Where next for UK house prices?

We have always maintained that the housing market will be the victim rather than the assassin of the UK economy. These are indeed testing times for this hypothesis. As always the media typically focuses on developments affecting high flyers in London. And there is more than a hint of schadenfreude at the prospect of a house price crash in Mayfair and Kensington. Indeed, there are plenty of stories of softness in the £100,000 to £200,000 luxury car market. Stories too of wine merchants keen to offload stocks of fine wines on fears that year end City bonuses could be much smaller than last year.

The question arises, will the difficulties experienced in the world of financial services undermine the underlying UK economy to such an extent that it provokes a generalised house price crash?

There is no denying that Britain is far more dependent on finance and related business activities than any other advanced economy. So it stands to reason that the UK will suffer disproportionately from a combination of tougher lending conditions and lower investment bank profits. According to the Centre for Economic and Business Research (CEBR), wholesale finance and related activities have been adding 10,000 jobs a year to the 340,000 highly paid financiers, lawyers and accountants who between them account for a fifth of the gross value added by the London economy.

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The last time the job count fell in the City was in 2002, when the bear market following the dot.com bust was gathering momentum and investors were concerned about Enron and the impending invasion of Iraq. Property prices in central London fell by 4% but that was not enough to steer the UK economy from its upward trajectory. Analysts expect the job count to fall by 5,000 this year.

Over the last few years London has become the world's richest city. Indeed last week a record was set for the world's most expensive office rents after Permal, a hedge fund group, committed to occupy a floor at 12 St James' Square for £140 per square foot. This may be the high point.

A survey by Rightmove indicated that "asking prices" in London were down 2.5% in September. But what was interesting was that asking prices in Kensington and Chelsea were up 0.7% while prices in less fashionable Brent fell by 7.8%. This does not really fit in to the media perception that house prices will crash in line with City bonuses. A more prosaic explanation is the introduction of home information packs for four bedroom houses has encouraged many to take these higher value properties off the market. This impact would be greater in Brent than in Kensington and Chelsea.

Indeed the current state of the property market for the UK as a whole has so far defied gloomy expectations. According to the Nationwide building society average house prices rose by 0.7% to stand 9% up on a year ago. And there are some interesting developments behind the figures.

Predictably borrowers who are most extended have suffered most from the re-pricing of credit risk. The difference in rates available on a loan with a 5% deposit and its equivalent with a 25% deposit widened markedly from 0.23% points in April to 0.45% points last month. Accordingly we are likely to see a further cooling activity at the first-time buyer end of the market.

On the other hand the credit crunch has changed the interest rate outlook to such an extent that a further hike in UK base rates is no longer a done deal. This change in market perceptions has led to a fall in sterling swap rates, which are generally a good proxy for fixed rate mortgages. So for mainstream borrowers on low loan-to-value ratios, credit conditions have not deteriorated as much as the headlines suggest.

To sum up, if there are to be substantial job losses in the City this will have an impact on house prices in London and the South East as it did in 2002, while tighter credit conditions will freeze first time buyers out of the market. But the fate of the rest of the property market is in the hands of the UK economy. If the economy continues to record steady growth then the housing market will cool further but not crash. On the other hand if the economy stagnates or tilts into recession the ensuing job losses will force homeowners into unwanted sales, causing house prices to fall across the board. This is still a low probability scenario but the chances of it happening are higher than they were three months ago.

By Brian Durrant of The Fleet Street Letter.