Mortgage Advice Centre

Looking back at the past two years it seems that the housing market is subject to irrational expectations helping to exaggerate booms in house prices that later prove unsustainable.

Why do Booms in Housing Markets occur and why don’t People see Them Coming?

The nature of the UK Property Market encourages volatility. With inelastic supply (unresponsive to changes in price) a change in demand causes a bigger % change in price. E.g. during boom the relative shortage of supply pushes up prices

Banks Encourage Bubbles and Aggravate Downturns.

With house prices rising, banks become much keener to lend. The last housing boom encouraged a range of unconventional mortgages which allowed more people to get on property ladder and enabled the house price to income ratio to increase.
However, as soon as prices fall, banks need to protect themselves from negative equity and falling prices. Hence the sharp rise in required deposits.

Difficulty of Predicting Housing Market.

It is true that many were predicting house price falls just before the housing boom turned to bust. But, it is also worth bearing in mind, people were saying they were overvalued and set to fall from 2002. House prices are still higher than in 2005.

Irrational Exuberance.

There is also an element of irrational exuberance. When prices are rising people tend to block out bad news. The potential of making large wealth gains appears tempting and there are no shortage of ‘experts’ saying how to get in on the bubble.

The big question is will the same trends in the property market be repeated again?

In the present climate, it is hard to imaging banks reverting to past mortgage lending. But, in the aftermath of the last crash. How many were predicting another boom and bust of even greater magnitued?

1. UK Housing Market
2. UK House price index

The Pound has had a rough time against the Euro, in recent months. But, whilst the UK economic climate is far from strong, the Eurozone economy looks to be experiencing increasing problems.

Led by the German economy, the Eurozone experienced a sharp contraction in the first quarter of this year. Eurozone GDP fell by 2.5% and the most optimistic forecasts show a decline of 4% of GDP.

It will come as no comfort to the Germany economy that they avoided a housing boom and bust and avoiding a similar credit bubble. It has shown the global recession has affected all countries - whether or not they were involved in the credit boom and bust.

So far the ECB have been the most cautious out of the Central Banks, ECB interest rates have fallen slower than in the UK and US. There is the possibility of ECB cutting rates even lower close to 0% interest rates. This would definitely weaken the value of the Euro.

Also, some analysts feel that the Pound’s weakness has been overdone and on purchasing power parity, the pound looks undervalued by 10 or 15%.

The UK still has many significant economic problems which could keep the pound undervalued

• Very high government borrowing (12% of GDP in 2009)
• Policy of Quantitative Easing to increase money supply increasing threat of future inflation.
• Deep recession.

Yet, these weaknesses of high borrowing and deep recession are now faced by Eurozone members as well. Also, although the UK may experience some inflation, it will mean UK interest rates have the prospect of rising and this would lead to a higher value of sterling.

The weaker value of Sterling and hopes the UK market may be bottoming out have caused foreign interest in buying UK houses. Neil Turner a Germany-based executive in charge of a 300 million-euro ($403 million) property fund says:

“Weaker sterling makes U.K. property more attractive,”

Barclays Plc predicts it will rise as much as 18 percent against the dollar and 11 percent versus the euro in the coming year.
Goldman Sachs Group Inc. sees a 23 percent gain versus the dollar and 15 percent advance against the euro.

Impact of not Being in the Euro on UK economy
Forecasts for Euro to fall
(bloomberg)

According to accountatns Grant Thornton, the total amount of outstanding debt amassed through mortgages, loans and credit cards rose by 7.3 per cent to £1.44 trillion over the year to June 2008, up from £1.35 trillion the previous year. UK GDP is estimated to be £1.41 trillion, having increased by just 5.1 per cent in nominal terms over the past year.(source: independent) This means UK personal debt exceeds total GDP. With GDP falling by an estimated 4% in 2009, this ratio of debt to GDP is only likely to get worse

Furthermore the fall in house prices have increased the ratio of debt that is not secured against the value of housing.

Growth of UK Personal Debt

source:

With Unemployment still sharply increasing, it may be overly optimistic to consider a housing recovery. But, with house prices already fallen 25% some forecasters are predicting the worst is over and house prices could stage a modest recovery by the end of the year.

On the plus side

• Signs of renewed activity in the mortgage industry - admittedly from a lower basis
• Affordability of mortgages has increased with 0.5% interest rates.
• Optimism returning to the market with more analysts and buyers expecting a modest rise in prices within the next 12 months.
• Fall in house price to earnings ratio. Halifax house price to earnings ratio has fallen from 5.85 to 4.26. This is a level last seen in 2002. However, it is worth bearing in mind, in the mid 1990s this ratio fell to 2.5. And 4.26 is still above the long term average.
• The slowdown in house price falls, allows mortgage lenders to offer better deals to homeowners. When house prices stop falling, banks will require less of a deposit to insulate against negative equity.
• The UK does not have an excess of supply in housing like for example Spain, Ireland and US

On the Negative Side

• Affordability has increased but mortgage lenders are still requiring large deposits which makes buying a house difficult.
• Unemployment is forecast to rise to 3 million, this will lead to more home repossessions and reduce house prices.
• House price to earnings ratio still above long run trends
• Prospect of rising interest rates in 2010, though many banks have kept their rates significantly higher than the bank of England base rate
• In the last housing bust, house prices fell for 4 years (with monthly exceptions of rising prices) before recovering (historical house prices)

Lloyds which comprises 30% of the UK mortgage market, expects UK house prices to fall another 8% this year, before staging a modest recovery at the end of 2009

Overall,

If the UK had built a large surplus of housing in the boom, I think house prices would have to fall for much longer and much further. However, given relative shortage of housing to long term demand, we may expect a house price to income ratio of 4 to be more likely. As house prices stop falling, it will also create a lot of positive momentum in the housing market. No body wants to buy when prices are falling, but, when this cycle is broken it may tempt many back into the market.

Given perilous state of economy, house prices will continue to fall further this year, but, the end of drastic house prices falls is in sight, which will come as a relief to many. Furthermore, at the moment, the recovery is likely to be weak, I cannot see a quick return to the heady days of the early 2000s. But, that is the last thing the UK housing market needs

The Times have a useful mortgage calculator for determining whether it is better to buy or rent. [link]

It is difficult to predict future house price growth. But, if we think of the long term, I would choose a positive figure of 2-5%. This is actually quite conservative figure given past trends and long range house price predictions.

Interest rates I would choose to be 2% higher than inflation. e.g. if you choose house price growth of 3% choose interest rates of 5%. (If interest rates were higher, it is likely to mean higher inflation so this would compensate the cost of higher rates to some extent.)

Assuming these figures, there is a pretty clear incentive to buy rather than rent.

A £200,000 house vs £900 a month rent could give a £290,000 profit after 20 years. Assuming interest rates of 5% and rent growth of 3% and house price growth of 3%.

Buying a house may not be a good idea in the current climate, but, in the long term it still represents a good investment.

See also: To Buy or Rent - which is better?

This shows the rapid decline in equity withdrawal from housing in the UK.
Peaking at £18bn a year in 2008, housing equity withdrawal played an important role in financing consumer spending in the UK. As soon as house prices started to drop in 2007, equity withdrawal dried up. Banks were unable or unwilling to lend and many faced the prospect of negative equity. WIth prices falling, many have tried to pay more back to their mortgage, this has led to negative equity withdrawal.

Note: This used to be measured as mortgage equity withdrawal MEW, but, is now measured as housing equity withdrawal HEW.