Is the continued gravity-defying rise of UK house prices a speculative bubble, or has there been a shift in the fundamentals that is imperfectly understood? The truth is probably a bit of both.
For bears, the most telling statistic is that house prices, which reached a peak of five times average earnings in early 1989 before crashing, reached similar levels earlier this year. To which the bulls respond that they won't crash this time round because mortgages today are far more affordable. In 1989, interest rates were over 12 per cent; now they are less than half that level. If what really matters is the ratio of mortgage interest payments to income, prices still have a long way to rise before borrowers become as stretched as they were in 1989.
But another salient difference is that today's borrowers are saddling themselves with a debt burden that will not go away quickly. In the late 1980s, with salaries growing at about 8 per cent, the burden of a fixed mortgage payment halved in nine years. Today, with wages rising at only around 4 per cent per annum, this takes twice as long. If the enduring burden proves too heavy, some may seek to lighten it by trading down to cheaper housing. The negative implications for property prices are obvious.
Another, positive, aspect of low interest rates is often overlooked. Houses, like stocks and shares, can be thought of as trading at a multiple of the annual income they generate. One of the iron laws of finance is that these multiples depend on the rate at which future income is discounted. The lower the discount rate, the higher the multiple.
If the housing stock is valued as the net present value of a future stream of rents, that value must have risen since the late 1980s. Back then, the lettings market had only recently been deregulated; today, there is a lot more private letting. Moreover, these future rents are discounted at a much lower real interest rate.
The stock market boom of the late 1990s can be partially explained by lower real interest rates, which boosted the fundamental value of shares. The housing boom may have a similar partial explanation in that the combination of rising rents and lower real interest rates would justify higher house prices relative to earnings. That ratio is not just driven by speculation but has some fundamental basis.
There is always a risk, though, in any market, that a one-off adjustment to a higher level is erroneously built by market participants into the long-run expected rate of growth. Something of this sort happened to share values, and it may still be happening to house prices. Perhaps the most astonishing feature of the current boom is that mortgage lending for buy-to-let transactions has overtaken lending to first-time buyers. The growth of buy-to-let has increased the supply of rented housing and so driven down rents to the point where they barely cover borrowing costs.
Buying to let is therefore a highly geared speculation on rising property prices, with a negative profit and loss account offset by expected capital gains. Once prices stop soaring, sales by buy-to-let landlords seeking to get out of an unprofitable activity could trigger the fall in prices that so many predict.
Bill Robinson is a director of economics at PricewaterhouseCoopers
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