all have to live somewhere and owner-occupation carries special benefits, both pecuniary and emotional. Nevertheless, I suspect that, from a purely investment point of view, over the next few years, residential property is not going to be a good bet.
As interest rates rise, prices are going to come under pressure. If the rise in rates is modest and gradual, and it occurs against the backdrop of a strong economy, low unemployment, and rising incomes, then all this may mean simply a period of sogginess in the market.
But these happy preconditions may not be met. In that event, the market may suffer a more dramatic adjustment.
Roger Bootle is executive chairman of Capital Economics