House Price Crash or Correction? - The illusion of wealth

On the 12th February 2008, the Halifax has said that house price rises are expected to remain flat in 2008; an apinion that was echoed by the governor of the Bank of England the following day. The implication of these views is that what they won’t be doing is falling. However when one takes even a cursory look at some of the figures that the present value of the market is resting on, the picture looks very different.

Between November 2001 and November 2007 the FT - Acadametrics house price index shows that the average selling price of a house rose from £121,153 to £230,504; an increase of 90%. Over the same period the Bank of England’s base rate rose from 4% to 5.75%, so it was certainly not a reduction in the cost of money that was driving the market. Nor was net disposable income responsible, which grew by just 29% over the same period meaning that house prices have grown three times faster than income for the last six years, while net disposable income is actually set to fall in the case of pensioners and the low paid. from April 2008. It was a flood of unregulated credit, allied to the presumption that the value of any house would continue to rise without interruption that underpinned this boom, not a growth in individual wealth.

The UK house price to average earnings (affordability) ratio is presently at around 8.5/1. This is nearly double the average of 4.5/1 that applied in 2001. In addition total personal debt in the UK in 2007 reached £1.35 billion (of which mortgage debt was £1.15 trillion), as against GDP of £1.33 trillion. As debt to equity ratios go, such a comparison (101%) usually spells insolvency.

What these figures tell us is that lower interest rates are not going to solve the likelihood of a correction; not that they are likely to fall by that much in any case. The cut of last December added a 6% devaluation tax on everything that we import from oil and gas, to food and manufactured goods. The February cut lost us another 2 cents against the dollar on the day, despite the fact that the rest of world doesn’t seem to want any more greenbacks at present. A sharp rise in inflation via a chronically devaluing pound is now a clear and present danger.

Another interesting ratio has been uncovered by the Royal Institute of Chartered Surveyors. They studied the relationship between interest rates and house price cycles going back to the end of World War 2. What they found was that a downturn in prices tends to kick in when rates reach the point at which they are around 60% higher than the low point in the cycle. For instance the present Bank of England base rate is 5.25% while the low point in the cycle was reached on 10th July 2003 when it was set at 3.5%. This is an increase of only 50%, not 60% but unfortunately the rules have changed since the credit crunch.

The traditional mark-up on these rates, known as libor added by the banks before setting their own commercial rates has usually been around 0.25%. Since September 2007, when the debt crisis emerged it has risen to 0.8%% and remains stuck at this level today. So now there is an extra 0.55% to consider and when one factors that into the equation, the applicable rate of increase on the 3.5% low point in the interest cycle comes out at 66%.

Then there is the buy-to-let market: There are now more than a million of these. Many of them are funded by mortgage debt. Returns on investment are reducing as lending rates remain high despite the cuts of the last two months and a significant proportion of these are in any case the subject of fixed rates that either are or will soon be coming up for review. As a result the costs of servicing the debt on them are rising at the same time as the value of the asset will be depreciating. The ratio of debt to equity is called gearing and if gearing gets too high, such as when the asset value falls against a sum of debt that remains constant, there will be pressure to sell that asset in order to clear the debt. The overhang of these properties over the market is going to play a major part in what follows over the next two years or so.

A million such properties potentially in play at a time when money is tight, rising inflation, liquidity problems among the banks plus an undeniable affordability crisis means that the best outcome the housing market can hope for over the next two years is that when the crash starts it will do so in slow motion.

Click here for Halifax press release on house prices

Click here for FT-Acadametrics survey on house price inflation

Click here for Grant Thornton press release on UK personal debt to GDP ratio

Click here for a BBC summary of the events surrounding the collapse of Northern Rock

Click here for New York Times article; 'After the money's gone.'

© Figurewizard.com ltd. This article may not be reproduced without our express permission

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