Where are house prices heading?

Pity George Osborne. The chancellor wants the UK to become a nation of property owners once again. In 2003, property ownership in Britain peaked at 71%. Since then it has fallen to 64%, and talk of a "housing crisis" is never far from the headlines.

The trouble is, he doesn't want house prices to fall either, especially with memories of 2008 still fresh in most people's minds. And beyond the impact on banks and the economy, falling prices haven't historically gone down well with voters.

Ideally, he'd probably like prices to stall a little, so that wages can catch up and gently erode the affordability gap without actually having to do very much. Unfortunately, house prices aren't co-operating. Despite some wobbles in London caused partly by changes to the taxation of £1m-plus properties prices UK-wide are still rising at a rate of more than 9% a year, according to the Halifax. And unless something big changes, that seems likely to continue.

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Houses are overvalued

UK house prices are expensive there can be no doubt about that. In 2007, at the peak of the last housing bubble, the average house in the UK cost 6.4 times the average full-time worker's annual salary, says Fathom Consulting. By early 2013, the house-price-to-income ratio had dropped as low as 5.2 a little higher than the level seen at the peak of the late 1980s house-price bubble. Yet that was as low as it got since then, it's been onwards and upwards. The price-to-income ratio is back at 6.1, not far off the 2007 peak.

This is concerning. The ratio should mean-revert (ie, return to its long-run average) and has done in the past. That's because it's based on other variables that are mean-reverting, such as mortgage costs. Yet, as Fathom points out, that would almost certainly be very painful. For the ratio to return to its long-term average of around 3.5 now, house prices would need to fall by up to 40% or household income would have to grow "at ten times its current pace for the next five years". London is by far the worst offender, but prices elsewhere in the UK are hardly cheap (see below).

So what's driven this rapid rebound? The argument you'll hear from most people in the property market is that there simply aren't enough houses. We built around 150,000 houses last year, but we need to be turning around closer to 200,000-plus a year. Indeed, the government wants to build a million houses by the end of this parliament. However, while there may well be an issue with the quantity and quality of houses that we're building, the high cost of housing has little to do with physical supply. Instead, it's mostly about demand and the availability of credit to fuel that demand.

Fathom notes that, for the past decade, house prices have risen at a significantly faster rate than rents climbing at an average of 2.3% a year nationwide, and 4.1% in London. Indeed, house prices are now nearly as high, relative to rents, as they were in 2007. "Why, if housing is truly in short supply, is the price of renting a property not rising as rapidly?" In all, Fathom reckons, "the reduced rate of growth in the housing stock per capita, when compared to the rate of growth achieved pre-2000, explains less than a 10% increase" in the price-to-income ratio.

It's all about credit

So what's really driving rising prices? It largely boils down to "the fall in the cost of owning and maintaining a property, brought about by exceptionally low real rates of interest". This has been aided and abetted by a "game changer" introduced in the 2013 budget the Help to Buy scheme. Help to Buy comes in various varieties, but it boils down to putting taxpayers' money at risk in the form of loans and guarantees for first-time buyer mortgages.

This cushions both banks and housebuilders from the biggest risks involved in lending to first-time buyers (note that the first-time buyers themselves are still at risk of repossession, alongside the taxpayer). This taxpayer underwriting has "triggered a surge in residential property prices" by boosting demand for housing. And it's not just price-to-income ratios that are at record levels, notes Fathom. "Median income multiples for both home movers and first-time buyers" now exceed the 2007 peaks. The average buyer is borrowing more relative to their income than ever before.

How is this possible, that just over seven years on from a bubble that never fully deflated, we're back to square one, with houses more overpriced than ever, and mortgages getting ever larger? One key factor is that, at the last peak in 2007, the rate on a typical two-year fixed-rate mortgage, assuming a 25% deposit, was just over 5%. Today, it's under 2%.

Not only that, but competition is returning according to the Mortgage Advice Bureau, the number of mortgage products on the market was up by nearly 50% in April compared with last year. At around 20,000, it is now at its highest level since March 2008. As Samuel Tombs of Pantheon Macro puts it, "house prices are continuing to be lifted by falling mortgage rates, in response to declining wholesale funding costs and intensifying competition between lenders".

This enables buyers to borrow ever-larger sums for the same given monthly mortgage payment. So even though prices might be high relative to incomes, payments remain affordable, according to the Council for Mortgage Lenders. Mortgage payments now account for 18% of the average first-time buyer's income, from 25% back in 2007.

Of course, this is also partly down to mortgage terms growing ever longer, partly due to the absence of the old-style "never-never" interest-only mortgages. As the BBC reports, "15 years ago virtually every first-time buyer had a 25-year mortgage", but today, "60% borrow for longer". The "typical term is 30 years, but many are choosing terms of 35 or 40 years". This is one way to get around the tighter affordability rules "there are no rules limiting the length of mortgage terms or stopping families who are already up against it from committing themselves for four decades".

Meanwhile, banks are coming up with variations on guarantor mortgages to allow first-time buyers to bypass high deposit requirements by formalising the process of borrowing from their parents. The trouble here is that it just shifts a problem at one end of the market the first-time buyer a bit further into the future. As Robin Hardy of Shore Capital notes, when this cohort of first-time buyers those with extra-long mortgage terms or those who bought with a borrowed deposit want to trade up, they won't have built up sufficient equity in their house to do so.

The risk then is that banks or the government come up with yet more schemes to "unlock second-steppers who can't currently afford to make the next move", rather like the 125% loans seen before the last crash there are "shadows of 2006, 2007" here, warns Hardy.

The big threat to house prices: political risk

This sorry state of affairs where not just individual first-time buyers but their parents too end up mortgaged to the hilt for their working lives and beyond is only sustainable while mortgage rates are at current lows. But, as Fathom points out, there's no obvious reason to expect that to change. Bank of England interest rate "normalisation" is a "distant prospect regardless of the EU referendum result" precisely because a significant rate hike would almost certainly trigger a house-price crash. The Bank would likely think it better to tolerate quite a leap in inflation rather than do that.

So what might pop the bubble instead? House prices have become so politicised that it's hard to see anything happening without the government's say-so. But that could be the market's Achilles heel. The government has become "fixated on home ownership rather than affordability", says Hardy.

It is trying to solve the crisis by promising to build more, while making affordability even worse via schemes like Help to Buy. But there's a danger that the government will get sick of builders not holding up their end of the bargain. Help to Buy was supposed to encourage extra building. But it's not happening fast enough to meet government targets. Instead, much of the money going into housebuilders' coffers seems to be funding higher dividend payouts.

It's understandable that builders are wary of overcommitting after the last crash. And, of course, the bullish case for the housebuilding sector, as Tristan Chapple of Phoenix Asset Management notes, is that as a result of all this, competition in the sector is low (it's hard for small builders to get a look in) and profits and returns on capital are high. But "too much of the housebuilders' profit is policy-derived rather than market-derived", says Hardy. If prices keep rising and the supply response is deemed insufficient, "the risk of [government] intervention" increases.

It's not just about the government forcing through policies to boost physical supply. High house prices could also become a political liability rather than a boon, says Hardy particularly if the rise of intergenerational mortgages and the reliance on the Bank of Mum and Dad grows. When the entire family is on the hook for a home loan, the sense that everyone is working away purely for the hated banks is bound to grow.

"There's a tipping point where high house prices become a burden rather than a benefit. Even those who are making money from the rising market can see that their children are suffering. And if you're going to take action, then you've got to do it while we're still relatively early on in the parliament."

New London mayor Sadiq Khan is talking of giving Londoners "first dibs" on housing. Councils in second-home hot spots around the UK, where locals are priced out, are trying to prevent new houses from being sold as holiday homes. This might not work at a local level if you stop builders from selling to paying customers, they'll just stop building. But it does demonstrate a shift in the political mood. Buy-to-let investors have already felt the consequences of an abrupt change in government policy they may just be the first.

Perhaps once the EU referendum is over, the government might get serious about Britain's housing crisis. That could tip the market into a downturn. Yet if it doesn't act, overvaluation is such that a nasty crash will certainly come in time we just can't say exactly when.

Are high prices just a London problem?

UK-wide house prices are back to where they were at the peak of the bubble in 2007, in terms of prices relative to incomes. But is this just a London problem? Figuring it out isn't an exact science, but by comparing gross average weekly earnings data from the Office for National Statistics with Nationwide data on average UK house prices by region, you can get a good idea of how prices in each area stand compared with the average since 1983.

So what does it show? Prices in London are as you'd perhaps expect far more expensive relative to incomes than in any other part of the UK. The price/income ratio is also significantly higher than at the peak of the last bubble, and almost twice its long-term average. Meanwhile, ratios in the regions nearest London the south of England, East Anglia, and the Midlands (to a lesser extent) are back to where they were at the last peak. The rest of the UK isn't quite as egregiously overvalued.

The price/income ratio in Northern Ireland is well below its bubble peak, while the north of England, Scotland and Wales still have a way to go to reach those levels too. Yet even in the less expensive parts of the UK, prices are hardly cheap price-to-income ratios in every single region remain at least slightly above the long-term average. In short, if you're looking for value in the UK property market, the pickings are slim.

Brexit: what's the damage?

The Treasury reckons that if Britain opts for Brexit, house prices could fall by 8% between now and 2018. If we stay, they'll rise by roughly 10%. But don't get too excited unfortunately, we suspect that even a vote for Brexit is unlikely to deliver lower house prices. Here's why. The Treasury suggests that a drop in sterling and a resulting rise in inflation (not to mention general "uncertainty") will lead to higher lending costs, higher mortgage rates, and as a result, lower house prices. It's all very plausible. But experience suggests it's unlikely to happen.

Firstly, any significant drop in sterling is also likely to attract foreign investors back into the property market. Following the 2008 financial crisis, the huge drop in the pound merely provided overseas buyers with the opportunity they needed to snap up London property (an item high on the wishlist of any globetrotting oligarch) at bargain prices. As for the Treasury's concerns about higher mortgage costs, the Bank of England is highly unlikely to raise interest rates post-Brexit, unless there is a genuine panic rush out of sterling assets.

Indeed, if a recession is what the Treasury expects, then the Bank of England is more likely to cut rates or print money which would pull gilt yields down. If you're remotely sceptical about this, just think if investors are willing to lend money to sclerotic euro-bound Italy at negative interest rates (as is the case right now), why flee UK gilts, which already trade on positive yields and are backed by a highly active central bank?

As for the impact of lower immigration (which isn't a given in any case) on housebuilding, as we note in the main piece, the primary influence on house prices in the UK isn't physical supply and demand. And in any case, any shortage of skilled labour that did somehow arise post-Brexit would surely be more likely to push prices higher, rather than lower them. In short, the Treasury's forecasts look like a stretch.

Even a pro-Remain report by the Centre for Economics & Business Research (put together for the National Association of Estate Agents and the Residential Landlords Association) could only muster a prediction that UK-wide prices would average £303,000 by 2018 if we stay, and £300,800 if we leave. That's a difference of £2,300, far less than 1%. That's scarcely a rounding error and certainly not a substantial enough drop to help improve the UK's dire long-term affordability situation.