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Why UK house prices are set to collapse

Andrew Gibson, Head of Research 15 October 2012 Since the financial crisis began, UK house prices have been remarkably resilient. Nationwide estimates UK house prices are 13% below their peak. Not great, but compared to other countries, not too bad either. For example, the average price in the U.S. is 34% below peak, Spain 31% and Ireland an astonishing 53%. Its not like economic conditions in the UK have been mild. Were in our second recession in four years, unemployment is at 17 year highs and people's incomes have been squeezed by a combination of inflation and low wage rises. So wheres the property crash? Why hasnt it happened? Then in the 1970s, a global inflation shock forced the Bank of England to push rates out of their reliable range. The UK base rate shot up from 5% in January 1972 to a nasty 12.75% only two years later. But this wasnt just a short-term blip the worst was yet to come. By 1976 the rate hit 15%, before finally peaking at 17% in 1980. Fortunately, as inflation was brought under control, rates eventually came back down again. By the mid 90s, the UK rate had settled at around 5% and stayed in a nice little range for the next decade and a halfthen the financial crisis hit.

Long live the King (Mervyn that is)

As we all know now, in 2007 a financial crisis began to sweep the globe. Its pretty clear the Bank of England didnt see it coming they actually increased rates twice in 2007 - in May and July. However, by 2008 it had become clear things were getting ugly and the Bank of England cut rates aggressively. Rates fell from 5.5% in January 2008 all the way down to 2% by end of the year. In January 2009, the Bank of England made history going below the 2% level for the first time ever. But they didnt stop there. By March 2009, the rate had been slashed to 0.5% - and has stayed at this emergency level for over three years now. To put todays emergency into perspective, consider that the UK economy has had to deal with the Napoleonic Wars, the Great Depression and two World Wars. Yet even during those hard times, 1

The main reason is cheap money.

To understand just how dangerously low interest rates are right now, its worth briefly looking back at history. You see, the history of UK rates goes all the way back to 1694 making it one of the worlds most complete economic datasets. Looking at a historical graph of UK interest rates what strikes you is how much more volatile interest rates have become in modern times. In fact, the base rate was once held dead flat at 5% for over a century (1719-1822). From about 1840 onward the Bank of England got a taste for meddling with the UK economy. Rates started to move up and down like a yo-yo. Even so, up until 1973 UK rates stayed in a broad range between 2% and 10% and interestingly 5% was still the approximate mid-point.

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the Bank of England didnt feel it necessary (or more likely prudent) to cut rates below 2%. But judging Mervyn King & committee by their actions, they feel todays situation somehow warrants it. Of course its easier to enter unchartered territory when youre not alone. You see, the Bank of England has followed the US Fed every step of the way. The US started cutting their base rate in September 2007 - three months before the Bank of England began. Co-incidentally perhaps, the Fed finished their cutting in December 2008 three months before the Bank of England stopped.

Furthermore in the US, long-term fixed rate mortgages are far more common. Whereas here in the UK, most mortgages are based on short-term variable interest rates. So sharp cuts in the base rate rescued British borrowers far more than Americans. This doesnt mean the UK has escaped the same fate as the US. It just means the UK has prolonged its correction.

No matter which way you look at, its clear that UK property is still expensive.
Its not rocket science. You can illustrate the point very simply. In the 10 years from 2001-2011, the average house price increased 94% compared to a 29% increase in the average salary. In other words, house prices rose three times faster than wages. You dont have to be a mathematical genius to see things are not right. Importantly, long-term studies have proven that ultimately property prices revert to the mean. In other words, they cant defy gravity forever.

Dont be fooled the UK has not been spared

You might be thinking then why have house prices in the US fallen more than they have in the UK given both countries have cut rates to near-zero? Because there have been a lot more forced sellers in the US. In the UK, home repossessions have been quite small running at a bit over 30,000 a year for the last two years. This is less than half the levels seen during the 1990s property crash. Whereas in the US, banks have been seizing around triple that number of homes every single month! More than 1.1 million US homes were repossessed in both 2010 and 2011. One reason for this is that in many US states home loans are non-recourse meaning if you cant pay, you can walk away. The lender can seize the property but has no further claim on the borrower's other assets or income. In the UK, you have no such luck.

How far could prices fall?

The Economist describes UK property prices as the unfinished bust and thinks they remain 20%-28% too high. Credit rating agency Fitch reckons 25%. Deutsche Banks calculates 34%. Morgan Stanley estimates 15%-25%. Even the IMF (International Monetary Fund) says UK house prices are 30% over valued. Of course, todays ultra low interest rates have provided a major market distortion, holding property prices above their natural level. To illustrate the extent of the distortion consider that over the last 20 years, the base rate has on average been around 4% above headline inflation (CPI). As UK CPI is currently running at 2.6% per 2

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annum (as at July 2012), that would imply a normalised base rate of 6.9%. But banks add on their profit margin too, so mortgage rates are typically 1-2% above the base rate.

year (39% based on the value of loans). What this tells you is that many homeowners cant remortgage because they dont have enough equity in their homes to do so. Those that are mortgage free may disregard all mortgage related data as irrelevant to them. But its very relevant to anyone who owns a house because house prices are clearly linked to credit conditions. If the housing market crumbles, the value of your house crumbles with it (even if youre not forced to sell).

Put simply, the current standard variable rate (SVR) should be around double what it is now.
If you doubled the mortgage repayments of the average UK household, we certainly wouldnt be experiencing a gradual recovery or signs of stabilisation in property prices. Even though at the moment prices might have stabilised, this masks the underlying weakness in the market. The fact is the number of transactions taking place is still 40%-50% below the levels of five years ago. The UK property market is effectively in a state of suspended animation. Buyers should be benefiting from the lower prices but the battered banks have tightened up their lending criteria, demanding higher deposits and offering lower income multiples. Sellers have their own set of problems. Rightmove says that the price falls of the past few years mean that many people, who would like to sell, cannot afford to drop their prices because of negative equity. But its not just cases of negative equity where sellers feel trapped. If a homeowner has some equity in their house but would take a loss on sale, it may not leave them with enough money to cover the costs of moving and the 20% deposit they now need to put down on the next house. The recent plunge in re-mortgaging activity is a warning sign that many existing homeowners are in a frail position. The total number of remortgaged loans has fallen 27% compared to last

The ticking time bomb

Earlier this year Martin Wheatley, a director of the FSA, told the Treasury select committee: There is a ticking timebomb that has been created over the last 20 years. You see, in boom times crazy things happen. And what he was referring to was the millions of interest-only mortgages in the UK.

Of the 11 million or so mortgages in Britain, about four in ten are interest-only.

Between 2011 and 2020, the FSA expects about 1.5 million of these mortgages will become due for repayment. Even more shocking is that the vast majority of people with these types of loans 80 per cent have no repayment strategy, the FSA said. While the horse has already bolted, the FSA has proposed new rules to clamp down on interestonly lending. These new rules are expected to come into effect next year. While the intentions are good, the changes are likely to make the situation worse.

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David Hollingworth, an independent mortgage adviser, has warned that interest-only mortgage holders will potentially have nowhere to go. And because the new rules impose age restrictions, over 50s will be particularly vulnerable. Treasury Committee member Michael Fallon has stated: There are an awful lot of people in their late 50s... who are not going to be able to remortgage. Its hard to imagine that this wont trigger a wave of forced sellers.

The UK cannot afford a further blow to public finances, which would leave the Bank of England with no choice but to defend the pound through interest rate increases. Sharp rate rises by the Bank of England are nothing new. In 1973, 1978 and 1989, mortgage rates doubled in the space of 12 months.

The failed experiment

Some people would point to the case of Japan as evidence that rates can remain near zero for a long period of time. Japan has actually had a zero interest rate environment since 1999. And like the UK today, Japan was the first country to experiment with quantitative easing. The results from this experiment are pretty clear. Its unprecedented monetary blitz has failed to revive its economy. Instead, its suffered two lost decades, barely growing in nominal terms. These days Japans claim to fame is having a government debt burden approaching 230% of GDP. Property prices are back to where they were in the mid 80s and less than half their 1991 peak value. This is hardly the road map the Bank of England wants to follow. But so far it seems to be copying the same policies near zero interest rates and loads of QE - refusing to let market forces take their course. The Bank of England is no doubt trying to do the right thing, protecting the banks from further losses in an effort to revive the UK economy as soon as possible. But leaving house prices at unaffordable levels does more harm than good.

Hidden risks
The bigger question for all mortgage holders is how long will todays near-zero base rates last? Obviously the Bank of England knows it cant keep it this low forever, but its trying to buy time for the banks and the economy to recover. One hidden risk is that worldwide inflation starts to take off, like in the 70s, leaving the Bank of England with no choice but to hike up rates quickly. In fact the UK economy is even more intertwined with the global economy than ever before, so external shocks are a real possibility. Another risk is that the US economy recovers well before the UK. Many economists believe that because US house prices have already undergone a large correction, the American economy is in a better position to spring back to life.

If the Fed starts to raise rates as the US economy recovers, then history suggests a lot of other countries will follow their lead.
If the Bank of England didnt then move in step, a run on the pound would be possible, leading to increased inflation through the rising cost of imports and far higher borrowing costs imposed on the UK government.

Its been revealed only recently that the UK's biggest banks are still sitting on 40 billion in undeclared losses, which is preventing them from making new loans.
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As Japan has proved, if the rot is not purged from the system, banks dont have the confidence to lend. Its also hard to make sensible loans when house prices are so out of whack with average wages. I hardly think Japans years of economic stagnation are something we wish to replicate here.

Consider this: with the Bank of England base rate near zero, are rates more likely to go up or down from here? Even if you think the base rate will stay at these emergency levels for a few more years, whats that say about the outlook the UK economy? Are you hoping for a Japan-style outcome? Even if you're a cash buyer, and mortgage rates arent applicable to you, the yield on investment property is still nothing to get too excited about. The direction of house prices is still the critical factor in your investment decision. And its a brave investor that thinks UK property prices can defy history and stay disconnected from salaries. As youve no doubt heard before, when it comes to investing the four most dangerous words in the world are This time its different. The moment yields turn negative, there will be a flood of buy-to-let sellers entering the UK market. Whats more, if rates spike many ordinary homeowners will be tipped over the edge. And lets not forget the interest-only timebomb that is only just beginning to unfold. Even those lucky enough to be mortgage-free are not immune to the consequences. If the market tumbles, it affects the value of everyones property. Common sense tells you that the UK property market has been grossly distorted by central bank meddling. Not to mention all the unfunded welfare schemes (government giveaways). The Bank of England does not have a magic wand. In the end you cannot argue with the market. A natural correction has not been avoided, its merely been deferred. UK property is an accident waiting to happen.

Why buy-to-let is such a dangerous game

The idea behind buy-to-let is straightforward enough: you make a tidy income from the rent and over time you make a big chunk of capital gains too. And with interest rates so low, rents creeping up and buy-to-let mortgages back on the market, its tempting to think that buy-to-let is a good place for your money right now. For those that can stump up a 25%-40% deposit, you can get a mortgage at around 3-5% interest (largely dependent on the size of your deposit). Looking at prices and rents on Rightmove, you should be able to achieve a gross yield of 4-5%. That should be enough to cover your costs such as mortgage repayments, letting agent fees, repairs and refurbishment. But even assuming a 100% occupancy rate, its unlikely youre going to left with much in the way of a yield. So its essentially a bet on house prices and interest rates.

For most buy-to-let investors theres a delicate relationship between the rental income and the mortgage rate.
If inflation does begin to take hold and rates rise, many buy-to-let investors will quickly slip into a negative yield.

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When will be the right time to snap up a bargain property?

The best yardstick for determining sustainable value is to look at the UK house price to earnings ratio. Nationwide actually publishes it online every month as part of their House Price Index report. This ratio is vital as earnings are the most enduring measure of house price affordability. After all, your salary is ultimately how you pay off your house. Whereas interest rates are a temporary factor and have a history of moving up and down (sometimes drastically), so can cause a value illusion. At the moment, Nationwide reports that the average UK house price is a bit of over 5 times the

average earnings. This compares to a long-run average of 4 times implying prices are 20% too high (or earnings 20% too low I doubt your boss will be keen on this). But as prices tend to overshoot on the way up and the way down, they have been known to bottom out closer to 3 times (as they did in the 90s crash). This would imply house prices could fall by closer to 40%. That also assumes earnings will remain flat in the interim but I think realistically they will continue rising, even if thats just to keep pace with inflation. Like any market correction, its almost impossible to pick the bottom, but my view is that a 25%-30% fall would return UK property to bargain levels.

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