Wednesday, January 01, 2003
The peculiar problems of the UK housing market
Posted by David Smith at 08:42 PM
Category: David Smith' s magazine articles

In the spring of 1988 I was lunching with a very senior Treasury official. We had done a run around the houses when the time came to part. As we did so, he leaned towards me and said: “We’re a bit worried about house prices.”

He had good reason to worry. Interest rates had just been cut to 7.5 per cent and the chancellor had announced a clampdown on the so-called living in sin loophole for mortgage tax relief. Unmarried couples living together had been able to claim two sets of relief, giving them an advantage over their married counterparts. Nigel Lawson decided to close the loophole but gave people five months of grace before the shutters came down.

The result of low interest rates (7.5 per cent was low then) and the scramble to take advantage of the loophole was the final phase of the 1980s’ housing boom. House price inflation hit 35 per cent and, while many recognised price rises on that scale were unsustainable, few thought prices would actually fall. Property, it seemed, was safe, not least in comparison with the stock market, with the October 1987 crash fresh in the memory.

The unthinkable, of course, happened. Interest rates rose from 7.5 to 15 per cent. Housing boom turned to savage bust. House prices fell nationally for the first time in the post-war period. It took until the late 1990s until the legacy of the bust, widespread negative equity, was over.

So many fingers were burned that, while I got optimistic about house prices five or six years ago, I did not expect a return to that kind of boom for a generation. But here we are. House prices are rising by more than 30 per cent. Everybody agrees it is unsustainable. Few, however, think prices will crash. Are they right, or is history going to repeat itself?

Before answering that, it is worth a reminder that Britain’s housing experience is by no means typical. Figures from the Bank for International Settlements show, in real terms, UK house prices have risen by 50 per cent since 1995 and more than 100 per cent since 1970. House prices tend to rise in line with average earnings. Average earnings outstrip inflation. Therefore house prices rise in real terms. Other countries, such as the Netherlands and Ireland, have also followed this pattern, if anything with even more vigour.

Plenty of others, however, have not. France has seen house prices creep rather than leap higher. Prices have risen by about 20 per cent in real terms since 1995, and only by about 50 per cent since 1970. American house prices have only risen by 20 per cent in real terms in 30 years. In Germany and Switzerland prices are no higher in real terms than they were in 1970. In Italy, inflation-adjusted prices have been static in recent years.

Why the differences? Patterns of household formation differ widely. In many countries it is unusual for young people to leave the parental home before marriage. In others house purchase usually happens much later in life. Britain’s problem of scarce building land – house building is running at its lowest peacetime level since the 1920s – is not matched in all other countries. There are international differences in real income growth and attitudes to debt.

As an aside, the performance of the UK housing market, and its contrast with those elsewhere in Europe, is featuring quite prominently in the Treasury’s assessment of Gordon Brown’s five economic tests. On the face of it, Britain’s housing performance is a significant obstacle to membership.

The strength of Britain’s housing market is not all bad news. At a time of weak and volatile equity markets housing has been a source of rising personal sector wealth, without which consumer spending would have been a lot weaker.

It is also perfectly possible for high house price inflation to co-exist with low general inflation. Housing is a classic “swing” market where a small change in the balance between supply and demand can have a big impact on prices.

The other key point regards affordability. The house price-earnings ratio measures the relationship between house prices and average earnings. Over the long-term, it averages about 3.5. Currently it is well above that, over four times' earnings nationally, and decisively so in London, where the ratio is nearer six.

But the crude house price-earnings ratio does not take account of another important determinant of affordability, the level of mortgage rates. People have adjusted to the fact that we have moved into an era of permanently lower interest rates. For a given level of house prices, monthly mortgage payments are lower. There is a strong “gearing” case for higher house prices.

These were good arguments for not worrying unduly about the housing market, even when house price inflation went above 10 and then 20 per cent. There is, however, a limit and the recent acceleration in prices may have taken us to that limit. Over the summer the three-month annualised rise in prices hit 40%.

Ordinary home-buyers, as is their right, were responding to low interest rates. So were investment buyers, aiming at the rent-to-buy market. So were old-fashioned property speculators. The market, however, began to take on classic bubble characteristics, as in 1988. People became anxious to get in before prices rose further. That is dangerous.

Is it going to crash? As the Bank of England said recently, the longer this period of rapidly rising prices goes on, the greater the danger of a painful correction, including falling prices. This could happen, by the way, without a sharp rise in interest rates. As in all markets, sentiment can quickly turn. For housing, the lessons of history, and the warnings of the present, both argue for caution.

From Business Voice - December 2002/January 2003

Comments

Interesting comments and discussions on the UK housing market.
My recent analysis on the Swedish market for private homes
indicates similiar type of tendencies. House prices continue to rise.
The debt income ratio has risen by 6%-9% in Sweden due to the
low level of interst rates. But lets assume that interest rates start
rising both in the UK and Sweden. What will happen then?
This will lead to an increase in the usercost of housing. Lets
assume that unemplyment rises. If both interest rates and the
unemplyment rate would rise simultaneously this would result into a fall in the house prices. Is not the house price bubble on its way to bust. House price increases are not sustainable. What goes up comes down. It is just a matter of time.
See www.nier.se for my Working paper on the UK and Sweden.

Posted by: Bharat Barot at July 15, 2004 04:29 PM

Is there any published material available re: earlier house price bubbles and crashes?
How far back does such information go?
If you know - or could point me in the right direction - I would be very grateful.

Posted by: Kathy Watson at June 2, 2005 05:48 PM