Sunday, August 22, 2004
House prices: The props show signs of strain
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

Where there was a huge amount of heat, there is now a decisive chill. And where the authorities were once carrying a big stick, they are now proceeding with a feather duster.

I am referring to the housing market, the Bank of England’s abrupt change of tone on interest rates and the big question: is this the start of a controlled housing slowdown, or the beginning of the much-predicted (but not by me) crash? In the past few days we have had evidence of a price standstill from the Royal Institution of Chartered Surveyors, with a net 3% reporting higher prices in the latest three months, down from 45% in March.

It said prices were static in the Midlands and East Anglia, falling in some parts of southern England, and rising only moderately elsewhere, with the exception of northeast England and Scotland, where the last vestiges of the boom continued to ripple on.

Rightmove, the property website, said asking prices fell by an average of nearly £4,000, or 2%, between July 10 and August 14. It was not claiming the start of a crash, but said the slowdown was “as clear as daylight”. Even buy-to-let is slowing, according to the Council of Mortgage Lenders. Loans to landlords rose in the first half of the year but at a slower rate.

It should be said there were also figures suggesting that the market’s death is greatly exaggerated. Gross mortgage lending hit £29.2 billion, a record, last month. Mortgage approvals rose, but they are probably falling on a seasonally adjusted basis.

Perhaps the clearest signal of a change, however, came from the Bank of England. In June, Mervyn King was playing it tough, warning homebuyers to expect further increases in mortgage rates and to beware a house-price crash. This month the governor has put his name to an inflation forecast pointing to just one, or possibly two, further quarter-point rate rises.

Not only that, but the monetary policy committee (MPC), while stressing the “great uncertainties”, said a crash is “not the most likely outcome”. Its main worry, according to last week’s minutes of its August meeting, is that buy-to-let investors will pull out abruptly.

The Bank of England has good reason not to want a house-price crash. Enough people in the property business are already blaming the governor’s June warning for the recent slowdown. A King “bust” would not do the Bank’s reputation any good, not least down the road at the Treasury.

There is also a specific economic argument. A crash in house prices would require the Bank to lower interest rates. It would mean that, having worked hard to push rates back up towards a “neutral” level of 5% or so, the MPC would have to endure a further period with rates below neutral. That, in turn, might store up inflation problems for the future. Either way it would lead to an unstable economy.

So where do we go from here? The first thing is to appreciate the housing market’s overvaluation. The standard measure, the house price-earnings ratio, used by the Bank and just about everybody else since time immemorial, suggests a huge overvaluation. The ratio stands at about 5.8, compared with an average since 1982 of 3.8. You don’t need a pocket calculator to work out that prices are more than 50% overvalued on this measure.

The house price-earnings ratio suffers from data problems. Even if you accept that house prices (the Nationwide figures) are accurately measured, average earnings are probably not. The statisticians have grave doubts about the New Earnings Survey on which they are based.

What about charting house prices against a broader measure of income, gross domestic product per head? The results, set out in the chart, show that in the 1950s and 1960s house prices were rock steady at five times per capita GDP.
In the 1970s and 1980s the ratio rose as high at seven and never went lower than five. But the housing crash of the early 1990s, in which prices fell to four times per capita GDP gave us a housing market that, in relative terms, had never been cheaper. The ensuing recovery has to be set in that context.

The 50-year average for this ratio is about 5.5. Prices rose above that average at the end of 2001, but went decisively above it only last year. Now it stands at more than 7.5, implying an overvaluation of about 35%. Even allowing for structural changes (low inflation and interest rates, a more competitive mortgage market and lack of housing supply), the overvaluation is a good 20%. That’s roughly the rise in house prices over the past year.

I also like another measure of house values. The two most important purchases we make are houses and cars. So what has happened to the ratio of house to car prices?

In 1957 the average house cost 4.5 times as much as a standard £444 Ford Popular. The ratio remained at between four and five through the Ford Cortinas of the 1960s before jumping to more than eight in 1973. But by the late 1970s it had returned to earth, the average house costing five times as much as a Mark IV Cortina. It rose again during the 1980s, although not spectacularly, the average house costing just over six times as much as a Ford Sierra in 1988.

Lately, however, there have been big changes. In 1998 the average house cost 4.2 times the price of a Ford Mondeo. Since then car prices have fallen and house prices have soared. The average house now costs 10.1 times the list price of a Mondeo LX. Purists would say this is comparing apples (housing is an asset) and pears (cars are consumption goods), but it impresses me.

Housing is clearly overvalued. How does it come down again? The debate is between the crash school and those who foresee years of soggy stagnation for the housing market.

I’m in the soggy camp, mainly because I don’t see the triggers for a crash: a sharp rise in interest rates or a dive into recession. But something has to give and may already be doing so. The soggy period is under way — I hope so, at least.

PS: Gordon Brown won’t go away, or at least the saga over whether he has been a good chancellor won’t. Those who have followed the tale will recall that I ranked him second (to Sir Geoffrey Howe) among the 20 holders of the office since 1945. That produced two kinds of backlash: one from businessmen complaining they were being strangled by the red tape introduced under Brown’s watch, and the second from stock-market investors, moaning about the dismal performance of shares since 1997.

I took up the latter theme on August 1 (“Stock market investors in a mood of Brown despair”) and concluded that the critics had a point. While share prices in Britain are down on their May 1, 1997 level, those in our major competitors are up, in some cases substantially so.

Now, however, there has been a backlash against the backlash. Alan Davies, former chief economist at Barclays, said I failed to take account of dividends, and hence total stock-market returns.

British firms are often accused of over-distributing profits to investors. If so, the picture may not be as bad as painted. A fair point, though Barclays’ own equity-gilt study suggests that real (after-inflation) UK equity returns from end-1996 to end-2003 averaged 1.6% a year, well below the 5.3% in America.

Harvey Cole, an economics consultant, suggests that the apparent superior performance of the stock market during the Tory years owed much to the flattering effects of inflation. Between 1979 and 1997, he notes, the FTSE 100 went up 7.5 times and the Dow 12 times, and this when inflation here was considerably higher than in America. I can’t argue with that. The aim was to introduce a caveat or two about Brown — not to praise the Tories

From The Sunday Times, August 22 2004