Despite the fact that the price of an average home has fallen by 10.9% since 2007, property prices in Britain remain considerably overvalued. This article shows why that is the case, what is holding property prices up, and why the bubble may already have burst.
What’s keeping prices up?
There is really only one reason that house prices in Britain are only 10.9% below their 2007 peak, and not 30, 40 or even 50% below, and that’s the fact that interest rates are the lowest they have been for 300 years.
Clearly there have been other measures designed to prop up the economy and house prices, including the £500 billion of deficit spending, the £375 billion of Quantitative Easing, the government’s Rent to HomeBuy scheme, and a stamp duty holiday for first-time house buyers (now replaced with the NewBuy Guarantee scheme). However, ultra-low interest rates are by far the biggest factor providing life-support to the housing market, and it looks as though this phenomenon is coming to an end.
Rates are now beginning to rise
The recent tightening of credit within global financial markets has forced some lenders to raise their mortgage rates (SVRs), in spite of the fact that the Bank of England (BoE) has kept their key lending rate at 0.5% since March 2009.
The reason for this is the fact that the loans made by mortgage lenders such as Halifax – Britain’s largest mortgage lender – are funded by a combination of repayments from existing borrowers, savings deposits and money secured from the money markets.
Back in May several lenders, including Halifax, Co-operative Bank, Clydesdale Bank and Yorkshire Bank, raised their mortgage rates for existing customers by as much as 0.5%.
This connection between the availability of credit and the cost of repaying a mortgage dispels the myth that property prices will be ok as long as the Bank of England doesn’t raise its official bank rate.
House prices remain considerably overvalued
Despite their fall of 10.9%, property prices in the UK remain considerably overvalued.
Average UK House Price – Jan 1991 to June 2012
Source: Nationwide house price index.
Notes: This chart shows the average UK house price from January 1991 to June 2012 as reported by Nationwide. Property prices began rising steeply in early 1996 when the average home value was £50,520. The price of the average home then rose for 11 years before peaking in October 2007 at £186,043. Today the average home in the UK costs £165,738.
One of the most common methods of determining the value of property involves looking at the relationship between the average house price and the average wage. This gives you the house price to income ratio.
Historically lenders used a house price to income ratio of 3.5. This meant that a borrower could take on a mortgage of no more than 3.5 times his or her salary, something which provided protection for both parties in the event of a recession or a rise in interest rates.
Between 1983 and 2002, i.e. before the major surge in property prices, the average house price to income ratio was 3.6.
Given an average house price of £165,738* and an average gross annual wage of £26,100**, and assuming a deposit of 20%, today the average house price to income ratio is 5.08. Meaning that to buy the average home, the average wage earner would have to borrow more than five times his or her salary.
It is clear then that property prices in the UK remain significantly overvalued and that the market is in a very precarious position.
If property prices were to fall such that the house price to income ratio returned to its historical 3.5 level, then the average UK home would need to fall in price from £165,738, to £109,620 – a fall of 33.8%.
In other words, property prices in Britain are overvalued by one third.
In my view Britain’s property market is in a bubble and it’s one that can’t be too far away from a pin. In fact, the bubble may already have burst.
Why the bubble may already have burst
Back in November 2010, in a special report on the future of UK house prices, I wrote, “The opening of London’s new 1,016 ft (310 m) skyscraper ‘The Shard’ will mark the precise top of the UK property market.”
This bold statement was only partly tongue in cheek, since history shows that there is an interesting correlation between the opening of new skyscrapers and the bursting of property bubbles. More specifically the opening of these buildings marks the beginning of a period of sharp economic contraction that is accompanied by a sharp fall in the value of property.
Examples of this include the world’s first skyscraper, the Equitable Life building in New York, which was completed in 1873 and coincided with a five year recession. The opening of the Empire State building in New York in 1930, which was right as the beginning of the Great Depression, and the opening of the Petronas Towers in Malaysia in 1997, which was right before the Asian financial crisis hit.
It will be some time before we know whether or not history has repeated itself with the opening of the Shard, but in my view there is a good chance it will.