The UK housing market has been a very good investment over the last 20 years. The return on UK property far outstripped inflation, and that performance has been down to a benign confluence of factors. Firstly interest rates have been falling for the last twenty years and that has given many people access to cheap credit so they can get onto the housing ladder. In addition, there has been a staggering demand-supply imbalance. There has been an insufficient supply of new housing stock and burgeoning demand due to demographics and immigration.
We think that is about to change. Read on to see why we think the UK housing market is not such a great investment now.
Let’s use this image of a seesaw to imagine what drives UK house prices. Low interest rates are very important because if people can borrow cheaply they will borrow more and as people are better armed in bidding wars that pushes up house prices. That only works up to a limit. Banks restrict the maximum amount they lend based on a multiple of your disposable income, with a cap of around four and a half to five times. As with any market housing supply and demand are also important and the UK housing market has been characterised by having strong demand and insufficient supply. That demand-supply imbalance has pushed up UK house prices even though affordability is very poor in the UK. And the final pair of factors we’ll consider on the seesaw are wage growth and inflation. If wages are growing at two percent but the cost of living is growing at three percent then disposable income will fall, houses will become less affordable and that tends to drive down house prices over the long term.
Now let’s drill into some of those factors in detail to see how that’s going to affect house prices in the short and medium term in the UK.
Let’s start with the Nationwide House Price Index. Here are some comments from Robert Gardner, Nationwide’s Chief Economist. As he looks into his economic crystal ball he thinks the housing market outlook remains clouded which is a sideways allusion to the uncertainty around Brexit. As a typical economist he gives you both sides: on the one hand, on the other… The economy didn’t slow after that fateful summer referendum and unemployment is at a very low rate, the lowest it’s been for 11 years and when unemployment is low that tends to push up real wages.
However, the one place where Brexit had a very large effect was on sterling. At the moment we’re starting to see fuel prices increase but the Bank of England expects the general cost-of-living will increase as well. This fan chart is their projection for what will happen to inflation over the next three or four years most likely it’ll go well beyond their two percent target maybe up to three percent or even four percent.
But as Robert Gardner says that’s going to have an effect on real wages that’s when you take away inflation from your wage growth. When your disposable income falls then you spend less and because services are such a big part of our growth in the UK that’ll be a considerable drag on economic growth and it could also affect employment.
The Nationwide thinks this squeeze on household budgets will intensify. The graph on the right shows UK growth for the last 60 years alongside UK house price growth. When there’s a recession, in other words negative growth, the housing market tends to fall in value but even if there’s a slowdown in growth that tends to slow down the housing market hence their concern.
But before we get too pessimistic they point out that this will just be a slowdown. They only expect house price growth of around two percent but if inflation is three percent that means in real terms house prices will fall. And they think the lack of supply is what will shore up UK property prices.
The Halifax survey is in broad agreement with the Nationwide. They say that currently we have fairly robust house price growth, but it’s decelerating which means it’s growing more slowly. Again they talk about weaker economic growth and increasing pressure on spending power, but they also mention affordability being a problem. So that’s where we are now.
Now what’s really important is what’s going to happen to interest rates. Now let’s step back a moment and look at interest rates over the long term. The blue line at the top is US interest rates, the Bank of England’s in the middle shown in green, and European rates are at the bottom in red. You can see that over the last seven years rate have been flat- lining both in the US and in the UK. Only recently has the Federal Reserve started to raise interest rates as they come out of the long recession following the Global Financial Crisis. The question is: are we going to follow suit? Most people think not, but we think we might… Currently, rates in the UK are the lowest they’ve been since 1694 when the Bank of England was founded.
But the US central bank the Federal Reserve has dropped some very strong hints that after they started raising rates in December they’re going to continue doing that, and as Janet Yellen says here, if they wait too long to raise rates they may have to raise them more quickly and that could disrupt financial markets and push the US economy into recession and that would be bad for everybody.
In another blog, we’ve laid out in detail why we think US rates and UK rates are strongly linked. The economic linkages occur through trade, financial markets and something called Animal Spirits, but the gist of the argument is that if the US does manage to engineer four percent growth that will spill over into other countries. Better growth in the US will mean rising interest rates and rising interest rates in the US will drag up interest rates in the UK as well, which means that that 20-year downward trend in rates will be at an end. And going back to the seesaw that will be a drag on the UK property market.
In the race between inflation and wages which will win? Well here’s the latest data on inflation in the UK. After a period of very low inflation, we’re finally starting to see it spike largely because of the Brexit devaluation of sterling. Wages, on the other hand, didn’t spike as a result of Brexit. That means that if we look at real earnings growth which is the rise in your weekly earnings minus the rate of inflation that’s been steadily falling and it’s set to fall more quickly and that’s what has got the Nationwide and Halifax economists worried it’s this fall in the buying power of your wages.
How about the balance between housing demand versus housing supply? A very strong support of UK house prices was that supply has been very limited. If we look at who actually built the houses after the Second World War in pink you can see that local authorities were very important up until around the nineteen eighties. But that component of supply was never really replaced by private enterprise and as a result housing supply has been constrained ever since. The structure of the UK housebuilding market is also unhelpful. It’s dominated by eight very large building companies and those eight companies account for more than half of the new homes which are built. As the UK ages many empty nesters want to move into smaller homes or older couples want to downsize into bungalows, but new housing supply is just not producing that kind of dwelling. The local authorities which used to provide so much of the supply are prevented from doing so by controls on public borrowing.
On the other hand demand has been extremely strong that’s because UK life expectancy has increased and people are tending to stay in their homes partially because they can’t move into appropriate new-build. Rising population due to immigration has also tended to increase demand for homes as have rising incomes and mortgage availability plus there’s a trend towards living in one-person households.
Now what you don’t want is the average age of a first time buyer to continue to rise because that’s unsustainable and in order for that to happen you have to build at least 300,000 homes a year and thas has to be for the foreseeable future. If you look at the net additions to the housing stock that were actually created you can see that we’re well below that target.
Fortunately, in February the Government came up with a solution. They produced a whitepaper called “Fixing our broken housing market”. However, the reception wasn’t all positive. Jon Bell, an analyst at Barclays, said that you could have mistaken the content as being distributed by the Ministry of Homeopathy because it was so watered down, and he failed to find anything of substance in its 105 pages.
Here’s Theresa May’s summary taken from the foreword to the white paper. She outlines the need for more land for house building and that each region will have to have up-to-date plans in place so that we’re comfortable with how those houses look. Secondly, she wants to streamline the process so that once planning permission is given the homes are built quickly. Thirdly, she says the Government wants to break up the oligopoly, in other words, the dominance of the house building market by those eight companies that we mentioned earlier and also housing associations and local authorities will come back to the party. For those who can’t afford to buy a house, the Government’s going to help people who rent.
Finally, let’s look at affordability. To see how affordable UK houses are we can take the household debt and divide it by the income of the household. You can see that the UK is highly indebted even after the fall and debt after the Global Financial Crisis we’re still up to our eyeballs in debt and a large part of that debt is due to mortgages.
If we compare house prices with disposable incomes we see a very similar picture: we’re close to levels that we saw just before the Financial Crisis which means that affordability is being stretched to the limits. If we break down affordability geographically it’s mostly London and the South-East which have the lowest affordability.
In order to buy those houses the loan-to-value, which is the proportion of the total house price that you borrow with your mortgage, peaked just before the Global Financial Crisis but now it’s started rising very sharply again. It really does look as if we’re pushing affordability to the very limits.
So going back to our seesaw, we’re expecting low interest rates to go away, housing demand will probably remain strong for some time, but wage growth will lose the battle against inflation. The government at least has a plan for increasing housing supply and as always affordability is stretched to the very limits. That’s why we think the overall balance of factors is shifting towards moving house prices lower and why we think the UK housing market is becoming much less attractive.
Remember this is not a recommendation. If you want financial advice tailored to your individual circumstances seek independent financial advice.
Do you think UK property’s a good investment? We’d love to know!