What Spain can teach us about the UK housing market

Property bulls believe that high UK house prices reflect supply and demand. They're right. But it's the supply and demand for credit, not houses, that matters, says John Stepek. And current conditions in Spain's property market are proof of the fact.

By John Stepek

published 13 September 2010

in Features

There's one factor more than any other that UK house price bulls use to back up their views. Supply and demand.

There are plenty of variations on the theme. But the general argument goes like this: "We live on a small island, our population is growing, and there just aren't enough houses to go around."

And the rebound seen in the market last year simply seems to confirm this view. There aren't enough houses so you can't go wrong with bricks and mortar.

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The bulls have got it right in one sense. House prices are indeed all about supply and demand. But it's supply and demand for credit, not houses.

If you want the proof, just look at Spain...

What's propping up Spanish house prices?

Spain has had a horrendous recession. It's on the infamous "PIIGS" list of threatened peripheral eurozone countries. It has unemployment of around 20%. And there are myriad horror stories of Britons who bought property in the country only to find that their homes were subject to legal disputes, or simply that their pensions couldn't sustain them when the pound slumped against the euro.

And yet, just as we've seen in the UK, the market seems to have managed to take the strain. In the second quarter of 2010, house sales in Spain rose by nearly 25% to just under 150,000, according to the Housing Ministry. The rise was driven mainly by growth in "second-hand" home sales up nearly 50% on the quarter, compared to just a 4.6% rise for new home sales.

That may sound impressive. However, sales are nowhere near their bubble-era peak, when figures would have been more like double that. Yet, the toll on house prices hasn't reflected this. As Fiona Maharg-Bravo puts it on Breakingviews.com, "the Spanish housing bubble isn't in a hurry to deflate. Prices have held up and are now just 12% off their 2008 peak." That's comparable to Britain if you use Nationwide figures, we're around 10% off the 2007 peak price for the average British home (and closer to 16% if you look at Halifax).

Yet there are estimated to be about a million empty new-build homes in Spain. Says the FT, "most experts say it could take another three to four years to absorb surplus stock." And that's despite a collapse in the number of homes being built, from 800,000 in 2006 to fewer than 100,000 this year.

So what's behind the surprising resilience of Spanish prices, if not a physical shortage of property? Obviously there are pockets where things are worse all those horror stories from expats having to sell at huge discounts, for example.

But by and large, what's propped up prices in Spain is the same as what saved the British property market from harder falls interest rates being slashed.

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Just as in Britain, home loans in Spain are generally variable, says Maharg-Bravo, "and interest rates are ludicrously low sometimes less than 2%." So people who might otherwise be forced to sell find that their home loans are cheap enough that they can sit on their property, rather than take an "unacceptable" price.

Compare that to the US, where payments on home loans were generally fixed or in many sub-prime cases, rising, and suddenly it's easy to see why Europe's crash has been nowhere near as severe as America's.

How long can the market hold out?

So how long can this state of affairs last? The trouble is, while prices have held up, it's been at the expense of market liquidity. Put simply, people aren't moving home the way they used to. And first-time buyers are a rarity in Spain as well as the UK. As Maharg-Bravo points out, Spanish net new home loan lending fell in the second quarter. "This suggests a shortage of first-time buyers, with activity reflecting existing home owners trading up or down among themselves".

Without new buyers coming on to the market, it's hard to see where the fuel for further price gains can come from. It might be cheap to borrow, but it's not going to get any cheaper.

Indeed, the biggest threat to Spain's market might be the fact that Spanish banks own so much of it. As Mark Mulligan notes in the FT, "after three years of bankruptcies, defaults, foreclosures, debt-for-equity and debt-for-asset swaps, and the winding up of several property funds, Spanish banks have become the country's biggest landlords and property agents."

The Bank of Spain reckons that lenders now have €60bn worth of land and property on their books. However, says Maharg-Bravo, "new rules will force banks to set aside provisions of 30% of the property's value if they haven't been sold after two years. This is a powerful incentive for banks to dump the inventory." She estimates that roughly 175,000 properties are in banks' hands, "not all of which have hit the market."

Why the British housing market is a losing bet

So what's the equivalent in Britain? Well, banks and building societies are still having difficulty lending. There's still a large 'funding gap' hanging over them. The Bank of England is planning to withdraw its support for the banks gradually by the end of 2012. This means that next year alone, banks will have to find £190bn of support from somewhere else at a time when funding is hard to come by, and that's on top of the £200bn of maturing bonds and residential home loan-backed securities that Nomura reckons will need funding. Meanwhile, the Financial Services Authority is cracking down on both self-certification home loans (also known as liars' loans) and interest-only loans.

But perhaps more importantly, the housing market looks like a losing bet either way. Deflation is bad for asset prices, we know that. However, if inflation picks up strongly normally good news for 'real' assets such as houses then interest rates will have to rise. That'll knock out the only prop keeping prices afloat right now.

If you are buying a property to live in, then of course it's a far more personal decision. A whole other set of considerations come in, although at the very least you should make sure you could afford your monthly bills if interest rates were to shoot up rapidly. But as an investment, property looks a lot like the government bond market very little upside and a great deal of downside if things go against it.

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John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He 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.

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.