Introduction 

In the UK many people are worried about a house price crash with good justification because it makes up such a large proportion of our household wealth.

It certainly seems as if house prices are slowing after the Brexit referendum in 2016 and although no one can predict what will happen ultimately, this blog lays out the factors which drive house prices so that you can make up your own mind about.

We will also look a number of predictions including a worst-case scenario from the Bank of England, just to see how bad things can get.

House Price Drivers

House price drivers are like a seesaw. Some factors drive house prices higher and some factors drive them lower:

• Low interest rates make the cost of borrowing lower and so they push house prices higher
• Affordability if few people can afford houses then that pushes house prices lower.
• Increased demand pushes up prices and increased supply pushes down prices.
• Higher wages make house prices more affordable and pushes up prices
• High inflation tends to reduce prices as it takes money out of our pockets by increasing our cost of living which means we can borrow less.

A key factor for house prices is economic growth. If we look back to 1960 and plot economic growth versus the growth of house prices you can see that during periods of recession house prices tend to be negative, whereas in periods of strong economic growth house prices tend to grow very rapidly. 

House prices are a critical part of UK wealth. They are almost as important as pensions in the total wealth of the UK, making up about 4.5 trillion of our total wealth in 2016.

In London and the Southeast, where we've seen the strongest house price growth, property wealth is even more significant.

Brexit: Forecasts

House prices will probably depend very much on what happens with Brexit, so below are some of the forecast that currently exist.

Financial Times "Property downturns compared"

In the diagram above the FT puts some context Brexit by comparing house prices in the UK with previous house price meltdowns elsewhere in the world.

In Hong Kong when an increase in supply was announced the housing market fell by over 60% and in Japan, after the asset price bubble burst in the 1990s, house prices started a steady decline which went on for over a decade.

In January 2019, the cost of UK housing grew to 7.3 trillion. The actual forecast that is illustrated by the FT depends on the type of deal that we get for Brexit, with no deal giving the worst performance and some form of deal agreed with the EU providing the best returns.

S&P "No-Deal" Brexit Scenario

S&P says that if there is a no-deal Brexit  then they expect a moderate recession lasting  just over a year and house prices to fall by 10% over two years.

Paul Smith, CEO of Haart Estate Agent

Paul Smith, the Chief Executive of Haart the estate agent, said the following relating to Brexit and house prices

Worst Case: "The Annual Cyclical Scenario"

The worst case scenario is the  Bank of England's Annual Cyclical Scenario which it produces to stress test UK Banks to make sure that even a severe global crisis wouldn't stop UK banks from lending.

The Annual Cyclical Scenario is split into three types of stress.

As economic stress hits, the scenario in the top left hand side of the slide below plays out.  In the bottom left hand graph you will see that the Bank of England's baseline scenario for growth moves along at between 3% and 4%, but in the Annual Cyclical Scenario it falls very sharply by over 2%, which is worse than the global growth after the global financial crisis.

Critically you can see that for the UK, it’s largest trading partners experience a sharp fall in GDP and in the far right hand graph, that residential property and real estate prices fall very sharply.

In this scenario the UK would also be impacted by the global growth shock and UK residential property prices would fall to about -33% percent, which is twice the fall we got in the Global Financial Crisis which was just 17%.

In the UK we have a very large current account deficit because we import much more than we export and that leaves us vulnerable if foreign investors shun UK assets.

That "kindness of strangers" is particularly important for the UK commercial real estate market. You can see in the slide below that UK commercial real estate is 50 percent owned by foreign investors,  so if they pull their money out it would have a severe impact on UK commercial real estate.

If there's a reduced appetite for sterling assets then there would be a sharp rise in funding costs, i.e. the cost of borrowing, and consequently sterling would fall very sharply. The Bank of England estimates that it would fall by approximately 28% percent from its 2018 quarter 4 level and sterling versus the dollar would fall by 30%.

It is also worth noting that sterling has already fallen very sharply after the referendum, by 17% versus the Euro and by 18% versus the US dollar.

In this scenario, as mortgages become more expensive and property prices fall,  you will see, from the purple line in the diagram below, that UK property prices fall by over 30%. However this diagram also places it into context with previous property price falls elsewhere in the world and you will see that in the UK in 2007 there was a fall of about 17% which rapidly corrected itself, in Ireland in 2007 there was a fall of 50% and in Spain in 2008 an even greater fall. However, it's important to remember that this is the Bank of England’s worst case Scenario and it is not meant to be an illustration of the most likely outcome.

Now (August 2019)

The UK map of annual house price change shows that the only region where prices have fallen over the last year is in the Southeast around London but elsewhere property prices are still increasing.

There was certainly a turning point at the time of the referendum after which the rate which property prices were increasing has definitely slowed.

The fall in London prices has been over 4% over the previous year.

Although London prices are starting to fall and other regions are still increasing we're still a long way from convergence in house prices. The reason for this is there was the period during which London grew much more rapidly than the rest of the UK. The average house price in London is £457k which is about 3x the average house price in the Northwest.

Affordability

House prices tend to increase most when affordability is best and the graph below from Vanguard research shows five decades. The x-axis is the starting price-to-income ratio scale, therefore the expensive house prices are on the right and cheap house prices are on the left.  The y-axis is the house price appreciation over the following decade, ranging from rapid house price growth at the top to slow growth at the bottom. 

At the moment you can see that house prices are still very expensive relative to UK income which suggests that house price growth over the following decade will be fairly muted at around 2% to 4%.

Below is a graph showing the average UK house price to earnings ratio since 1989 and you can see that we're still well above the long-run average This means that for house prices to increase significantly we will need to see a substantial increase in UK earnings.

Interest Rates

In August 2019, the US Federal Reserve started to cut interest rates in what Jerome Powell called `a mid cycle adjustment’. The reasons for this were concerns about trade war and falling global growth.

Central banks around the world have followed suit for similar reasons and although the reasons why banks are cutting interest rates isn't a positive for the housing market at least the cost of mortgages will stay low.

Wages Versus Inflation

Wages are also telling a positive story In their battle versus inflation. Wage growth in 2019 is steadily improving but what’s critically important is wage growth versus inflation. While this was negative for a long period of time, since 2010 it has turned positive and it seems to be steadily rising. Greater household disposable income means that we can borrow more and that tends to push up house prices.

Supply Versus Demand

The supply and demand story really hasn't changed for quite some time and supply still remains very much constrained. 

After the Second World War most of the supply of houses were produced by local authorities but that stopped in the 1980s and nothing else has really filled that gap.

In the UK we have an oligopoly,  where the eight largest builders create more than half of the new homes and it's not in their interest to increase supply because that would reduce prices. Additionally the type of housing which is being created isn't suitable for older people which means they are staying in their houses for longer rather than moving into appropriate accommodation.

If Brexit reduces immigration then that may be a negative for demand, but as we get a greater number of one-person households, rising life expectancy, rising incomes and greater mortgage availability that increases demand.

According to a survey by RICS, the stock of properties on estate agents books is at a record low and that's probably because of Bexit and its uncertainty. They estimate the normal level to be about 70 properties at a time but at the moment there are only 41 on average.

Consequently the turnover rate (the % of households that move) is low at 5.1%, well below where it was before the global financial crisis. 

The good thing is that the rate of first-time buyers who are buying with the mortgage has recovered to the rates that we saw in 2007. The rate of cash purchases is much the same as it was in 2007, but what has fallen dramatically, probably because of a taxation and legislation change, is the number of buy-to-let purchases with a mortgage and movers who aren't first-time buyers moving with a mortgage.

In summary, the outlook for UK house prices is still fairly weak, affordability is stretched and that usually means that house prices don't increase much over the next decade.  However we do have fairly strong wage growth and supply is still constrained, which is a positive for house prices.