What the shrinking housing shortage means for house prices

published 17 November 2015

151117-property — More than 24,000 homes have been built in London in the last year

UK house prices are still rising fast.

According to the Office for National Statistics this morning, prices rose by 6.1% in the year to September 2015, up from 5.5% in August. The biggest jumps were seen in the east and southeast of England, and London, as usual.

Meanwhile, housebuilders have been reporting that business is booming. Taylor Wimpey's chief executive was cheerfully reporting a record order book, helped by wage growth starting to outpace inflation.

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But could we be approaching a tipping point?

Because believe it or not, supply is starting to catch up

Believe it or not, the supply of housing in the UK is rising

One of the main benefits of free markets is that they're the most efficient mechanisms we've found to provide people with what they need or want.

(You don't have to be an ardent capitalist to respect the market's effectiveness by the way food banks in the US use a market-based auction system to distribute the available food between outlets in the least wasteful manner we've more on that in the most recent issue of MoneyWeek).

If there's a big profit to be made, entrepreneurs will flock to it. They then compete with each other to meet demand, until the amount of profit available has fallen to a level where the entrepreneur can make enough to survive at a price the consumer is willing to pay.

That's why it's often said that the cure for high prices is high prices.

It can take a while. In the commodities market, for example, it takes a long time to set up mines and bring new production online. But as we've seen recently, all that extra supply is having an effect.

Of course, this rule seems to apply to just about every apparently free market except for the British housing market. Everyone constantly tells us that high prices are a function of short supply (on this tiny island nation of ours), and that this is an insurmountable problem.

However, what's interesting is that despite the apparent impossibility in Britain of building anything that anyone would want to live in, anywhere that anyone would want to live the number of properties being slung up around the country is rising fast. Faster than you might think.

So even in our incredibly restrictive, inefficient property market, high prices are doing their job creating more supply. And recent government reforms have helped.

According to Kate Allen in the weekend FT, housebuilders have been complaining that "official housebuilding statistics significantly underestimate new construction activity".

In the past year, more than 155,000 homes have been built, up by 25% year-on-year. And it was also significantly higher than recent previous estimates of just over 124,000 new homes which is what the builders are complaining about. They feel they're not getting enough credit for contributing to supply.

As one source told Allen: "At the very point the industry is getting hammered for not delivering, and government is pressuring it to deliver more, it is now clear the official statistics are creating a very misleading picture and a lot more homes are getting built than people think".

On top of that, more than 20,000 new homes were created by converting commercial premises. That was up by 65% on last year. What's interesting, notes Allen, is that "some established businesses have been evicted by landlords keen to benefit from the increase in their property's value that comes from its conversion to residential use".

That's a pretty poor way to treat your loyal tenants, but it does demonstrate that the market is working. If it makes sense and it's viable to convert business property into residential, people will do it. That should help the market balance out more rapidly than it otherwise would.

As for London, more than 24,000 homes have been built, compared to earlier estimates of just over 18,000. "Some of the capital's most expensive areas saw their housing completions more than double in the most recently published statistics."

These are the sorts of developments that my colleague Dominic Frisby recently wrote about. High-end properties aimed squarely at foreigners looking for prime property, who don't really realise that they're buying into a second-tier part of London.

The risk of course, is that when you're flooding the market with supply to take advantage of apparently endless demand, the chances are you'll get horribly caught out when the market turns. As it eventually will.

As Izabella Kaminska puts it on the FT Alphaville blog, "in the quest to exploit outsized gold-rush-type profits generated by the entrance of dumb overseas money to the market, London house builders are potentially about to become the housing market's equivalent of shale producers".

The other important factor in the UK housing market

It remains to be seen, of course, whether this will be localised perhaps like the buy-to-let crash that hammered northern city centres particularly hard during the 2008 crash or whether it'll be part of a wider collapse.

You see, there's another major factor in the UK housing market, which for my money explains our affordability problems far better. It's not just about the supply of houses it's about the supply of money.

The crash in 2008 wasn't driven by a sudden surge in housing supply. It was driven by a crash in the availability of funding.

The market rebounded although mainly in London. That was driven by a number of things. Prices fell. The Bank of England took emergency action and slashed interest rates, preventing a flood of forced sales. Crashing interest rates created demand for tangible' assets that could offer a yield (like property).

And the plummet in the value of sterling meant that London property prices absolutely collapsed in foreign currency terms, creating an irresistible bargain for overseas buyers looking for a bolthole.

With mortgages harder to come by and cash sales an ever more important part of the market, it's tricky to see what will replace demand when (and if) the foreign buyers wake up. With interest rates still more likely to rise than to fall further, it's hard to see support coming from the ordinary buyer in the street.

Of course, I'm perennially gloomy on the property market. So when we hold our annual property roundtable shortly, I'll be looking forward to questioning our experts on what they see coming next for the UK market. Don't miss it. If you're not already a subscriber, sign up now.

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.