What will happen to house prices in central London?

Property: What will happen to house prices in central London - at Moneyweek.co.uk - the best of the week's international financial media.

They'll drift upwards slowly, argues property developer Richard Collins.

Those who are gloomy about the residential property market in central London are ignoring its special characteristics. It is characterised by a tight inventory and a high level of international demand and cash buyers. Demand almost always exceeds supply, largely because at the top of the market there isn't much pressure to sell. If vendors don't get the prices they want, they often refuse to reduce prices to what buyers expect, or withdraw their property from sale. At the same time, the demand is truly worldwide. In some new developments, foreign purchasers account for 70%-80% of sales. This should be no surprise: London is not only a cultural feast, but an effective tax haven for rich foreigners and the financial centre of Europe. The City of London itself generates 17% of UK GDP and thousands of jobs, and its occupants require quality housing.

Unlike the general market, the central London market is lowly geared. As base rates rise from a trough of 3.5% to possibly 5.5% next year, the majority of homeowners, where levels of indebtedness are already high, will be reassessing their budgets. But rich buyers in central London will be less affected as London takes its direction from sentiment in the US, the mood in the City of London and worldwide events. This explains why the market countrywide has enjoyed double-digit increases recently (driven by cheap money) but the central London residential market hasn't. But while it is static, it's far from crashing. I have lived through dramatic falls in the London market. In 1974 there was a secondary banking crisis. Some prime residential values halved. In 1990 the effects of the world recession, intensified by domestic policies, led to falls in the London market. But we are not living through 1974 or 1990.So if the market isn't going to crash, what is it likely to do over the next year or so? There is a chance that pent-up demand, the strong US and UK economies and improved city bonuses could drive a bounce, but I suspect that the market is more likely to just drift upwards at something slightly more than inflation.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

My conclusions? When you are looking at a property market, beware of setting too much store by forecasts that indicate fixed percentage movements up or down. Never treat any forecast in property prices as any more than a guess. But most important, think long-term and, given its special characteristics and recent undramatic record, my advice is buy residential property in prime central London.

They'll follow the rest of the house market down, argues James Ferguson.

Remember the captain of the Titanic? He wouldn't heed any warnings to slow down. Why? Because his ship had "special characteristics". It was, he thought, unsinkable. He was, of course, famously wrong. And so, I think, will be those who say that the special characteristics of the London property market will sustain high prices. Limited supply; foreign buyers; low gearing; pent-up demand; improved confidence; strong economic growth; the return of city bonuses; there-emergence of inflation and the fact that price rises have been fairly muted since September 11th are all factors, says Richard Collins, that augur well for continued price growth of "slightly more than inflation". I would love him to be right, but I'm pretty sure he won't be.

Firstly, the limited supply argument explains the central London premium but doesn't peg the price. Chelsea houses sell for around £1,000 per square foot, whereas large family houses in Clapham or St Johns Wood can be bought for £300-£400 per square foot. Given that Clapham is a ten-minute drive from Sloane Square, what will save Chelsea if Clapham prices collapse? Prices may still be double, but they'll be double less. Then take the foreigners. Estate agents often claim that they will support the market during any domestic weakness, but actually the reverse is true. Foreigners can go where they like, but the decision to buy here is often made purely because the market is hot. Unfortunately, like buy-to-let investors in less salubrious locations, foreign buyers in central London are less likely to be full-time owner-occupiers, and so are more likely to sell if the value of their investment starts falling.

And low gearing? Richard Collins is suggesting that the wealthy are immune to the implications of rising interest rates because they put more equity into their homes. But rising interest rates also give higher returns on cash, returns the wealthy have to give up if they buy property. This opportunity cost is especially important because prime central London properties generate low yields. "Pent-up demand" is another estate agent favourite, but I don't quite know what they mean by it. If they mean people who wouldn't buy at today's prices, why would they suddenly do so to support prices? Surely they'll be looking for a sizeable drop to make the wait worthwhile and to get over whatever financial obstacles prevented them being in actual demand' in the first place.

But most importantly, when rising interest rates prick a mortgage equity withdrawal debt bubble, as I think they are about to, the repercussions are not limited to the property market. A recession and unemployment didn't cause the 1989-95 property collapse; it was the collapse that preceded and caused the recession. With 8% of current consumption coming from equity withdrawal, rising rates, be they to combat inflation or not, will deflate the economy, confidence and city bonuses, too. Overall, the only thing I can say in defence of the central London market is that the percentage price falls are likely to be no worse than the national average, since the true horror of any deflating property bubble always hits the speculative, peripheral locations the hardest. Those that were the last to soar are always the first to sour.