Tuesday, 11 December 2007

What really determines house prices

As the UK house bubble took off, experts were telling us that prices were determined by "fundamentals" - planning regulations, scarce land, migrants, changing family size, divorce and a myriad of other half-baked explanations.

Take a look at these two charts, and see whether you can see any patterns. The first is real average wages (deflated by the retail price index) and the Halifax UK house price index (again, deflated by the retail price index)

I think we are are fairly safe ground if we conclude that house prices have departed significantly from earnings.

Here is a second chart, this time, we take out average wages and include real personal sector debt secured on housing. This series comprises of mortgages and home equity loans. Again, it is deflated by the retail price index. As you can see, there appears to be a close connection between the two series.

While there may be many factors that influence house prices at the margin, the availability of mortgage debt is the key driver. Without the huge growth of mortgage debt, there could be no bubble.

However, that average wage series may yet have a say in the long run level of house prices. How can all this newly acquired debt be repaid? Yes, it has to be wages. At some point, house prices must re-establish a heathly relationship with average wages.

Perhaps we are at that point right now. Take a very close look at those pink lines. The last data point is looking downward.

(All series are indices where April 1993=100; average earnings data is from the ONS; debt data is from the Bank of England; house price data is from the Halifax. Although the charts were constructed by myself; anyone who wishes to use them on their sites, just go ahead; an acknowledgement would be nice but not compulsory.)


speedtheplow said...

That there has been a bubble of the magnitude of Commodities 70s, Nikkei 80s, Tech 90s--cannot be in dispute. But what will bring it down? Last time I posted you corrected me about the effect of interest rates, and I agree--but if rates continue to come down then people will continue to pay off their mortgages and prices will, if not go up, remain static. That would be terrible. Every bubble that has broken (in the recorded history of bubbles) has seen a decline of 50% at the minimum--this is what it would take to bring UK (esp London) house prices back to the realm of reality. But without rising interest rates, I do not think we will have the crash. Even though inflation is soaring, the BoE is determined to turn the other way.

Anonymous said...

Killer graphs, but you might want to label them if they are your own, and cite the data source.

ukhousingbubble said...
This comment has been removed by the author.
Budvar said...

"But without rising interest rates, I do not think we will have the crash."

It's affordability that causes crashes, higher interest rates were just the mechanism that caused the unaffordability.

What this means in real terms is this, the housing ladder is supported from below, once people stop buying on the bottom rung, the whole lot comes crashing down.
With house prices running at 10 times earnings, these prices are unsustainable long term, and the only way they can be viable short term is if there's significant appreciation in price as in recent years. Interest rates are irrelavent, even if they drop to 0% and people still cant afford the payments, prices have to fall.

speedtheplow said...

Point taken. But if sellers sit tight, refusing to lower prices, the market might just sail on indefinitely until inflation eats up the difference in ten years or so...What we want is a full-blooded crash, and I am mightily worried that the smug and complacent UK public won't panic far and fast enough to give us one. Certainly the BoE is going to lower rates again and again to support the bubble.

Anonymous said...

The kink int he house price graph around 2000 is interesting, that would correspond with the 'dot com' boom.

My two favourite personal data points are in 1976 a packet of crisps in the school tuck shop cost 2p. A similar packet of crisps today is now pushing above 50p, that is 10 shillings. And a pint of beer in 1980 used to cost me 48p it now costs five times that where I live(outside London).

Anectodal reports of people buying a new build house in the seventies for £500.

The point of all this is that we should not underestimate the impact of inflation.

That of course is in my opinion the reason behind these bubbles, the government uses inflation as a policy instrument, it means they can buy today devalue the currency and pay the debt in devalued monetry units tomorrow. It suits the government because by and large they won't be in government much more that ten years in the future.

But the problem is that it discourates responsible attitude to saving, if your hard saved cash is being erroded on the one hand by inflation and on the other by tax on the interest earned you would be a fool to do anything but spend it as quickly as possible unless you can get an extra ordinary return.

The only place people can do so is in the next bubble, it was 'dot com' it is now the 'property boom' who knows if there will be another bubble, but if you recognise it now you might be well advised to sell your house now and put the cash into the new bubble.

Budvar said...

"But if sellers sit tight, refusing to lower prices, the market might just sail on indefinitely until inflation eats up the difference in ten years or so.."

Have you really thought this through?

House builders sitting on inventory for 10 years until they get their price, what are they supposed to do for a living in the meantime, stop building?
Also if by some means of sheer luck that these empty houses don't deteriate any in that time, I'm sure the current bathrooms and kitchens will be just as desirable as mahogany kitchen cabinets, toilet seats and avocado and burgundy bathroom suites are today.

Are people going to stop dying, or do you think the money grasping wasters with their money grubbing wives that inherit grannies large Victorian will sit it out until the price rises until they get their grasping little fingers on the cash?

Do you seriously believe that banks with reposessions on their books will also hang onto them until they get the price they think they deserve?

You also need to take into account people who bought over 5 years ago, if they sold their houses today for half what they're "Worth", they'd still get twice what they paid for them.

What about estate agents, solicitors and surveyors, what do they do for the next 10 years waiting for house prices to pick up again?