Don't believe this dangerous myth about house prices

published 23 May 2011

Today I want to debunk the myth that our 'little island' can sustain higher house prices just because land is in limited supply.

In fact, I want to show you why land prices fall even harder and faster than house prices in a downturn and why you need to be very wary about investing in one particularly exposed sector right now.

Whenever I write about either the housing market or land, it draws a lot of, let's say, passionate comment from readers. It's a sensitive subject especially if I'm downbeat on the subject! But that's not going to stop me so feel free to let me know your thoughts on this critical subject.

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The most alarming myth about property prices

The fact is, a building plot on this green and pleasant land could be a terrible investment, as I'll show you in a second. And given that the house-building sector sits on an awful lot of land, it's no surprise that shares in that sector can get smashed if the housing market turns down.

Most people I talk to seem agreed. Today, house prices have a lot more downside risk than upside potential people see that there's an accident waiting to happen.

House prices are (at best) muddling along, despite the fact that rates are pegged to the floor. That should sound alarm bells, because rising interest rates will surely kick off a slide in house prices at some point.

So what are most homeowners doing? Well, for most people, absolutely nothing. And rightly so. A house is for living in - and anyway, the transaction costs and hassle of trying to take advantage of a downturn is more than most families can cope with.

But here's what I find most alarming about the consensus opinion on house prices amongst British people.

While many think that prices may suffer in the short-term, most people are still convinced that this will be temporary. "We're living on a small island don't you know?" The backbone of their argument is that a strictly limited supply of land coupled with considerable planning restrictions will put a floor under property prices.

The result of that is that many people think that a building plot could be a great investment. And worryingly, many investors in the house builders haven't got a clue how brutally the builders' main asset (the land bank) can get smashed.

Building plots can fall twice as quickly as house prices

The important point here is that a piece of greenfield or brownfield land is a highly-leveraged investment. And I'm not talking about any sort of financial leverage here. It's got nothing to do with mortgages and financial gearing of property stocks which incidentally, leverage up the risk even more.

Let me explain 'land leverage' with an example:

Let's say it costs £200,000 to build your dream home (including the developer's profit margin). And let's say the house is worth £400,000 on completion.

That means the plot is worth £200,000.

But let's say that one year from now prices have fallen 10%, or £40,000 for the house in question. Now the house is only worth £360,000 (£400,000 - £40,000 = £360,000). What would a similar plot cost then?

Well, if the finished house is worth £360,000 and it costs £200,000 to build, then you'd only want to pay £160,000 for the plot. That's still down £40,000 but in percentage terms, it's a fall of not 10%, but 20%!

In this case, the plot has fallen by twice as much as house prices in general. You can see the dangerous effect of leverage at work.

So as prices turn down and the market values of plots fall, the house builders have to write down the value of their land bank. When you factor in the house builders' financial leverage on top of land leverage, house builders' profits can quickly turn to massive losses.

It's little wonder the house building sector took a hammering during the 2008 credit crunch. Several had to come to the market for new capital. And a fund-raising during straitened times can be disastrous for the share price.

For instance, Barratt's went from above £8 to become a penny stock. Persimmon collapsed from £14 to £2.

Barratt Developments share price (last five years)

Persimmon share price (last five years)

House prices are wildly misunderstood

The house price phenomenon in the UK is wildly misunderstood. For starters, many don't appreciate that prices have much more to do with supply and demand of credit (mortgage) than supply and demand of houses, or building land.

And the innate leverage on building land certainly isn't well understood. That's why you need to be very careful about the house building sector.

If rates do get squeezed up and house prices get squeezed down, then expect to see some significant write-downs in the sector as land banks get reappraised. That could be devastating for house-building stocks.

And if you're considering buying a building plot, I think it's probably worth sitting on your hands for a little bit longer. That's the way I see it. Let me know your thoughts.

This article was first published in the free investment email The Right side. Sign up to The Right Side here.

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Bengt graduated from Reading University in 1994 and followed up with a master's degree in business economics.

He started stock market investing at the age of 13, and this eventually led to a job in the City of London in 1995. He started on a bond desk at Cantor Fitzgerald and ended up running a desk at stockbroker's Cazenove.

Bengt left the City in 2000 to start up his own import and beauty products business which he still runs today.