Can you imagine a world where house prices are 10 times income? Apparently, today's Times can envisage such a state of affairs. In an article today, the newspaper predicts that house prices will keep on rising so that by 2026 the typical income will only be a 10th of the price of the typical house.
But what would such a ratio mean to a new homeowner? Let us assume that a person takes home ₤50,000 a year and has a mortgage for ₤500,000. At a 6 percent interest rate, the annual interest costs would be ₤30,000 a year. In other words, interest charges alone would account for 60 percent of income. So if the Times is right, we can be sure about one thing; there will be no first-time buyers in Britain in the 2026.
Perhaps such a ratio could be sustained if homebuyers have large down payment. In such circumstances, homes will be transferred between affluent homebuyers, while the poor and propertyless can continue renting. Those who are desperate to own a house will have to resign themselves to years of savings, building up a deposit sufficiently large to make it possible to enter the market.
Alternatively, interest rates might fall to say 3 percent, making the ratio somehow affordable in terms of monthly payments. If the Bank of England became really serious about inflation, and pushed price growth down to something close to zero, then perhaps nominal interest rates could fall further. Judging by the arguments presented above, one need some fairly contorted arguments before a ratio of 10 seems reasonable.
However, there is a stronger argument suggesting that house prices will be somewhat depressed in 2026 - demographics. The UK's population is ageing rapidly. Without immigration, the UK's population would be falling slightly. Over time, increasing numbers of migrants will be required in order to keep the population constant. However, will all those Polish plumbers, and Latvian waitresses keep coming to the UK?
If housing costs keep on rising, the answer is probably not. Within the next few years, continental Europe will gradually relax its migration policies, and those Polish plumbers will be able to settle in Germany and France, where housing costs are significantly cheape than the UK. Eastern European workers may also stay at home. Furthermore wage rates are rising in Eastern Europe, and although they have some way to go before they reach UK levels, wages are catching up.
Furthermore, far too many people have relied on housing as a substitute pension. Presumably, these pension schemes will start a mature somewhere around 2026. It's not hard to imagine the housing market for the impoverished 67-year-olds pedalling their dilapidated houses. It will be a market full of fixer-uppers reeking of that odour that only old people produce.
Demographics might tell us that there will be plenty of bargains around in 2026, but we don't have to forecast 20 years into the future to figure out that the housing market will crash. House prices in the UK are high because of a series of temporary and unsustainable factors.
It started back in 2001 with a foolish Bank of England pumping the economy full of money, which reduced interest rates. The long run consequences of that irresponsibility is inflation, which if it were properly measured by the retail price index, now stands at a 17 year high. However, initially this tidal wave of easy credit flowed into the housing market.
Equally stupid mortgage lenders took their cue from the Bank of England and started extending ever larger loans to desperate housebuyers, who in the face of soaring house price inflation somehow convinced themselves that house prices never fall. Some housebuyers got carried away and thought that they could make easy money by buying additional houses and renting them out. Again, mortgage lenders were complicit. They made it increasingly easy for small-time property speculators to take out massive loans.
This process was further strengthened by the collapse of pensions and the general loss of confidence in financial markets following the dot.com bubble. Houses speculation and the buy-to-let racket became a substitute for long term savings in anticipation of retirement.
Rapidly rising house prices temporarily sustained economic growth. People used rising house prices as collateral and took out mortgage equity withdrawal loans and use them to finance essentially frivolous consumption. The strong growth attracted migrants from abroad, which helped sustain the buy to let market. London, in particular, attracted an unusual form of migrants; Russian oligarchs anxious purchase a bolthole should political circumstances in Russia require a sudden exit.
If any one of these factors were to change, the housing bubble would crash. For example, suppose that the stock market started to produce higher returns. Investors would exit the buy to let market and return to buying equity. Alternatively, the Bank of England might get serious about inflation and put in a few more interest-rate hikes. In fact, it isn't hard to think up half a dozen plausible scenarios which all give the same result - crashing housing prices.
So, a house priced income ratio of 10 is not reasonable, either today, tomorrow, or in 2026. UK house prices are massively overvalued. A correction is coming, and when it does come, it will be painful.