By many measures, but not all, the cost of buying a house in the UK is more expensive than ever before. House prices are also similarly high across many international markets.
Real (Inflation Adjusted) House Prices
Adjusting for inflation, “real” UK house prices are at an all time historic high. They are simply more expensive than ever before.
Price vs. Earnings ratio
The high real price of housing is reflected in the house price - earnings ratio. Traditionally this is one of the key housing measures, indicating how much earnings have kept pace with house prices. In the UK this metric once averaged within the 3-4x range, with notable spikes associated with housing boom-busts of the 1970s and late 1980s. Today this ratio is at an all time high, some 20% above the peak rates seen before. This has prompted some commentators to predict another bust.
An alternative way to measure the relative price of housing is to look at the price vs. rents ratio. This simply measures if rents are keeping track with house prices. It’s also broadly comparable to the p/e (price/earnings) ratio commonly used to measure the value of shares. Again, by this measure property in the UK this is at an historic high, with the ratio currently 50% above the long-term average, and even higher than spikes associated with the bubble markets of the 1970s and 1980s.
Source: The Economist
“Affordability”
However, both of the above measures use the actual price of the property as a yard stick to measure against. Many commentators today argue that this is misleading because property is often purchased using debt and thus it is the cost of servicing the debt that is the key measure, not the headline cost of the property nor the amount of the debt itself.
This lower “affordability” measure is driven by the low interest rate/low inflation environment that has characterised the globalised economy of the early 21st century. Low interest rates mean that for a given debt early payments are more affordable.
Unfortunately, the “affordability” description is also somewhat misleading as it does not take account of the low inflation environment that enables the low interest rates. “Affordability” as often discussed in the press is only really a measure of first year cash flow affordability and takes no account of payments in later years, nor the total cost of servicing the home loan.
Inflation has many faces. Whilst commonly viewed as public-enemy-number-one, it can actually be a friend to those in debt. If inflation is running high, interest rates and thus the cost of borrowing is generally higher too, so paying the mortgage hurts in the early years, but inflation driven wages rise rapidly and the mortgage payments quickly become much easier.
Source: Andrew Farlow
This was most typical experienced by those that bought houses during the oil shocks and stagflation of the 1970s. High inflation, and thus high interest rates, meant that many home buyers of that period will remember that they had to make significant sacrifices and experienced very tight finances for the first few years of their mortgage. However, this burden eased rapidly and they were quickly able to trade up or enjoy more spare money. It is here that the concept of a housing ladder was born.
In contrast, in a low inflation environment this “free” erosion of mortgage debt does not take place so rapidly. Low inflation lets debts linger longer. While initial payments might be cheaper than before they also stay higher for longer, and in later years the mortgage payer will pay a greater percentage of their salary than they would have done in a high inflation environment.
This has implications for the longer term.
The peak of the late 1980s boom was in 1989 and 1990. At that time UK interest rates were between 13% and 14%. It was within this context that the all-time record first year mortgage payments were eating up 60% of take home salary. However, at the same time inflation was running at over 10%. This meant that even if everything had stayed the same throughout the early 1990s it would have been approximately 10% easier to make the payments for each subsequent year of the mortgage, as earnings approximately track inflation. Thus it would have taken just over three years of a mortgage for the payments to drop from their record 60% to the 2005 rate of just over 40%, even without a change in interest rates. This is much more rapid than today, where we have inflation at circa 4% (RPI is more comparable to the inflation quoted in the 1990s than the modern CPI). As it was there was a housing bust and a recession anyway and interest rates dropped rapidly to ~6% by 1993. With this double combination of dropping interest rates and high inflation the difficulty in making mortgage payments decreased rapidly, becoming easier than the 2005 rate by 1992.
Thus, whilst the first year affordability of UK property is not yet at an historic high, the lack of inflation means the debt lingers longer. If interest rates and inflation remain broadly at current levels then the “crossover” point at which payments will become higher for today’s borrowers than even those that bought at the top of the late 1980s boom is somewhere in the 3rd year of the mortgage. In years subsequent to this mortgage payments will be greater and the owners will have less spare money to spend in the wider economy, and less ability to trade up the property ladder.
Is this storing up trouble for the future?
Source: Office of National Statistics, The Economist
The thing to remember is that even though early monthly payments are lower in a low interest rate/low inflation environment, the debt is still there and must be paid back. If house prices are also higher then the rungs of the property ladder have effectively moved further apart.
Simply put, in the absence of any shocks to the economy, those buying today are dedicating more their future earnings to servicing their debt than any other previous generation.
Lifetime affordability still counts.
Not many commentators, pundits, or pub experts really argue that housing is cheap. Many bears point to the real price of housing, or the price-earnings ratio and worry about a crash, whilst the more bullish point to the “affordability” and claim that we are not yet at an historic high.
However, it’s not often noted that the affordability description only focuses on the first year of payments and misses the point of higher payments in later years. Measuring the lifetime affordability of a mortgage might be more contentious, and may not affect purchase decisions, but it remains important, if not for its impact on house prices today then for the social and/or economic impacts tomorrow.
Whichever way you look at it there’s just no way around the fact that house prices are very, very expensive. High house prices alone do not mean that there will be a crash, but if there isn’t to be one there will have to be social consequences.
Part 2 -What’s less certain?
What’s less certain is why this has occurred, or what happens next. It’s clearly here that the bull vs. bear discussion really begins. There are quite a few arguments for either side, with the bears asserting that house prices will eventually (always next quarter) revert to some mean, whilst the bulls assert that house prices can continue to grow rapidly year on year forever with no consequences or risks… A quick summary of these arguments will form part 2 of this blog...
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