The housing market correction may have a long way to go. Near term, the outlook for house prices, for transactions levels and for mortgage lending is significantly cooler than we have seen over the past five years. In our view, UK house prices probably remain overvalued, perhaps significantly so.
Updating our study from October last year, we find that many of our valuation measures suggest, if anything, an even greater degree of overvaluation now than last autumn. The longer-term outlook for owner occupation, demand for rental properties and the level of lending remain healthy, but over the coming year or so, falls in house prices would be unsurprising.
A near-term adjustment back to levels that are closer to estimates of sustainable values could happen in a quiet and orderly way, which is what the central forecast of our model predicts (on that projection, real house prices fall 5% over the next 12 months). But a much more volatile path back to fair value is also possible.
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It is abundantly clear that the housing market has slowed very sharply and for the UK as a whole, average house prices have been fairly flat in real terms since the start of the year. But how house prices, housing market transactions and mortgage lending develop from here is hard to predict.
Periods after which nominal and real UK house prices have risen most rapidly (e.g. in the late 1980s) have been followed by periods when house prices fell significantly, relative to consumer prices. If that were to recur now, then given low consumer price inflation, nominal house prices would fall. However, because volatility is great from month to month, no-one can have much confidence calling the turn in the market based on a few months of flattish or even falling prices.
Average house price to income ratios remain at exceptionally high levels. But these measures ignore the cost of borrowing a key determinant of housing demand. While the ratio of aggregate debt servicing to post-tax income for UK households is now much lower than at the peak of the housing market at the end of the 1980s, it is nonetheless well above the average over the past 20 years and has been rising steadily since 2002.
There is a strong argument that the right valuation measure is based on the difference between the user cost of housing and the value of owner occupation. The user cost approach to the valuation of housing is, in principle, fairly straightforward.
It rests on comparing the cost of owning a house for a period, say a year (for example, the cost of repairs, and the value of funds tied up in a house, which can be measured as the interest payable on a mortgage, less any capital gains) with the benefits (the value of rental services that home ownership generates).
If the user cost measure is higher than the implied rental value, houses are too expensive; if the two are roughly equal, prices look to be at a sustainable level. Based on the assumption that people are predominantly backward-looking in the way they form expectations on capital gains, houses look about fair value. In other words, if people think that prices over the next year will rise at the rate over the past year, then average UK prices are about where they should be. But if people think prices will be flat, houses look expensive.
There is another, related, way of thinking about equilibrium in the housing market and that is by comparing residential property as an investment asset against alternative financial assets most obviously equities.
If one used the average ratio of yields on property and on equities in 2001, 2002 and 2003, then, based on a dividend yield now of around 3.2%, one would expect a net rental yield on UK property of a little under 4.7%. Since the actual net yield seems to be around 3.8%, that would imply an overvaluation of property of about 20%. If, however, it was reasonable to assume an improvement in the prospects of rental growth over the long term relative to dividend growth, then that degree of overvaluation could disappear.
Our own modelling suggests a gentle downward adjustment in house prices from today's levels, but the degree of confidence we have in that profile is not high. Our model says real prices will fall about 5% over the next 12 months and suggests that average UK house prices are now overvalued by around 30%.
One indicator of the extent to which house prices have posed affordability problems is that the number of first-time buyers has fallen. With buy-to-let demand appearing to slow, it is likely that more first-time buyers need to come to the market to play the role of marginal buyer and liquidity provider at the lower end of the market. In the absence of a sharp fall in interest rates this may require a significant price adjustment.
By David Miles, Melanie Baker and Vladimir Pillonca, Morgan Stanley economists, as published on the Global Economic Forum
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