Monday, May 07, 2007

UK House Prices; Caveat Emptor

A surprisingly accurate article from Will Hutton in this weekend's Observer, reprinted in Comment Is Free, about the need for the Bank of England to raise interest rates significantly to stem the house price bubble.

His observations are as follows;

i) Housing today is seen as a 'one-way bet'
ii) Money is cheap and hence people are taking ever larger mortages
iii) Lending standards are too lax
iv) The scarcity of property has contributed to its rise
v) Valuations (at six times earnings) are sky-high
vi) Rising inflation will cause interest rates to eventually rise to much higher levels, crippling mortgage holders.

Will's Solutions
a) Tighten bank lending standards
b) Raise rates significantly, starting with a 0.75% increase on Thursday

To examine Will's article, one must first realise that the British housing market boom is not isolated. The world is experiencing a housing price bubble, and the most important market is that of the US. Therefore, to see the future of our bubble, one must look first at the US market.

The last major market to experience such a bubble was the Tech Bubble, which ended spectacularly in March 2000 . If only we had all sold our shares in Cisco and Microsoft in March 2000! But how does one predict the end of a bubble? First, some golden rules;

Golden Rule No. 1
Markets bottom when no one is any longer calling for the bottom. They bottom in silence.
When you hear about 'one-way' bets, worry.

Golden Rule No. 2
All asset prices move in cycles.

The housing cycle started in 1993 when the market bottomed. You literally couldn't give away property in 1993. No-one was calling for a turnaround. This is best measured by Housing Starts, ie the number of new properties being built.

The graph above shows the number of new US properties over the past fifty years. The current upswing ended in January 2006 and the market has been falling ever since. The upswing was the longest in recent US history.

So how long do downturns last? We are currently into month 16 of the US downturn. The shortest downturn on record was 28 months in 1972. The average is 46 months or nearly four years.

Another measure of the future direction of the housing market is the number of homes available for sale - inventory. In the US this indicator has just peaked at an all time high.

This is the equivalent of six months supply.

Every single time over the last forty years at least that months supply of homes for sale has been at eight months or above, we've either been entering or in an official recession. No exceptions.

Golden Rule No. 3

The first behavioural stage of every asset class cycle decline is denial. And the denial of the moment is over price. Sellers are reluctant to drop prices and buyers reluctant to pay current prices. So what about valuation. Are UK house prices overvalued?


Asset prices trade at fair value over the course of a cycle. However within the cycle, prices can dramatically over- and undershoot.

Golden Rule No. 4

Over the short term, asset prices are driven by supply and demand.

The UK has a twin policy of restricting land for housing development (supply is reduced) and encouraging mass immigration (increasing supply). This almost turbo-charges the rally in prices over the short term.

i) The long term average ratio of house prices to earnings (the key metric) is 3.5:1. It is currently 6:1. However, this ratio can trend higher during a period of low interest rates.

ii) Hence the second metric is the mortgage affodability ratio. This is a measure of the % of a first time buyer's wage that must go toward paying the mortgage. On this measure, the UK housing market looks fairly priced at 39% of earnings.

iii) Another metric is the rental yield. This is the same as the dividend yield of a share. It measures the annual dividend of a house (its rent) divided by the market price. current UK rental yields are around 4% versus an historical average of 8%.


Central Banks across the world have been pursuing a policy of containing goofd inflation but ignoring asset prices. This has created bubbles everywhere (currently in property and commodities). The actual rate of inflation experienced by indiviuals is way higher than the reported rate by Central Banks. The UK is currently experiencing a resurgence of even this under-reported inflation. Hutton is right that mortgage rates are headed inexorably higher.

For anyone thinking of taking on a buy-to-let property now, pay heed to this graph showing the comparison with Japan in the 1990s. As a reminder, the Japanese housing market is only just starting to show signs of recovery, 15 years after it first began to fall.