Through the roof
For buyers, sellers and everyone in between, property is a hotter topic than ever. David Smith looks at the current price of housing and the potential effects for the economy…
If there is one issue guaranteed to provoke debate, it's house prices. Lately though, the subject has become much more than just a debating point, as the USA has been gripped by the sub-prime mortgage crisis. Defaults on these sub-prime mortgages - loans to borrowers who have a poor credit history - have knocked confidence in America's housing market, slowed the economy and unsettled financial markets. Ben Bernanke, the chairman of the US Federal Reserve Board, recently warned that the crisis could cost the financial sector $100bn (£49bn).
Despite this, US house prices have slipped rather than crashed. The National Association of Realtors predicts that the average price of an existing home will fall by a modest 1.4 per cent this year, before rising by 1.8 per cent next year. If that prediction turns out to be correct, the question of why house prices are so high will remain - and not just in the USA.
Recent research from the firm Demographia rated different housing markets on affordability, depending on the ratio of house prices to annual household incomes. It claimed that any market where prices were more than five times the level of income (as in Britain, where the affordability multiple is 5.5) is severely unaffordable.
While America's overall rating of 3.7 was only moderately unaffordable, parts of America were severely unaffordable, with the ratio of house prices to income in Los Angeles a huge 11.4.
In Britain, the problem is most acute for those on lower incomes, particularly first-time buyers, according to the National Housing and Planning Advice Unit, set up by the Government under the chairmanship of Professor Stephen Nickell to provide advice on housing affordability. The ratio of house prices to earnings for the bottom 25 per cent of the population had risen from less than four in the year 2000 to seven by the end of 2006 it said, warning that "this has consequences, not only for individuals and their families, but for the economy and society as a whole." The Council of Mortgage Lenders says that, despite generally lower interest rates, the mortgage payment burden for first-time buyers rose during 2007 to the highest level for 15 years.
The price of houses in Britain has trebled since 1997, according to Nationwide Building Society and, according to Professor Nickell, there are three main reasons for this. One reason is that not enough new homes have been built relative to the rise in the number of households. The second issue is the significant fall in short-term interest rates set by the Bank of England, which are closely linked to mortgage rates. The bank rate averaged 12 per cent from 1979 to 1992 but has averaged less than half that figure since then.
The effect of lower mortgage rates is to cut the 'upfront' cost of monthly payments, allowing people to borrow much more. The third factor is the fall in long-term interest rates. This has a direct link to long-term mortgage rates - fixed rates - and boosts valuations across a wide range of assets, including housing.
Another prominent explanation for the rise in the cost of housing, particularly in Britain, is the rise of the buy-to-let landlord. Rightly or wrongly, many people have come to see property as an essential investment. It is no accident, perhaps, that the start of this enthusiasm coincided with the bear market in shares, from 2000 to 2003, and a period of relatively low interest rates.
So will these 'severely unaffordable' markets come back down to earth, or are the current high prices here to stay? The National Housing and Planning Advice Unit is clear. Predictions of a housing market crash do not reflect market fundamentals: "Demand for housing, driven by economic and population growth, continues to outstrip available supply," it says. The poorest quarter of the population will see house prices rise to 10 times earnings by 2026, it warns.
Whether or not this comes true depends on various factors - including whether interest rates can stay as low as in the past decade (despite some recent rises). Certainly, significantly higher short and long-term interest rates would make housing valuations look even more stretched. There is also the question of the ability of the housing market, both in Britain and elsewhere, to survive an economic downturn.
In America, where the sub-prime crisis has been raging for many months, both Bernanke and the Treasury Secretary Hank Paulson insist the effects will be contained. The International Monetary Fund has predicted US economic growth this year to be down from 2.2 to 2.0 per cent but forecast 2.8 per cent growth for 2008.
In Britain, where the Bank of England has been concerned that the economy is growing too strongly, a moderate housing slowdown would probably be welcomed. Some draw the parallel with the early 1990s, when house prices plunged and the economy endured a long and painful recession. The cause then was a near doubling of interest rates, from just over 7.5 to almost 15 per cent. The hope now is that, even with house prices at elevated levels, those days are behind us and the possibility of a major default on mortgage payments is less likely.
The views expressed in this article should not be taken as fact and no reliance should be placed on them when making investment decisions.
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