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Will UK House Prices crash in 2013?

Andrew Gibson, Head of Research 19 December 2012

Whats really going on in the property market?

The UK property market remains in a state of suspended animation. A gloomy economic backdrop has been counter-balanced by the lowest interest rates in 318 years. The result is a stable but stagnant market. UK property prices have been pretty flat for around three years now, based on the comprehensive data from both Halifax and Nationwide. But stable prices shouldnt be confused for a healthy market. According to HMRC, in 2009 the number of homes sold in the UK fell to the lowest level since modern records began in 1978. Volumes have subsequently lifted off the low, but not by much, and remain at barely half the levels they reached in the boom years of 2006 and 2007. This stalemate of activity is a result of extraordinary policy efforts by the Bank of England to distort the housing market through cheap money. To understand just how extraordinary todays interest rates are, you only need to have a basic understanding of history. You see, the history of UK base rates goes all the way back to 1694 making it one of the worlds most complete economic datasets.

During this 318 year period the UK economy had been through such major events as the Napoleonic Wars, World War I, the Great Depression and World War II. And yet during these truly challenging times the Bank of England NEVER believed it was necessary (or more likely prudent) to cut rates below 2%. Even when the Nazis were bombing 16 British cities during the Blitz of 1940/41, the Bank of England kept the base rate at 2%. But how times have changed. We now live in an age of the Celebrity Central Banker. They have more power than ever before. So I guess it shouldnt come as a total surprise that they have abandoned the old rules and invented new ones. Speaking of which, in March 2009 the Gods of Threadneedle Street felt circumstances were so beyond anything weve ever encountered before, that they decided to cut the base rate to 0.5% and have kept it there ever since almost four years now. Not only that, theyve injected 375 billion into the UKs financial system via a fancy form of money printing (QE). This alone amounts to almost 30% of GDP. The net result of these massive money distortions has been to merely keep house prices FLAT. Consider this: in the two decades before the crisis, the base rate was on average around 1

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4% above headline inflation (CPI). As the CPI is currently running at 2.7% per annum (Oct 2012), that would imply a normalised base rate of 6.7%. But banks add on their profit margin too, so mortgage rates are typically 1-2% above the base rate. Put simply, the current standard variable rate (SVR) should be around double what it is now. If you doubled the mortgage repayments of the average UK household, we certainly wouldnt be experiencing a flat market. Sure, its saved millions of homeowners and investors from a nasty fate. But likewise, its prevented millions from getting a foot on the ladder known collectively as Generation Rent. You see it doesnt matter how low rates go. If house prices are kept at artificially high levels, then the real barrier to entry becomes the deposit and earnings multiple. Banks are less willing to lend these days after taking billions in losses over the last 5 years. They want a bigger deposit (margin of safety), which is fair enough. But countering that should be substantially lower house prices, which would have naturally lowered the deposit required and also made lending less risky relative to a borrowers average earnings. You see press reports all the time blaming banks for a lack of affordable loans. Its not the loans that are unaffordable, its the houses.

Charlie Cunningham, CEO of affordable homes developer FreshStart Living makes a good point Rather than moves to encourage lending, the Government should be applauding banks for lending more responsibly and not encouraging first time buyers in particular to invest huge sums of money in overpriced assets. In the 10 years from 2001-2011, the average UK house price increased 94% compared to a 29% increase in the average salary. In other words, house prices rose three times faster than wages. You dont have to be a mathematical genius to see things are not right. But as we know, extreme government policy hasnt allowed a natural correction in prices to happen. So now we have a situation of high prices and low mortgage availability the worst possible combination. Of course first-time buyers need no reminding of this. They used to be the lifeblood of the property market the first rung that underpinned the rest of the ladder. But not any more. A study by Post Office Mortgages revealed that in the 1960s, the average first-time buyer was aged 24. This increased to 28 in the 1980s but has now risen to 35. Getting a foot on the ladder is becoming a middle-age aspiration. And its worth pointing out that home ownership is often an illusion anyway. Most

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people dont actually own their property. They own a little bit of property and a lot of debt. In other words, most UK homeowners are at the mercy of interest rates. Now I know what youre thinking, the Bank of England isnt going to increase rates any time soon. Why would they? Theyve thrown the kitchen sink at this, so theyre not going to suddenly change their minds now. But what if they dont have a choice in the matter?

Rates can stay high for long periods because economies fall into a vicious cycle of rising prices triggering rising wages which then triggers rising prices etc. Its known as a wage-price spiral. Between 1972 and 1992, the UK base rate moved between 6% and 17%. Double digit rates werent a freak event, they became commonplace. It happens. The world moves through cycles. So what happened in the last couple of decades? Why has inflation and therefore interest rates been so lownot just in the UK but globally? In a word: China. China became the worlds workshop. Their cheap labour meant cheap prices for us. We got low inflation, they got jobs. We borrowed, they lent. But the evidence is growing that China is facing intense cost pressures. The Economist ran an interesting article in May 2012 called The End of Cheap China. It highlighted that many Chinese manufacturers are facing surging costs including land prices, energy, regulations and taxes. But the biggest squeeze is coming from labour costs. Labour costs (including benefits) for bluecollar workers in Guangdong rose by 12% a year in US dollar terms between 2002 and 2009; in Shanghai the increase has been 14% a year. The cumulative effect has been to increase labour costs by 2.5 times in under a decade.

What trigger event could cause a collapse?

The fact is if global inflation kicks in, Central Banks will be forced to act. In the 1970s a global inflation shock forced the Bank of England to increase rates from 5% in 1972 to 12.75% in just two years. Things then got even worse. By 1976 the base rate was increased to 15%, before finally peaking at 17% in 1980. Interest rates also shot up to 15% at the beginning of the 1990s when the UK was trying to keep the value of Pound fixed in the ERM and reduce inflation. The point is the Bank of England didnt want to do these things. It had no choice. Events beyond its control happened. Inflation began to rear its ugly head and interest rates had to go up. The thing about inflation is that once it starts its hard to stop.

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Its only a matter of time before China switches from globally exporting deflation to inflation. Then this miracle era of low interest rates and rampant money printing will draw to a close. Around three quarters of mortgages in the UK are on variable rates. So if the inflation genie finally re-appears, its going to get ugly. For most buy-to-let investors theres a delicate relationship between the rental income and the mortgage rate. A small rise in rates and many buy-to-let investors will quickly slip into a negative yield. And the moment yields turn negative, it wont be long before a flood of buy-to-let investors start running to the exit. And even with rates this low, many cash-strapped homeowners will also be tipped over the edge. Government giveaways such as the latest wheeze called The Funding for Lending scheme are going to put people in debt that cant afford to be. Its like state-sponsored subprime. Those that are mortgage-free may dismiss the threat of rising inflation as irrelevant. But it is relevant to anyone who cares about the valuation of their house. Because a sharp rise in mortgage rates will put downward pressure on all house prices not just the ones with mortgages. The valuation of your house is

very much linked to the valuation of houses around you. A common argument is to say a particular region is somehow immune. The most obvious one being London. London is currently a property hot spot due to a surge in international buyers. There are a number of reasons for this. Firstly, the UK has been more welcoming to foreign property investors than places like New York, Paris or Berlin. The taxes and paperwork are more lenient (fewer questions are asked). Secondly, the pound has been battered in the last 5 years in fact its been the worlds worst performing major currency. Thats made UK property prices a lot cheaper for foreign buyers. Between 2007-2012, the pound has lost around 46% against the Japanese Yen, 40% against the Swiss Franc, 34% against the Chinese Renminbi, 20% against the Euro, 18% against the US Dollar, and even 5% against the Russian Rouble. These falls effectively act as a discount for foreigners. Thirdly, London is perceived as a safe haven in times of turmoil. Its Western Europes largest city. Its cosmopolitan - just about every country and culture has a presence. And its a deep and liquid market, so can absorb large sums without attracting much attention (great for dirty money). The rest of the UK cant offer

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these qualities, so has largely missed out on the foreign boom. London property prices certainly seem to be detached from the rest of the UK. But the momentum of the market is dependent on a never ending stream of foreign investment. That may prove a false assumption. If the pound were to strengthen from these historical lows it would make London property less attractive to new foreign buyers and tempt existing foreign investors to sell. The government may begin to increase its tax grab on foreign investors. Property is seen as an easy target because unlike most other assets, it cant be shifted offshore. Scared money may begin to dry up or retreat if the global economy begins to recover. The UK could lose its AAA rating in 2013 - all 3 of the major credit rating agencies have us on Negative Watch. Will London still be viewed as a safe haven? There are many possible scenarios (positive and negative) but the point is that there is nothing in economics that is a one-way street. Its usually a big warning sign when investors begin to believe a certain type of asset can ONLY go up in value. Importantly, long-term studies have proven that ultimately property prices revert to the mean including London. Property prices simply cant defy gravity forever. "This time it's

different" are still the four most dangerous words in investing.

How far could prices fall?

The Economist describes UK property prices as the unfinished bust and thinks they remain 20%-28% too high. Credit rating agency Fitch reckons 25%. Deutsche Bank calculates 34%. Morgan Stanley estimates 15%-25%. Even the IMF (International Monetary Fund) says UK house prices are 30% over valued. In our view the best yardstick for determining sustainable value is to look at the UK house price to earnings ratio. Earnings are quite stable and ultimately underpin affordability. After all, most peoples mortgage repayments come from their takehome pay. People often think interest rates are a good gage of value but forget how cyclical they are meaning they have a long history of shooting up and down (sometimes drastically). In periods of low interest rates this can create a value illusion where house prices might appear affordable but the moment rates rise the affordability goes out of the window. At the moment, Nationwide reports that the average UK house price is a bit of over 5 times the average earnings. This compares to a long-run average of 4 times implying prices are 20% too high (or earnings 20% too low

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I doubt your boss will be keen on this). However prices tend to overshoot on the way down and on the way up, so there is no concrete floor or ceiling. Some of the industrys leading lenders are expecting 2013 to be another dull year. Halifax thinks prices will remain flat but lack any genuine direction. Nationwide predicts prices might end up slightly lower. Are they just extrapolating the recent past? 2013 could well be another uneventful year, but there are certainly risks of something big

happening which cant be modeled. In our view, the potential risks are far greater than the potential rewards due to the stretched valuations of UK property. Forcing banks to lend and manipulating the market through central bank tricks ends up causing more harm than good. The market will only function properly when prices become affordable. A natural correction has NOT been avoided, its merely been deferred.

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