House prices

House prices have got to come crashing down

Sanjeev

Sanjeev

It can’t go on like this. House prices simply cannot continue to rise faster than earnings as they did again in 2006. First-time buyers can’t afford homes in 90% of Britain’s towns.

Disclaimer: This article was written originally in January 2007, so some data points may be outdated.

Halifax reckons the average first-time buyer paid £151,565 in 2006, up 11% on the previous year and more than double the £77,814 average for 2001. Of course, there are significant regional variations, but in 2006 the average paid by new homeowners in every region of the UK topped £100,000 for the first time.

In London, those looking to get on the housing ladder for the first time paid an average of £251,000 and had the pleasure of handing over 3% in stamp duty (at least £7,500) to the Treasury as part of the price of becoming homeowners.

And with interest rates increasing for the second time in three months, first-time buyers will also be burdened with increased monthly mortgage repayments, making buying a home even less affordable than it already is.

Therefore, house price increases simply can’t go on. Why can I say this with such confidence after so many experts got wrong-footed by predicting a housing crash last year? It’s simple. You cannot have a rising housing market without having entry-level buyers.

First-time buyers feel the pressure

In 2006 Halifax reckons there were 325,000 first-time buyers, which is 7% less than in the previous year. But those new homeowners were increasingly strapped for cash. They paid an average deposit of £28,130, more than twice as much as they needed back in 2001.

So that’s one limit you face as a new buyer – how much cash can you raise? Nationwide reckons parents stumped up more towards home deposits in 2006 than ever before, but thinks they’re reaching their own limits in what they can afford to hand over to their kids.

The second limit is earnings. Back in 1997, first-time buyers’ average income was in line with national average earnings. By 2001, their income was 20% higher, but last year the average new homebuyer earned £33,202, which is 35% higher than the national average earnings. Mortgage lenders have increased the multiples of earnings they will lend, but they too are at the limits, because the first-time buyer borrowing 4.5 times his or her income will use over a quarter of net income in mortgage repayments.

Buy-to-let numbers are wrong

This means that millions of people with earnings lower than the national average are priced out of the housing market. So there is an ever smaller number of potential new owner-occupier entrants to the market.

In 2005 and 2006, this gap was made up by buy-to-let investors; those buying homes in order to rent them out to tenants. Probably over half the 150,000-odd new housing units built last year were flats that were bought as investments. But the rental return on buy-to-lets in the southeast of England is now under 4%, which is a lousy investment unless you expect capital growth on top.

Effectively, buy-to-let investors in the southern half of Britain are assuming they will get about 5% a year of capital growth as well as rental income. But you have to ask whether this is possible in the long term because it assumes that rents will rise faster than average earnings, causing rents to absorb an ever-rising proportion of net income.

Soviet-style rules won’t work

So far, the government has relied on a good old Soviet-style command method to solve the problem that not enough new housing is being built to exert downward pressure on prices.

It has instructed regional authorities to permit more houses to be built. This ignores the reality of the marketplace. Builders could today be building twice as many houses as they are doing. But they prefer to ration supply, sit on their land banks and make whacking profits – just as you would if you could get away with it. The housebuilding companies complain about how slow the planning system is, but actually, the system works well for them and the last thing they want is free-for-all competition.

In addition, NIMBYism and our weird system of local government finance, which means it actually costs local authorities money to allow new housing to be built, are powerful brakes preventing the large-scale building that would be needed to make free-market housing affordable.

Because it isn’t affordable, the government’s Homebuy scheme gives mortgage subsidies to ‘worthy’ public sector workers, but it suffers the usual problems of too much complexity and red tape. I reckon it won’t be long before people get the idea that it might actually be cheaper and more effective for the government to build homes and rent them to the people we need to make society function.

The dysfunctional market needs a radical shake-up           

Therefore, only far more radical treatment is going to sort out the UK’s dysfunctional housing market. It is now fair to call it dysfunctional because it is hampering mobility and using up resources that would be better spent elsewhere.

Think about Germany and France, where wages are somewhat higher but housing costs (either rent or mortgage repayments) are about a third less than those in the UK. Who gets the better lifestyle?

High house prices may seem good to people who own houses but they carry a substantial cost. They transfer wealth from the young to the old and from the poor to the rich. Inflated prices create an illusion of wealth, but it only becomes real when you sell up and go and live somewhere much cheaper (not Wales anymore, so maybe Croatia?) They reduce mobility and are in danger of creating a permanent underclass in the UK.

Different rules for Planet London

Now for the joker in the pack that skews everyone’s perception of the problem. London is no longer really part of the UK housing market. A third of the population of greater London is not ethnically British, and London holds far more than its share of new immigrants. Of course, it does, because London’s where the money is.

So you have pressure on housing from below. But you also have it from above. Virtually every seriously rich person in the entire world wants to own a home in London because, despite all its problems, London is actually one of the best two or three cities on the planet. That combined with bumper City bonuses means a steady escalation in top-end house prices at many times the national average.

How do you sustain free-market principles in the face of these pressures? You can’t. Just think about the buying power there is at the top end of the market, with the number of Chinese and Indian millionaires soaring as their economies boom.

The only possible solution

In the short term, there’s probably just enough leeway for first-time buyers for UK house prices to keep rising, though at a slower rate – maybe 7% or so this year. In the longer term, however, there has to be a period in which earnings rise faster than house prices.

I know exactly what’s needed to achieve this without a crash in house prices: inflation, which raises earnings and erodes the value of debts (and in general, transfers wealth from the rich to the poor). Despite this month’s interest rate rise, my prediction for 2007 is that by the end of the year, people will be saying that a bit more inflation may not be such a bad thing after all.

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