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Let's Clarify The Argument : The Long Run .....

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Some of the uber bulls have been making the general point that house prices rise in the long run and suggesting that we should all buy to-day because of that long term trend.

Their observation has been patently true in the long run. A good long run proxy for house price changes should be very highly correlated with the rate of growth in after tax household incomes as after tax household income is the means by which mortgage debt is repaid

Where I think that the uber bulls are confusing themselves is that they are missing the critical point that house prices have risen well above the growth rate in after tax household incomes for a very long period of time and are now so overvalued relative to incomes that they are in for a sustained period of declines (with a few counter-trend rallies along the way) until they reach fair value relative to incomes.

To put the uber bull argument in context, the are right that prices move with average after tax household incomes in the long run. They are wrong to assume that incomes will continue to rise in the future. They are also wrong to assume that a stabilization in economic conditions will mean an immediate sustainable rise in house prices. They are ignoring the fact that rising tax rates leave us with less capacity to service debt.

Finally, they are foolish to assume that stressed borrowers will be able to hang on to their houses when the economy weakens and unemployment rises. They do not understand that even with very low mortgage rates, the marginal borrower can still be blown out of their house because of a poor cash flow position even if their mortgage payments were zero.

The long run trend is really irrelevant to most of us. What really counts is the price action in the short term. While I believe that, in general, after tax household incomes rise which should support a gentle increase in house prices in the long run, I am also certain that buying a house to-day is a poor decision as prices will be lower in 12 and 36 months than they are to-day.

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Exactly, this is so stark to me where I live in London - by looking at the property pyramid.

For simplicity say there are three levels, flats, semis and detached houses.

At trough, flats cost £75k, semis £125k and detached £250k.

At peak, flats cost £300k, semis £600k and detached £1m.

In 1997, someone could buy a flat in this area of London for £100k. Assume he had a £25k deposit and £75k mortgage, based on 3 x £25k.

In the meantime, his pay doubles to £50k and he gets married. Him and his wife manage to pay off their very small mortgage and by 2001 they could sell it for £200k, and now he can buy a semi for £400k.

So in 2001 he buys a semi for £400k and needs a £200k mortgage. Because they were cautious and didn't stretch themselves they pays of a good chunk of the mortgage, and again his pay doubles to £100k. His house is now worth £600k.

By 2005 his wife's salary is eaten up by childcare costs and she works part time. Now he can sell his semi for £600k - and he can borrow up to £400k 4 x £100k. So he buys his £1m house with a deposit of £600k - he now owns a house thats worth 10 x his salary.

The question for the bulls is - look at the people starting off in 2007. They pay £300k for their flats. In order to borrow that they have to take a 4 x mortgage based on joint salaries, and possibly money from bank of M&D.

In their starter flat they are totally stretched to the limit, they struggle with their mortgage, and unlike the person who bought in 1997 they can't pay back chunks with spare cash - the mortgage eats so much of their savings.

Assuming prices "only" fall by 20% - well now they have lost the equity from the bank of M&D, and they can't move up as they can't borrow another penny. Even if they get a good payrise and earn £100k like the other person once they have kids they still are quite stretched and would probably have to buy a semi in a less nice area. To buy the detached house they are going to have to earn more than twice what the person who started in 1997.

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