Hamish McRae: The housing boom must end, but 1988 won't be repeated

Stable home prices are a possibility. But it is not what buyers, hoping to make a profit, expect
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Will there be another house price crash? No, but if you buy now do not expect to make a great profit on your investment.

Will there be another house price crash? No, but if you buy now do not expect to make a great profit on your investment.

Soaring house prices, together with soaring retail sales, are one side of the two-speed economy of Britain. On the other side is some manufacturing, hi-tech industries and agriculture. This tension, of course, is the immediate concern of the Bank of England's Monetary Policy Committee, which will today announce whether interest rates will move up, down or sideways. It is also the longer-term concern of nearly all readers of this newspaper, either as homeowners or putative ones. Leaving aside the little practical matter that we have to live somewhere, is this a good time to be buying or selling a home?

This week the view of the Halifax seems to be that it might be time to sell. House prices are rising at 10 per cent a year, a rate that it believes is unsustainable. That dreaded expression of the early 1990s, "negative equity", when the mortgage on the property is larger than its value, might return. It was such a bruising experience for the many 30-somethings who bought their first home around 1988 that the very phrase sends a shiver down the spine.

So first the good news. No, this is not 1988 again. There are similarities, to be sure, but the present boom is not nearly as serious. There is one negative factor absent in 1988, of which more in a moment, but the general valuations are much more sustainable.

Some facts. The most important one is that UK housing is a segmented market, reflecting not only the very different economic performance of different regions, but also micro-differences in places quite close to each other.

The general picture of sharp price differentials between north and south is widely appreciated. Of course a house in central London is going to be worth more than a similar one in the north of Scotland, for incomes in the South on average are higher. What is less widely appreciated is that this gap has been widening rapidly over the past couple of decades, driven by population movements. London in particular has outpaced the rest of the country, as its rising population puts pressure on the existing housing stock. Scotland has experienced a small fall in population, and has seen a correspondingly small rise in house prices – as the left–hand graph shows.

These broad regional trends conceal "hot spots" and "cold spots", towns where property has been in special demand or where it is unusually depressed. For example, Edinburgh has seen a surge in prices, despite the relatively small rises elsewhere in Scotland, because the market has been driven by two factors: the strength of the financial services industry and the creation of the new Scottish parliament. By contrast, Hastings, despite being in the generally prosperous South-east, has seen only slow growth in prices, largely because it has poor road access both to London and east-west along the south coast.

Looking ahead there are areas where demand looks promising: for example the presently rather depressed Medway towns will be revitalised if London's new cross-rail connects to them (as it should). East Anglia will benefit from the expansion at Stansted, a development of particular value to the Cambridge hi-tech cluster.

There will also be influences on prices from demographic and social trends. It is easy to predict strong demand for homes that suit older people: as the population ages it is inevitable that smaller property will do well. But there are also surprising trends: the market for large homes in prime areas is increasing despite the trend to smaller families. We have converted so many homes into boxy flats that we have overdone the process and now it often makes sense to convert them back. The desire of young professionals to live close to work has also stimulated inner city living, with a consequent impact on prices. Expect that to continue.

So making the right decision on a home purchase, then, is not just a matter of getting the market as a whole right. You have to get the detail right, too.

But the Halifax was worrying about the overall level of house prices, not the hot spots. It is right? Well, it has a point. It is not sensible to expect rises of 10 per cent a year to continue and some people will now be taking out mortgages they cannot afford.

But the overall ratio of prices to earnings is OK. As the graph on the right demonstrates, prices are around 3.5 times earnings, well below the average since 1985. It is, however, a touch above the level since 1993, and arguably that is a more appropriate benchmark. After all, in the late 1980s people still expected inflation to continue at a reasonably high rate and accordingly reckoned that even if they made a mistake buying at the wrong price, inflation would rescue them in the end. Now they know better.

That leads to the cause for concern noted above. Suppose our inflationary expectations are still too high, what then? Most people expect inflation to carry on at 2 to 3 per cent a year, and earnings to rise at 4 to 5 per cent. If these expectations are right then there is little problem. Rising earnings will enable people to service their debt, and while there is some general inflation, sooner or later the capital value will catch up.

But suppose there isn't. Suppose we have stable prices, or even slightly falling ones as they do in Japan. If earnings only crept up, then house prices would not be buttressed by a general rise in the price of everything else.

Stable prices are at least a possibility: companies in many areas are finding that they face declining prices and it is possible that this deflation will spread to other areas. Under these circumstances, home prices could be stable for a generation. In many ways that would be good news, for it would improve access to home ownership. But it is not what most home-buyers, hoping to make a profit on their purchase, currently expect.