How owning a home in Britain became a luxury

This week I’m taking a look at how low interest rates have distorted the UK economy.

Today I want to take a look at the one financial topic that pretty much everyone in the UK has an opinion on.

House prices.

The housing crisis is all about supply and demand – of credit

Our current housing crisis is fundamentally down to low interest rates. That’s not to say that there aren’t other issues – physical supply and demand, the favourable tax treatment of land and property, constant counter-productive government interference – but at the heart of the housing crisis is a simple fact: if you pump more money into a market, then prices will go up.

The economics are not hard to understand. Let’s take a really simple example (and it is simple – the point is not to be realistic, just to demonstrate the colossal impact of falling interest rates, because lots of people still can’t seem to get their heads around the fact that solving this isn’t simply about throwing up a load more houses).

Let’s say you can afford to pay £1,000 a month on accommodation. At 10% interest rates, that amounts to a mortgage of just under £110,000 (on a 25-year repayment basis). At 2% interest rates, it’s roughly £235,000.

At first you think: “Wow! I can afford to buy TWICE as much house!” But you can’t. Because everyone else has access to the same mortgage range as you. So all you can do is pay twice as much – for the same house.

Now, say the person you are buying from bought their house for £110,000, back when rates were at 10%. They’ve paid a fair bit off the mortgage, and built up maybe £50,000 of equity, say. You pay £235,000 for the house. They pay £60,000 to the bank. That leaves them trousering £175,000.

They go to buy their next house. They can’t afford a bigger mortgage payment – just the same £1,000. But they can stick a £175,000 deposit down. And they can now borrow £235,000 as well. So they can buy a house for £410,000.

Throw in ever-increasing levels of leverage (as interest rates fall) and eventually you get to a point where prices are so high that saving enough for a deposit – even a starter home – becomes almost impossible.

And over time, as long as prices continue to rise, then what really begins to matter – far more than your income – is your ability to access equity stored on a prior rung of the great property Ponzi. This can be equity in your previous house, or equity you’ve borrowed from someone else’s house (hence the bank of Mum and Dad).

This is why home ownership in the UK has fallen sharply (it’s at a 30-year low). Potential new owner-occupiers have been locked out of the market, leaving only buy-to-let investors (who can leverage up existing equity).

The distance between “rungs” also increases, meaning that more recent homeowners cannot afford to upgrade, which impinges on labour mobility.

How can we get out of this mess?

Now, this might not matter so much if renting in the UK were on a par with ownership – in other words, if renting were a viable long-term option both financially and in terms of security. But it’s not.

I realise that lots of landlords are good landlords and I realise that a lot of landlords out there have suffered from nightmare tenants. So I’m not interested in getting into an evil landlord versus lovely tenants mudslinging match here.

The point is that in the UK, renting is an insecure form of tenure, where the balance of risk is on the tenant. If you want a semi-permanent base – ie you want to have kids and send them to local schools and settle down and all the rest of it – then you have a lot more security owning your home.

So most people aspire to own one before they have families. This is having the additional unfortunate effect of delaying household formation – ie people getting married and having children.

How can we change this? Increasing the tax payable by buy-to-let investors will help, in as much as it reduces the competition for first-time buyer properties, but it’s not going to increase affordability in a massive way.

Imposing capital gains tax on primary residences (as is being kicked about in various policy circles, though it’s still a politically toxic idea) would help, in that it would reduce the quantity of fresh equity being rolled over into new properties. It would also help British people to stop seeing their homes as a savings vehicle as well as a place to live in.

There are also good arguments for imposing taxes designed to discourage sitting on unproductive land or property – ie higher council tax for empty properties, and disincentives to hoard land.

The wishful thinking option

But the only answer right now that doesn’t involve a major slide in house prices (which would probably batter the economy and the financial system all over again) is rapid wage inflation combined with static or gently falling house prices.

Is that likely? I certainly think that a gentle rise in interest rates at this point could help, by drawing a line under ever-falling mortgage rates. Just enough to help house price expectations adjust to the idea that the days of “real” (after-inflation) gains are gone.

And then if the economy continues to chug along and investment picks up and competition for employees improves – maybe, just maybe, we’ll get an improvement in wages that’s significant enough to both supply a soft landing for the housing market and fuel rising home ownership again.

However, it’s also possible that we get a political shift, resulting in heavy-handed moves that could derail the housing market without improving things very much for the “have-nots”. Jeremy Corbyn could get into power and undermine property rights, for example.

But we could also see more short-term mistakes made by a government keen to get young people onside, but also scared of being seen to drive prices lower. That’s how we got the Help-to-Buy scheme, and I wouldn’t be surprised to see more variations on that theme in the future.

One thing I can say is that this is going to be one of the most intensely political sectors of the market over the next few years. So if you own housebuilders, just beware – as Shore Capital recently warned, keep an eye out for legislation that could affect the sector negatively.