Date: 12 November 2004
Most people now agree that the housing market is vulnerable to a sell-off. But will it be a mild slowdown, or a Nineties-style crash? James Ferguson reports.
The housing market suffered its sharpest fall for almost a decade last month, reported The Independent. According to Halifax, UK property prices fell 1.1% in October; Nationwide estimated prices had fallen 0.4%. The debate about house prices has largely moved on from whether house prices are vulnerable to a sell-off or not, to whether the sell-off will be little more than a levelling-off or whether it will be a Nineties-style ‚€œcrash‚€Ě.
Seven months ago, estate agents were most confident, 93% of them believing house prices would increase further over the year, according to property website Findaproperty.com. Most claimed that their expectations were ‚€œhigher now than at the start of the year‚€Ě. Similarly, earlier this year, John Wriglesworth, senior economist at Hometrack, told the Daily Mail: ‚€œThere‚€™s more chance of the sun setting in the east than any housing-market crash in the next 12 months.‚€Ě Estate agents don‚€™t seem to be good judges of their market.
Even now, many commentators refuse to accept the market is falling. ‚€œThe rises and falls we‚€™ve seen in prices in recent months are part of the ebb and flow of the market as it finds a new base,‚€Ě soothes Halifax chief economist, Martin Ellis. That assessment is shared by Alex Bannister, chief economist of Nationwide, who predicts: ‚€œHouse prices are more likely to grow at a subdued rate rather than fall sharply.‚€Ě
Homeowners are unconvinced. They know a stack of negative data has swung the debate for them. The latest Woolwich survey of consumer confidence shows just 45% of homeowners now believe their property will continue to increase in value; a new four-year low in sentiment.
It is sobering to note that almost all the optimists are either estate agents or mortgage lenders, while those forecasting price drops over the next two years in the region of 20% to 45% tend to be those with no conflicts of interest, including City analysts and the IMF. But who is right? Why are the optimists so upbeat? Do their arguments bear scrutiny?
The strong economy
The first thing the optimists always cite is the strength of the economy. The problem is that the economy was also strong in the late Eighties, at the top of the last housing bubble, and only weakened after the house-price collapse. Ed Stansfield, property economist at Capital Economics, notes house prices move closely with the economy and that each of the last three housing downturns was accompanied by full-blown recessions is ‚€œominous‚€Ě.
Moreover, Stansfield‚€™s research shows that the housing market falls first, with the impact spreading to the wider economy ‚€œbefore long‚€Ě. This is not surprising when you consider that mortgage equity withdrawal (MEW) equates to a mind-boggling 8% of total consumption expenditure. Since MEW is driven by rising property values and falling interest rates, it is likely that any fall in house prices will lead to lower MEW, causing consumer spending to fall too. The problem with consumer-debt financed growth is that it can clearly evaporate almost overnight.
The same is true of unemployment - also cited by the optimists as a reason why a house-price crash is unlikely. According to Stansfield, unemployment always tends to be low just before a house-price correction. This is hardly surprising since you would expect a booming economy in which jobs are being added to send house prices higher. But the chilling thing is that after all three previous house-price reversals, unemployment had started rising sharply within a year and never rose less than 40%. It appears the economy lags housing, not the other way around, so instead of citing a strong economy and low unemployment as support for the housing market, we should all be afraid of what a falling housing market may do to the state of the wider economy.
Ever since the Treasury-commissioned Barker Report into the state of the housing market was published earlier this year, optimists have insisted the property market can‚€™t fall because there‚€™s a shortage of new houses. In fact the Barker report said nothing of the sort. It said the UK would need many more new houses in the future, but this conclusion was only reached as a result of the (much criticised) assumptions the report was forced to make. In fact, the UK built 190,000 new homes last year, which was 4,000 more than the 186,000 average for the last decade and only just below the 22-year average of 197,500. In other words, there is not now, nor has there been for decades, any appreciable drop in the supply of new homes.
Less negative equity
During the current boom, people have borrowed less as a proportion of the value of their homes, house prices have risen slower and the volume of property transactions has been lower than during the 1980s boom. As a result, optimists argue that the risk of negative equity, whilst still appreciable, is lower than last time. In the late 1980s, a drop of 20% in nominal house prices caused some 1.2 million households to fall into negative equity by the end of 1992. Ed Stansfield reckons this time ‚€œa smaller number of households will have bought their houses at the peak‚€Ě. And since homebuyers have been borrowing on average only 75% of the value of their property compared to 80% in the late 1980s, he calculates that if house prices fall 20%, only ‚€œaround 400,000 households [will] owe more on their properties than they are worth‚€Ě.
All this may be true, but the truth is that negative equity isn‚€™t actually the worst thing that can happen to a homebuyer. Once all your equity is wiped out, the remainder of the problem becomes the mortgage lender‚€™s. This cycle, however, people have more of their own savings locked up in their homes, which means they will suffer the full effects of any house-price crash directly on their own net worth. Besides, the problem for economic growth isn‚€™t negative equity itself but the fear of negative equity, which drives up precautionary saving at the expense of consumption.
Few signs of debt distress
For all the talk of Britain‚€™s ¬£1trn of household debt, optimists take comfort from the fact that there‚€™s remarkably little evidence of any debt distress, let alone 1990s-style home repossessions. Until very recently, that is. In July, John Raven at PricewaterhouseCoopers (PwC) built both a soft-landing and a hard-landing scenario into his study into the affordability of UK household debt.
He ignored the self-employed, since they go in and out of bankruptcy all the time, and focused only on the employed and unemployed. In the first quarter, personal bankruptcies were 8% above even his hard-landing scenario. But it was
the second-quarter numbers that were the real shock - up a whopping 25% above his worst-case view. This shows how quickly things can go wrong and how far they can fly from even analysts‚€™ most conservative forecasts.
Foreigners are still buying
It is widely believed, particularly in London, that foreigners will keep house prices up, especially at the top-end of the market. Optimists have persisted with this line of argument even though central London prices are already the weakest in the land. Besides, foreign investors usually arrive late at any residential property party. Once they see the market is falling, history suggests they will lose interest fast. More importantly, foreign investors are also sensitive to currency fluctuations. If a fall in house prices has a similar negative effect on the economy that it has had in the past, then the pound will fall. Faced with the prospect of a currency loss as well as falling house prices, foreign investors are not likely to prop up the housing market much longer.
Indeed, the likelihood of a slide in the currency is one reason why interest rates are forced to stay higher for longer after housing bubbles burst. ‚€œIn each of the three previous housing downturns,‚€Ě says Stansfield, ‚€œofficial interest rates did not begin to fall until the annual rate of house-price inflation had already slowed sharply from its peak.‚€Ě
Low interest rates
The optimists say that it doesn‚€™t matter if interest rates this time stay higher for longer since they are already at very low levels for this stage of the cycle. But this misses the point. The reason why interest rates are important is that they are one of the two factors that determine the all-important burden of debt servicing costs that people will have to pay. The other factor is the total debt outstanding. To look at one and not the other is to miss one half of the equation. Since interest rates have been low for several years, people got used to them being low and, instead of keeping their repayments low, many opted to keep their payments flat and raised their debts to the maximum this strategy allowed. While debts kept rising, rates were falling, so the debt-service burden never got too high.
That remained true until rates started to rise last year. The problem is that debts have continued to soar, which means the debt-service burden has got worse from both sides. According to some analysts, including John Hawksworth at PwC and Tim Crawford at Halifax, mortgage payments as a percentage of earnings are still way below the 1989 peak. But this is misleading because they only include the interest portion of a mortgage. Capital Economics looks at actual monthly mortgage repayments and uses disposable income rather than pre-tax earnings. As a result, it has come up with a different, and more realistic, picture. It concludes that UK households currently spend nearly 15% of their disposable income on mortgage repayments. This is worryingly close to the 15.8% level the UK reached in the second quarter of 1989 at the very top of the last house-price cycle.
Worse, if you add the costs of servicing unsecured debts, the nation is already spending more than 20% of disposable income on debt servicing. No matter that interest rates are low in relative terms, thanks to our huge debts, we are now suffering just as much as we were at the top of the last housing bubble. If there is a maximum limit to what we can take before we crack, then it is fair to say we have now reached that point. We just can‚€™t afford any more debt.
Where do we go from here?
On closer analysis, none of the arguments the optimists cite in support of their view that house prices will only drift sideways are very convincing. We are left with the uncomfortable conclusion that we are facing a very normal crash, which means it will last at least two years and will involve an inflation-adjusted drop of about 30%. That is likely to mean a fall of 20% in nominal terms, depending on how fast prices fall.
The last time house prices collapsed, the UK savings rate virtually tripled, from about 4% to nearly 12%, as debt became a dirty word. That sort of a retrenchment in households‚€™ balance sheets must be on the cards again and the current savings rate of about 6% must be set to rise. The lending institutions‚€™ business can only suffer as a result, as will retailers of big-ticket items and anyone involved in residential property construction or sale.
According to FPDSavills, rental yields in most major cities are now below even the interest portion of a mortgage. Add in the repayment portion and the average cost of servicing mortgage debt rises to about 7.5% a year. From a cash-flow point of view, at this point it really does pay to rent. Indeed, it is likely the true cost of home ownership is actually approaching 10% per annum. Crispin Odey of Odey Asset Management reckons that the cost of home-ownership, taking account of buildings insurance, service charges and maintenance, can average about 3% of property value a year.
This means that in London, where rental yields are 4-5%, a potential house buyer could live in a property worth twice as much for the same monthly outlay if he rented rather than bought. This is on top of any ‚€œgains‚€Ě a renter would make as a result of capital depreciation if property prices continue to fall. Indeed, once you take away the promise of capital gains from the mix, renting becomes what is known in the City as a ‚€œno-brainer‚€Ě.