Are we too bearish on house prices?

Sometimes we suffer moments of doubt. Sometimes we even think we might be too bearish on house prices. Then we look at the numbers again and think we might not be quite bearish enough. This week, I’ve been flicking through a report out from Shore Capital on the UK housebuilding sector. Jon Bell, its author, sets out his stall with a run through of his views on prices. They fit pretty nicely with ours.

First he points out that UK house prices remain “materially overvalued based on their historical relationship with earnings.” The house price to earnings ratio in the UK (based on Nationwide data) is around 4.4 times. The historical average is 3.4 times. To get back to that level implies a further fall in prices of 23%. However, if you take 2000-2007 (the nutty lending years) out of the equation the average price to earnings ratio is more like three. That implies a fall from here of just over 30%. However even these numbers make the optimistic (heroic even) assumption that real wages in the UK will remain constant. That clearly isn’t the case.

Real income in the UK has been falling fast (see my last blog) and we know that wage settlements are running at 2-2.5% even as inflation heads for 5%. Real wages aren’t rising. And they aren’t constant. Instead they are falling and have been for 34 of the last 36 months. The contra argument to this is of course that mortgage affordability is better than it has been for decades. Payments as a percentage of take home pay come in at a mere 28%. At the end of 2007 that number was 48%. However this number only tells us about the very short term: affordability is good because interest rates are abnormally low (the base rate has never been this low before). And while I think they will stay that way for some time to come, there is no guarantee of this: given the state of the global economy, the capacity for sudden change is huge.

What if the market suddenly loses confidence in the UK’s ability to cut its deficit for example? That would push up bond yields and have an instant effect on mortgage rates. Anyway, how high mortgage rates are or are not is by the by given that it still isn’t easy to get a mortgage. Approvals are still way below historic norms and the levels at which we normally see rising house prices. And given the extent to which banks are being forced to improve their capital ratios, that is highly unlikely to change (note that the higher a loan to value ratio (LTV) a bank lends out at, the more capital it has to hold in reserve). If anything, it could get worse, as Bell puts it: “there could be a further tightening of mortgage availability as banks’ capital adequacy ratios fall foul of sovereign debt issues.”

It all adds up to an environment in which house prices are very unlikely to rise and very likely to fall. They may not fall fast in nominal terms from here – their fall is being held back by the low rates being paid by existing mortgage holders and by lender forbearance. But fall they will. How much? Having looked at the UK in isolation, Bell also looks at a few precedents for crashes overseas and in particular at the experiences of the Scandinavian economies in the early 1990s.

There, sharp rises in prices in the 1980s were followed by crashes that wiped out all the gains of the boom “regardless of the policy response” of the government in question. Were the same to happen in the UK, says Bell – ie, were prices to return to their levels of 1995 in real terms, we should expect to see a fall in prices from peak to trough of 62%. There’s another 52% to go. And you thought I was bearish.

So what of London? Prices there have defied all the bears (us included) by becoming a proxy for risk aversion and rising at speed. Can it continue? Maybe. Maybe not. However we do note that asking prices in London have fallen since the riots began (our capital doesn’t look like such a safe haven any more). We also note one of Bell’s most dramatic statistics. Between 1989 and 1994 the nominal price of the average UK house fell 19%. In London it fell 41%.