What’s really going on in the property market

The UK property market 'has turned the corner' - or so the property Pollyannas like to imagine. But MoneyWeek economist James Ferguson has been looking at the numbers and he isn’t so sure. There's a lot of 'wonky maths' propping up house prices - which means the outlook for 2006 may not be quite as benign as most forecasters think...

By James Ferguson

published 23 January 2006

in Features

The UK property market 'has turned the corner' - or so the property Pollyannas like to imagine. But MoneyWeek economist James Ferguson has been looking at the numbers and he isn't so sure

The mood has been very festive among the property market cognoscenti. In The Independent, Julia Kollewe noted that "house prices have risen for the first time in 18 months, providing further evidence that the housing market has turned the corner". Indeed, the latest month's upward blip seems to have convinced most observers that the housing market is already past the worst. "The property market may have slowed but house prices are expected to stand firm in the year ahead," says the FT; Richard Donnell, director of research at Hometrack, told The Daily Telegraph that he believed the housing market had "finally bottomed"; and Propertyfinder.com's MD Jim Buckle announced that "the dark days of late 2004 and early 2005 for the housing market are well and truly behind us".

I don't think they are right. Many of the market's bears have lost their nerve over the last few months, but I still believe that the economic fundamentals are pointing us towards a quite normal end-of-cycle house-price correction of at least 30% in real terms, even if the absence of an external shock does mean it will take most of the next decade to unwind. And as for the complacency of the UK's estate agents and the mainstream press ("Crisis, what crisis?" said the FT at the end of 2005), as far as I can see it is predicated not on fact, but on wonky maths. For starters, it really isn't clear exactly what did happen to house prices last year. Most industry groups reported that house prices finished the year up in nominal terms (even if this meant they were actually flat, or even down once adjusted for inflation), with the average claim being of gains around 3%.

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But did this really happen? Not according to Hometrack, which had house prices across England and Wales falling by 1.29% in 2005. I'm minded to take quite a lot of notice of the Hometrack survey. As any statistician will tell you, the larger your sample, the more confidence you can have in its conclusions, and while the Halifax and Nationwide surveys are the most widely used, they cover only their own client bases making them quite narrow. The Hometrack survey is much more broadly based, covering a total of 7,500 estate agents countrywide, something that makes it more comprehensive and hence more reliable. It's alarming, then, that, according to the Hometrack data, the average house price has already fallen by 4.17% since the market actually turned (in June 2004). Of the 54 cities surveyed by Hometrack, 48 saw price falls in 2005, with Milton Keynes being the worst performer (prices there fell by more than 7%). And even according to the great optimists at Halifax (who reckoned overall prices rose 5.5% in 2005), prices are falling in many towns. On their numbers, prices in Bromley, Kent, saw falls of about 7% in the year to September 2005, for example. The final numbers for the year were only rescued by the fact that prices for homes in more remote areas (such as Scotland and Northern Ireland) surged. That the price of houses in Scotland should make all the numbers look so good should be no real surprise. In these early stages of any downturn, it is normal to get "aggregation problems". Areas that are lagging the national trend and where prices are still rising feature much more prominently than usual in the statistics, because where prices are stagnating and buyers are refusing to pay asking prices transactions volumes slump. This gives a disproportionate emphasis to those outlying regions where prices are still rising. But falling transactions tend to be a good leading indicator for falling house prices.

And while we are on the subject of wonky maths and misleading numbers, look at the numbers out from the Royal Institute of Chartered Surveyors (RICS) for November. These, wrote Chris Giles in the FT, suggest that house prices were rising. But as he then points out, they aren't really of the surveyors and estate agents surveyed, 24% reported that prices had fallen in the preceding three months and 11% said they had risen, giving an unadjusted balance of 13%. "However, estate agents tend to be unduly pessimistic in November, so the RICS seasonally adjusted measure turns the negative reading into a positive balance of +4%." It doesn't matter how negative the number; those with a vested interest in making the market look good can find a way to report them as positive.

Next, consider affordability. Everyone admits the house price/earnings ratio (HPE) is at record high levels, but it's actually even worse than it seems. According to the Nationwide's average house price figure of £157,250, affordability has levelled off at an all-time high figure of 5.8, which would be bad enough. However, the most widely used HPE ratio is the one provided by Halifax. The Nationwide has a very low exposure to London, where the country's costliest homes are, so you'd expect their HPE of 5.8 times to be lower than most. But Halifax give an even lower ratio of just 5.6, despite telling us that the average house price is £171,632. This discrepancy should be impossible. So how do they do it?

Three ways. First, they use what they call "a standardised average house price" of just £161,288 to calculate their HPE. Next, they use a higher estimate for earnings the New Employment Survey (NES) rather than the National Statistical Office's Annual Survey of Hours and Earnings (ASHE) figures, even though the NES figure hasn't been updated since last April. If they stopped using these two fudges, their ratio would be 6.2 times. And instead of using all workers' average earnings, they take male employees' earnings only. If they were to include the rest of the working population, their figure would be a chilling 7.5 times. And it is actually entirely possible that the affordability situation is even worse than that. Take the Government's estimate of average annual wages of £23,400 and the Land Registry's most recent (July-September) house price average of £194,589, and the HPE appears to be 8.3 times.

Now, most analysts are telling us that from here there will be no crash. Instead, sums up the FT, "the market will spend the next few years moving sideways until earnings catch up with prices". What they don't point out, however, is that at the current rate of earnings growth, we have to see stagnant nominal house prices, not for "the next few years", but for the next 12 years, before affordability hits the average levels of the last 30 years.

The consensus view for 2006 is that there is nothing to worry about and lots of the bears have stopped predicting major house price falls. In December, Capital Economics, which for three years had stood by its 2002 forecast that house prices would fall by 20% from 2004 peaks, threw in the towel. Although their UK economist Ed Stansfield doesn't believe "the danger of a sharp fall in house prices has evaporated altogether", he does now expect that a combination of looser lending criteria, the effect of low interest rates on affordability and "solid" employment growth will see prices stagnating, not collapsing. Stansfield's new forecast is for house prices to fall by just 5% in two years. Other independent forecasters concur that some sort of shock is required to trigger a crash a sudden jump in unemployment or interest rates that would leave people unable to service their many debts, perhaps.

It's tough to turn the subjective argument that no one seems to be saving any longer into the objective case that people will soon no longer be able to manage their debts. However, we do know what proportion of disposable income going towards debt costs has triggered massive retrenchments in household spending in the past. The absolute limit of indebtedness seen in the last 20 years was in late 1990, when the last housing crash began. At that time, 22% of the nation's after-tax income was being spent on debt service and repayments. Today, that proportion is 21.5% and rising. We also know that what is happening in the mortgage equity withdrawal market (MEW) tells us a great deal about the economy and about how much people can afford to borrow. And sure enough, MEW has started to plummet (just as it did in 1988/1989, a year ahead of the last housing crash). MEW as a percentage of disposable income has halved over the last year, an enormous drop, equivalent to nearly 3% of GDP.

This, in turn, has had a sudden and very savage impact on consumption (which makes up 60% of our GDP), sealing the fates of more than one high-street name this Christmas. Little wonder, then, that Gordon Brown's much-vaunted 3.5% economic growth forecast for 2005 was so very wrong. Growth was actually more like 1.7%, a level that in the last 35 years growth has never hit without continuing to head down into full-blown recession. Each of the last three periods of recession also coincided with housing-market slumps.

Excessive debt service costs would seem to preclude further household deficit financing, something that means MEW has to fall further, with the inevitable consequence that consumption must be even further curtailed. But the slowdown in the rate of house-price inflation also makes people feel less secure in general, something that also feeds directly into lower consumption. Over the last 18 months, retail sales have dropped from growing at an annual rate of 7% to little more than 2%.

Anyway, rates may not be able to fall much. The experience of the last 50 years shows that, mid-way through almost every period of rising rates, almost as soon as policy makers felt they could start cutting rates they were forced to return to a tighter policy soon after. Economic downturns face a myriad of late-cycle inflationary pressures, which can force rates up even as the economy falters. Still, the Bank of England is having a good go at a soft-landing' approach, and, if that works, maybe the market won't crash as fast' as last time (people forget it actually took seven long years 1990/1996 for prices to bottom then). Instead, this correction will be even more of a long, drawn-out version.

Indeed, it is sobering to reflect that over the last 35 years, each period of real house-price inflation, however long it was, was followed by an almost identically long period of real house depreciation. On that count, the fact that we have enjoyed nearly a decade of uninterrupted real price growth might suggest that the coming period of deflation won't look so much like the UK 1990-1996 crash', but more like Japan's Lost Decade' of deflationary recession, which actually lasted 15 years.

For the eight months after the outbreak of World War II, from September 1939 to April 1940, during the so-called Phoney War', so little happened that children evacuated to the country were returned to London. Some probably argued at the time that it was all going to blow over without incident. As we all know now, things heated up quite considerably after that. I would certainly argue that it's just a little early to start crowing about house-price survival just yet. "Just because the market has defied expectations for so long," writes the FT's Scheherazade Daneshkhu, "does not necessarily mean that the danger is now past." Indeed, it does not.

There's a lot of pain being felt in the UK housing market, but no one is suffering more than the builders and owners of new-build apartments. These now account for 50% of all homes being built in Britain, but they aren't as easy to sell as they used to be. Developers targeting buy-to-let investors used to be sure that pretty much anything they built would sell itself. Now they have to offer incentives, such as free carpets and curtains, payment of stamp duty and "guaranteed rental periods" or cashback deals just to get people to think of looking around. The price of new-build flats dropped 5.7% in the year to September whilst December saw a further average price fall of 0.3%. In Liverpool and Blackpool, prices have fallen 3% in the last month.

So just what is the problem? Oversupply and the fact that valuing flats in the sector has become "more of an art than a science", says The Guardian. The Mortgage Works, part of Portman building society, has decided to stop making mortgage offers on buy-to-let apartments because "too many valuations are based on off-plan judgements by surveyors, which often leads to inflated and dubious conclusions".

James Ferguson qualified with an MA (Hons) in economics from Edinburgh University in 1985. For the last 21 years he has had a high-powered career in institutional stock broking, specialising in equities, working for Nomura, Robert Fleming, SBC Warburg, Dresdner Kleinwort Wasserstein and Mitsubishi Securities.