January 2, 2008
The coming decline in UK house prices: how large and how helpful?
How stretched is the UK housing market? Given how long UK house prices, especially those in London, have defied both gravity and conventional models of valuation, a confident answer to that question is hardly possible. A look at a couple of the conventional “affordability” measures suggests, however, that – in MPC speak – “the balance of risk to house prices is skewed to the downside”. In English, house prices are more likely to fall sharply than to rise steeply.
Exhibit 1 is a measure of average UK house prices to average earnings. The specific measure is Nationwide’s ‘First time buyer gross house price to (annual) earnings ratio’. As shown in Chart 1, the current value of this ratio, 5.3, is the highest since 1983 (in fact since records began), easily exceeding the 3.9 reached during the previous housing bubble in Q2 1989. The average value over the period shown in the Chart 1 is 3.2. If we fit a simple linear trend over the period, the most recent value of the (rising) trend line would be just under 4.0.
Chart 1
Source: Nationwide
There is no logical reason for the house price to earnings ratio to revert to either its historical average value or to its trend value. Even if we believed that a reversal to trend, say, were inevitable, this would not tell us whether this would happen through a decline in house prices, through a rise in earnings or possibly even through a further increase in house prices swamped by an explosion in earnings growth. Earnings growth has been much more stable, however, than house price inflation. So let’s assume earnings will continue to grow at, say, 4.5 percent per annum. To restore the house-price to earnings ratio to its historical average of 3.2 over a two-year period would require almost a almost 19 percent annual decline in house prices (for each of these two years). If the restoration of the historical average ratio were to take three years, the annual rate of decline of house prices would be just under 12 percent.
If the house price to earnings ratio reverted not to its historical average but to its 2007 Q2 trend value of 4.0, the annual rate of decline of house prices would be around nine percent if the 4.0 value for the ratio were to be reached in two years, and about five percent if it were to take three years.
Of course these are just ‘what if’ calculations, but these and similar, more detailed numerical simulations do cause me as someone who is ‘long housing’ (that is, someone who owns a house whose value is greater than the present discounted value of the future housing services I plan to consume) to sit up and take notice.
A similar worrying story (for home owners) is told by Exhibit 2, shown in Chart 2 below. This plots Nationwide’s First Time Buyer Affordability Index, mortgage payments as a percentage of take home pay since 1983. This index peaked in 1989 Q2 at 147.6 percent. Its current value, 133.4 percent is still some way below the all-time high, but well above the average for the period of 85.2 percent. While the Official Policy rate set by the MPC is now coming down, and could end up quite a bit lower than its current 5.5% value (say around 4.5% a year from now), the cost of mortgage borrowing is unlikely to come down much, if at all, even for those who meet the much stricter eligibility requirements imposed in the wake of the 2007 financial crises. There won’t be much aggressive mortgage borrowing or lending any time soon to prop up the UK housing market.
Chart 2
Source: Nationwide
All this affordability analysis is, of course, rather woolly stuff that an economist approaching housing valuation using a conventional finance approach would not deign to touch. A finance perspective sees the value of a house as the present discounted value of current and future rental earnings, actual or imputed, derived from the ownership of the house. With a bit of hand waving, this produces the following expression for the ratio of the current house price to the current rentals (actual or imputed) from housing:
where p is the current house price – rental ratio, r is the long-run risk-free interest rate, ? is the long-run average risk premium on housing equity and g is the long-run expected growth rate of housing rentals. Finally, b is the value of the housing bubble (if there is one). The first term on the right-hand-side is therefore the ‘fundamental value’ of the price-to-rental ratio.
Market measures of the long-term risk-free real rate of interest for the UK continue to be ludicrously low, partly because of continuing anomalies in the demand for long-dated index-linked gilts by pension funds and partly because of the inexplicable failure of the UK authorities (and other public agencies) to issue more of the stuff. There can be little doubt, however, that the real risk-free rate is rising globally and also in the UK. The decline in the real long-term risk-free rate of the early years of this century no doubt accounted for part of the increase in the fundamental value of UK property. That process is now in the process of being reversed.
It is hard to tell a convincing empirical story about the fundamental determinants of the housing equity risk premium, and I will not try to do so here. The future expected growth of actual or imputed rental income from housing therefore must carry quite a bit of the weight in any rationalisation in terms of fundamentals of the past and present strength of UK house prices. A limited supply of new residential housing (due in part to planning and zoning restrictions) other than in parts of the buy-to-let market and, in comparison with much of continental Europe, relatively housing-friendly demographics, were sources of housing price strength. With suitable land in highly inelastic supply and real incomes rising, rents could well grow faster than earnings almost indefinitely. The fact that London is the favourite pied-a-terre for every nouveau riche and ancien riche alike, has influenced house prices well beyond the rarified quarters where the owners of the mega money themselves are squatting. I don’t compete in the housing market with Roman Abramovitz, but I may well compete with his chauffeur, or with the child minder of his chauffeur.
The fact that prices in part of the UK housing market are strongly influenced by global fads, fashions and other factors is good news for UK homeowners when the UK economy is about to slow down significantly, as it is now. It is, however, also a potential source of vulnerability. Fads and fashions change. Tax-averse expatriates may be footloose and may consider a move to Paris, New York or Dubai when their non-domiciled tax status in the UK is threatened. I also believe that even the mega-rich will at some point discover that London has no transport infrastructure, public or private, and may as a result consider relocation. One dirty bomb, even a small one, would certainly end the party once and for all. I am not making predictions here - just listing risk factors.
So yes, I consider a significant decline in UK house prices, say by thirty percent or so over two or three years, to be likely but not inevitable.
Would it matter, and if so, would it be a good thing or a bad thing? On balance a good thing, I would say, although I myself would stand to lose quite a bit. A decline in house prices does not, on average, make UK residents worse off. It merely redistributes wealth from those long in housing to those short in housing: the representative UK household will lose as homeowners, but will gain the same amount in present discounted value terms, either as renters or through the opportunity cost of the imputed cost of renting saved by owner-occupiers. Typically the middle-aged and the old who have not yet traded down will lose. The young and all those expecting to trade up will gain. Since housing prices in the UK have become ridiculous (not just in London either) and an increasingly large contingent of first-time would be buyers is priced out of the housing market at current prices, a significant decline in house prices would, on balance be welcome. Just imagine: a London where essential workers (police, fire fighters, teachers, nurses, bus drivers etc.) can actually afford to live! I wonder what such a city would look like. If the market can achieve this kind of socially desirable redistribution, who knows, governments may discover ways to enhance efficiency.
There are two downsides to this scenario, in addition to the losses suffered by those long housing. The first is that if the decline in house prices reflects the bursting of a bubble (a decline in b in the formula) rather than a decline in the fundamental value of residential property, there will be a net negative wealth effect, because there will be no consumers of housing services to benefit when the value of the housing stock declines. This negative wealth effect could be macroeconomically significant.
Second, even if there is no net wealth effect from a decline in house prices, there will be a liquidity or collateral effect. Residential property is mortgageable, unlike human capital. It acts as security for consumption loans (through mortgage equity withdrawal) that would not be forthcoming if they had to be provided on an unsecured basis. When this source of collateral shrinks, consumer borrowing will decline and consumer spending is likely to decline with it.
These detrimental effects from a decline in the price of residential property are, however, likely to be transient – cyclical at most. The social benefits from a significant decline in UK house prices are bound to be significantly larger than the social costs associated with any short-term credit squeeze on consumers it may cause or aggravate.
The formula isn’t really that of the fundamental value, since all factors (eg r, g) are assumed to remain constant from now and until the end of time.
Here is an interesting resource for anyone who enjoys valuation equations:
http://edoc.hu-berlin.de/series/sfb-373-papers/2002-55/PDF/55.pdf
Posted by: Ron Cohen-Seban | January 2nd, 2008 at 9:06 pm | Report this commentMost people would welcome some sanity in the London housing market. To a certain extent any real estate collapse would be delayed if the sellers played the waiting game. The London labor market will decide the outcome. If unemployment occurs then the banks will be in the repossessing game. Ultimately the banks will then have to decide what to sell and when. When the dam breaks there may be some panic because most people dont remember 1974 when the skids cameoff. The Treasury will certainly miss that Stamp Duty income. Tax increases inevitable?
Posted by: richard bond | January 2nd, 2008 at 10:11 pm | Report this commentMaverecon sort of implies that: “house prices are more likely to fall sharply than to rise steeply [especially those in London]….Exhibit 1 is a measure of average UK house prices to average earnings”
For those of us that have discovered your national businesss plan of turning London into the mother of all the luxury resorts for the foreigners (competing with Paris) and see how successful you’ve been at it, your proposition sounds a bit doubtful, unless you have recently gone too short and must now cover your positions buying some of those properties back, at a much lower cost.
Most of us work need to work like crazy in order to be able to afford the attractions that London has to offer, like for instance a real living queen.
I wish you all a Happy New Year
Posted by: Per Kurowski | January 3rd, 2008 at 2:35 am | Report this commentOn the other hand Nationwide claim (I can’t quite believe it) that the average house prince in Belfast is £307,000, not that far short of London’s £329,000. Now averages conceal a lot, but I’d suggest London’s house pries look quite fairly valued by comparision to Belfast (which doesn’t of course mean they are, just that other towns might take more of a hit).
On historical house prices measurements, the article here is surely in the right ball park. I would note, however, that houses have always been a good investment, with very few exceptions (perhaps buying in 1989). This suggests they were always underpriced, hence Mr Buiter’s higher historical ratios are perhaps more accurate.
Posted by: Matthew | January 3rd, 2008 at 8:46 am | Report this commentRegarding: “Market measures of the long-term risk-free real rate of interest for the UK continue to be ludicrously low, partly because of continuing anomalies in the demand for long-dated index-linked gilts by pension funds and partly because of the inexplicable failure of the UK authorities (and other public agencies) to issue more of the stuff”.
Posted by: JonA | January 3rd, 2008 at 10:21 am | Report this commentIt strikes me that the market solution to this excess demand was to deconstruct your formula and create risk-free securities by slicing up packages of mortgages. However, the losses in the mortgage-backed security market suggest that the arbitrage opportunity was not really there.
A very balanced article I thought. A couple of points to add. On the positive side (to house prices): 1) Employment terms are much more flexible today than anytime since WWII, ie, if you loss your job, there are myriad ways to patch over with consulting, part-time, etc and this is at all levels. Also, more double incomes. 2) Having worked in Tokyo in 1986 (The Top), I can say UK is blessed with an international bid while the Japanese had only one - themselves. 3)Alot of international investors/residents are now “comfortable in their skin” being in the UK. Do they want to adjust to the local oddities of France or Spain, etc? Now, negatives. 1) The ratio of City stars and Russian carpet-baggers to ordinary working folk is about the same as the number of professional footballers to those who simply follow the game. These vast majorities are being priced out while the spotlight remains on the few. 2)Almost all reasonably transparent govt’s these days seem to be reporting 2-3% inflation which bond markets (hence mortgages) dutifully reflect. How come everything I buy (electricity, fuel, housing, school fees, food, etc) seem to be going up closer to 10%. Plus the Chinese are turning the corning from exporting deflation to exporting inflation. If all you are buying everyday is another LCD TV, you’re OK (for now). 3)UK stops being “cool”. The sleeper here is the US, I think. If the US elections can put an internationally friendly admin in place and make people feel comfortable about going (and investing) there again, a 2-for-1 cable rate makes 5,000 sq ft 6 bedroom homes at the price of a Croydon bed-sit look pretty attractive. Also, did I read that Brown wants to make foreigners who spend over 4 days a month in the UK tax residents? That’s not cool. 4) Lastly, if you are going to treat housing like a commodity (rather than a shelter from the elements), expect it to trade like a commodity. If you doubled your money on pork belly futures over a year, would you borrow on the un-realized gains to take your kids to Euro Disney?
Posted by: YT | January 3rd, 2008 at 1:56 pm | Report this commentWhile the long-term social and economic benefits of reduced house prices would be undoubted I do not share Mr. Buiter’s confidence that they will arrive any time soon.
Mr. Buiter makes the middle-class dinner party assertion that “housing prices in the UK have become ridiculous” but doesn’t offer very much to prove his claim. A rough-and-ready reckoner for the aspirant home buyer not versed in discounted cash flow models is as follows. Could I rent a house of identical specification to the one I seek to buy for less than the interest on a 100% mortgage?
Now I will be the first to put my hand up to the significant costs, insurance, maintenance, stamp duty etc. which I have missed out of the home buyer’s side of this simplification. However in this static world view (no rental growth, interest rate changes or capital value appreciation) there remain offsetting values to the home buyer not accounted for in the discounted cash flow. Security of tenure (UK residential rentals are typically limited to a 12 month term), control over the building (residential tenants are not free to make changes to their demise) and the increased social status of being a home owner, amongst others, are all of significant value to the home buyer.
On this simplistic basis properties in London where rents are high are better value than houses in other parts of the country where rents, and more importantly rental yields, are much lower. Problems housing key-workers are particularly acute in London because even the cost of renting property is prohibitive. Sadly we cannot look to falling rents to drive down housing costs, both rental and purchase, because rents have been held down in recent years by the increased supply of rental property onto the market from buy-to-let investors.
More likely the 2007 banking crisis will result in wealth transfer would be away from London residents who are short in housing as increased demand and reduced supply in the rental market forces up rents, bolstering house prices in the process. If a greater proportion of London’s population become tenants the House Prince – Earnings Ratio becomes a useless indicator of true housing value as it ignores a significant chunk of the market.
There are only two events can seriously mitigate these pressures, a serious effort building more homes or major migration away from London and more importantly London jobs. Neither strikes me as likely in the near future.
Posted by: TJB | January 3rd, 2008 at 3:21 pm | Report this commentDear TJB,
Posted by: Davie P | January 3rd, 2008 at 10:19 pm | Report this commentOn my street in “desirable” North London a house is currently on the market for £850k (opportunity cost @ 6% of around £50k p.a.).
The same house is on the rental market for £500pw - or £26k p.a. How does that affect your theory? Plus you don’t have to pay £34k stamp duty, repairs or watch as its price plummets.
Do you work for a building society or estate agent or elsewhere in the housing value chain?
ps. I have had 3 rental flats and 2 leased out shops for years and I find this bubble obscene because it will end in a lot of pain for so many naive people
Dear TJB,
Posted by: Davie P | January 3rd, 2008 at 10:19 pm | Report this commentOn my street in “desirable” North London a house is currently on the market for £850k (opportunity cost @ 6% of around £50k p.a.).
The same house is on the rental market for £500pw - or £26k p.a. How does that affect your theory? Plus you don’t have to pay £34k stamp duty, repairs or watch as its price plummets.
Do you work for a building society or estate agent or elsewhere in the housing value chain?
ps. I have had 3 rental flats and 2 leased out shops for years and I find this bubble obscene because it will end in a lot of pain for so many naive people
Dear TJB,
Posted by: Davie P | January 3rd, 2008 at 10:20 pm | Report this commentOn my street in “desirable” North London a house is currently on the market for £850k (opportunity cost @ 6% of around £50k p.a.).
The same house is on the rental market for £500pw - or £26k p.a. How does that affect your theory? Plus you don’t have to pay £34k stamp duty, repairs or watch as its price plummets.
Do you work for a building society or estate agent or elsewhere in the housing value chain?
ps. I have had 3 rental flats and 2 leased out shops for years and I find this bubble obscene because it will end in a lot of pain for so many naive people
I agree with Davie P. I nearly bought the house that I’m living in for £200k. The mortgage would have been around £1250 per month, with a £10k deposit, not to mention the cost of insurance, maintenance etc. Due to a stroke of luck I am renting the same house for £800 per month. Under the circumstances I’m quite prepared to put up with my lack of social status!
Posted by: Nick M | January 4th, 2008 at 12:11 pm | Report this commentDavie P,
Your neighbour had a choice, having a property surplus to his own requirements he (or she) could either sell or let it. In fact he chose to offer both which provides us with an interesting way of working out how he values security of tenure, control etc granted to the buyer but not the tenant.
Presumably being a rational actor he sees equal value in both transactions. If he did not find them to be of equal value he would only offer the transaction in which he saw more value for himself. As a consequence we could figure out his valuation of the additional rights granted to the buyer on the back of an envelope.
You would assert that he and many other people have over valued these facets (or rental growth or capital appreciation) granted to the buyer, your own valuation of these being considerably lower.
Excitingly for you, your model suggests that there is an opportunity to increase your wealth here. Will you be selling your own house to rent your neighbour’s house as your valuation suggests you should do in order to maximise your present discounted value? Don’t worry I’m not an estate agent or a mortgage broker looking for a fee!
Posted by: TJB | January 4th, 2008 at 12:51 pm | Report this commentThe point about housing as a commodity, vis-a-vis the housing problem as one of affordability, to me, is key. I’m a City worker, but even I won’t bother with Chelsea where the last Nationwide survey showed the AVERAGE price well into the seven figures. I’m not a big fan of market regulation where it’s not needed, either, but I think the central bankers are missing an angle here by not managing the mortgage rates enough (i.e. by funding longer, for instance). The problem is not all that different from the short rate, in that if property affordability disappears, consumer spending is constrained in a way that is not good for the economy when things start to slow down.
I think the commodity-like behavior is really what we don’t want. Your average consumer doesn’t operate efficiently in a market with volatile prices. How the Fed and others manage this without creating other bubbles is a question whose answer is not at all obvious to me.
Posted by: kr | January 4th, 2008 at 11:35 pm | Report this comment[…] http://blogs.ft.com/maverecon/2007/10/ok-then-housinghtml/; http://blogs.ft.com/maverecon/2008/01/the-coming-declhtml/) that, because this outside asset yields its future income stream in kind, in the form of […]
Posted by: FT.com | Willem Buiter’s Maverecon | Double Counting 101: Inside versus Outside Assets | March 11th, 2008 at 8:15 pm | Report this commentTJB, many people hate decorating, and are not terribly interested in ‘improving’ a property, as long as the house is in good nick, recently painted etc (not to garishly tho) it’s all good. Besides that, houses are a bottomless pit when it comes to decorating them(and the cause of many divorces), so most folks are better off being ‘banned’ from such activities
As for security of tenure, it’s not necessary, there are plenty of good houses to rent out there for a fraction of what an interest-only mortgage would cost to ‘own’ them. And renting is a lot less stressful than hoping for a buying and hoping to buy a nice new house… if you rent and don’t like the neighborhood, you give 2 month notice and your problem with neighbors from hell is solved.
Lastly, there is not much social status in being a debtor, and you’re not going to get ‘rich’ by paying 2-3x the amount because you took on credit instead of paying with cash.
Posted by: Big Leg Emma | April 21st, 2008 at 6:16 pm | Report this comment