Why the UK housing market is still primed for a crash

The upsurge in activity in the UK housing market has been driven by buy-to-let investors, not first-time buyers. The longer this goes on, the more likely an eventual crash becomes...

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What's one of the first things you do when you move into a house you've just bought?

We're not talking about paying the lawyer's fees, or stamp duty, or any of the annoying administration like moving furniture or getting the phone connected. What's the first thing you do to the house?

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That's right you decorate. You buy furniture, you get carpets, you change the bathroom suite. Even in the nicest new home, it's very rare not to find something you want to change.

So if the UK housing market is picking up again, why are home improvement retailers having such a hard time?

According to official retail sales data, the high street had a bleak January after the brief flurry of Christmas activity. Sales fell 1.3% on December, the most since December 2004. The average weekly sales value was unchanged on a year ago, the first time this has happened in the month of January since records began.

The decline was led by household goods, with sales falling 3% on the previous month. This was backed up by a trading update from Kingfisher. The home improvement retailer said sales excluding new stores at DIY chain B&Q had fallen 9% in the 13 weeks to January 28th. And apparently B&Q outperformed the market as a whole, stealing market share from rivals like MFI so this isn't a company-specific problem.

Why the downturn in the UK DIY sector?

Well, there seem to be a couple of reasonable explanations. The first reason is that first-time buyers remain an endangered species in the housing market. The ones who do manage to buy somewhere have to borrow so much that they are hard-pushed to pay for any redecorating.

New figures from the Council of Mortgage Lenders show that the typical first-time buyer now has to borrow £103,000, on a salary of £33,000, to buy a house. They are also borrowing a typical 90% of the home's value.

Worryingly, more and more are relying on future price increases to pay for their homes. During the fourth quarter of 2005, the percentage of first-time buyers using capital repayment mortgages fell to its lowest since 2000. One in four now use interest-only mortgages, with most of those not specifying how they will repay the capital once the mortgage period has ended.

That's not the only risk they are taking to get on the property ladder. Official statistics show that the average salary in the UK sits around the £20,000 mark. This means that first-time buyers are either all extremely high achievers, or more likely, are relying on twin incomes to pay their mortgages.

It may seem counter-intuitive, but having two earners in a household can actually increase the risk of going bankrupt. It's fine if one income is essentially for luxuries, or "wish-list" spending like private school fees, healthcare or annual holidays.

The problems arise when couples start to rely on both incomes for the basics, like heating bills, council tax and of course, paying the mortgage. That means it only takes one person being made redundant to land the household on the slippery road to repossession.

So with a backdrop like that, it's not surprising that today's first-time buyer might be reluctant to splash out on a new kitchen. Hence the troubles at MFI.

The other key point is that an increasing number of new purchases are driven by wannabe landlords yes, even now, despite historically low yields. Buy-to-let investors accounted for one in ten new mortgages for house purchase last year, according to the CML. And by the end of 2005, the buy-to-let sector accounted for 8% of outstanding mortgage debt, the highest ever.

We've said it before, but investing in buy-to-let these days is simply wrong-headed. Even an industry body like the CML reckon prices will only grow by 2% this year which means prices will be flat or fall after inflation.

That leaves a landlord hoping that the rental payments alone will be enough money to pay the mortgage and clear a profit. But even if everything runs smoothly, the potential returns are in the low single-digits at best, which seems like a lot of risk and effort for a minuscule reward. No wonder they can't afford to decorate the places properly.

Of course, it's not that surprising that buy-to-let is still popular. People tend to stick with investments that have done well historically, and it takes a lot to knock that tendency out of them. The buy-to-let investors who purchased in the second half of 2005 probably thought they were being smart, picking up some bargains' after a year-long slowdown in house prices. But then investors who bought into internet stocks just after the crash kicked off in March 2000 probably thought they were being smart too.

And the financial industry isn't doing anything to discourage their folly. The hype around Sipps won't have helped, even though Gordon Brown made a U-turn on putting residential property in them. But also, quite staggeringly, lenders have relaxed buy-to-let borrowing criteria. The typical lender will now allow borrowing of up to 85% of the property's value, up from 80% in the first half of 2005. Similarly, rental cover of just 125% is now accepted, compared to 130% before.

UK housing market: house price crash on the cards

Rampant speculation, irresponsible lending, stressed and squeezed first-time buyers there's nothing new about this year's UK property market. Except that all the necessary conditions for an eventual crash have become even more firmly entrenched.

And just a date for your diaries Gordon Brown will deliver the 2006 Budget on March 22nd. We're sure you're as excited as we are. But fear not, we'll endure the inevitable flood of self-congratulatory pomp to bring you the edited highlights and a rundown of all the new stealth taxes we'll be paying this year.

Moving swiftly on to the wider stock markets...

The FTSE 100 rose 37 points to close at 5,828. The main riser was mobile phone giant Vodafone, up 4% to 124.5p on rumours of an impending management reshuffle, denied by the company. Retailers were among the main fallers on a grim January reading for the high street. Next fell 1% to £17.04, while Marks & Spencer shed 1% to 514p. For a full market report, see: London market close.

Over in continental Europe, the Paris Cac 40 closed 39 points higher at 4,973, while the German Dax rose 24 to close at 5,789.

Across the Atlantic, US markets made gains as new construction of US homes jumped 14.5% in January, the biggest percentage gain in 12 years, helped by unusually warm weather. The news offset worse-than-expected inflation data. Import prices rose at an annual rate of 8.8% last month. The Dow Jones gained 61 points to 11,120, its highest level since May 2001. Meanwhile the S&P 500 rose 9 to 1,289, and the tech-heavy Nasdaq gained 18 to 2,294.

In Asian trading hours, oil moved higher, trading at around $59 a barrel in New York. Brent crude was trading at around $57.60. Meanwhile, spot gold rose as high as $547.50 an ounce, before falling back to around $545.

In Asian stock markets, the Nikkei 225 slid 330 points to 15,713. The Japanese economy expanded at an annual rate of 5.5% in the three months to December, but concerns that foreign investors are selling out of the market hurt sentiment. Investors are also nervous about the possibly imminent ending of the Bank of Japan's zero-interest rate policy.

And here in the UK, the National Audit Office has said that Gordon Brown's claim that the Treasury has so far saved £4.7bn in an economy drive is based on unreliable data. Double-counting, the choice of inappropriate starting points to measure savings from, and a failure to account for added spending incurred in making the 'savings' are just a few of the basic accounting flaws uncovered by the NAO. It's nothing we couldn't have told them already, but it's nice that someone else notices these things.

And our two recommended articles for today...

How to ride the gold price rollercoaster

- The gold price has experienced a volatile couple of weeks. Don't expect things to get any better, warns gold commentator Paul van Eeden. As increasing numbers of bulls and bears take positions, the gold market is set for even more heavy turbulence. For his tips on how to keep your nerve and invest successfully, click here: How to ride the gold price rollercoaster

Can Japan save the global economy?

- Japan's recovery has been 'nothing short of stunning' says Stephen Roach of Morgan Stanley. And it looks set to continue. But can recovery in Japan resolve the imbalances threatening the global economy? Unfortunately that burden still lies with the most unbalanced economy of all - the US. To find out which country really looks set to benefit from the return of the Japanese consumer, click here: Can Japan save the global economy?

John Stepek

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.