Thursday, 26 January 2012

Big House Price Fall- comming soon - here's why.

I am still injured from when the car hit me – back and neck pain is still stopping me having a reasonable night’s sleep. Additionally given that my bike is not yet back from the repairers there is basically nothing I can write about of value (do I ever) about cycling (other than complaining about lack of cycle lanes but I am not a fan of that – besides there are already enough people Blogging on that topic). So I am going to have a blast at some Economics as a diversion (be grateful my other passion is History). Please bear in mind by using cycling I was able to predict the fact that Medvedev would not run for President of Russia months before it happened!

Whilst reviewing my list of Twitter followers – I noticed one of my favourites @freakonomics Given that I was an investment banker for 18 years of my life (Salomon Brothers) I have always had an interest in Economics – not the  boring bread and butter FX / Interest Rates but in searching for a hidden key into how and why people act and think in certain ways. To me this has always been an added and valuable tool in predicting market movements (and profitable I may add).

That’s the intro over – now why do I think house prices are due to come down more significantly over the next year or two? Let’s be honest there is always some doom-sayer coming out with such a line on a fairly regular basis. That not my style – my pet dog could have predicted the recent decline with all the macro-economic events occurring (seemingly daily). But in my opinion we have now reach a significant tipping point that is going to remove the whole foundation of the current market. The interesting thing to me is what was that tipping point and how will it alter some previous market conceptions.

Let’s look at the recent history; despite a raft of bad news and poor lending conditions, the housing market still seems to be carrying on in a reasonably solid way and to be honest no really reflecting economic statistics, so why is this? Well there are a number of factors – simple things such as the intransigence of sellers to move their prices too low and maybe move into negative equity. More importantly a large amount of support has been put into the housing market (particularly the lower end) by “buy to let” buyers. This market has also been artificially inflated by the current low interest rates that don’t look like rising significantly for the foreseeable future. Finally there seems to be an unending demand that only grows daily this is because social housing is at a low, and for many other reasons such as more people living alone or mass immigration.

When other markets dropping, there is currently few reasonably safe areas to invest in, housing and gold being the obvious exception. To understand this you have to think about the average Joe on the street – not for him a Bloomberg Terminal firing a raft of statistics. His job does not involve constant chats with fellow market professionals about the nuances of the market about a stock that is going to outperform the market as they have just completed R and D on a major new killer product. He will glance at the markets in the middle of his daily free paper and only be aware of the headlines. In the UK, property has always had a soft spot in small investors hearts – and why not. Despite everything, prices rise in general and you can earn income from renting out the property and if worse comes to worse you will always have a roof over your head.

The buy to let market has now taken over from Social Housing. The Government now builds less housing and relies on private investors to buy and lease their properties. Many landlords choose to lease to the Social Housing sector – people renting in this sector often offer two major benefits; firstly they have their rent is paid by the Government (still a triple A) and secondly tenants tend to be less fussy, after all the house is free for them. With careful management of your residents you can weed out undesirables and find yourself on a nice little earner – house prices may vary but over time they are bound to rise, and all the time you have your debt (mortgage) paid for you by the rental fees, meaning you should make some income on it as well.

Now we come to the reason why this is all going to fall apart and look at the effects this could have.

The Government has recently put in place a housing benefit cap as follows:

£250 for a one-bedroom property  per week
£290 for a two-bedroom property per week
£340 for a three-bedroom property per week
£400 for a four-bedroom property per week

All in all, unless you are very liberally minded, not to low. But this is below the amount being paid to quite a large number (nice and vague of me) of Landlords currently, especially in places like London where rents are higher.

“Buy to Let” is a very simple calculation – no Black and Scholes or Newton Raphson needed for this. How much have you borrowed to buy the house multiplied by the mortgage rate then subtract that from the rent. As long as rent is greater than mortgage payment all is bearable maybe not fantastic income but there is no way you are going to pull out due to the long term benefits (owning the house outright in 25 years’ time and therefore a pension in place) unless that is, it starts to drain your monthly income.

Once the scenario is reached of a negative impact on the landlords monthly income then the they are going to think seriously about selling up, even if the landlord can take the pain at the beginning, others will not be able to, they will sell, then as the housing market becomes a buyers’ market and prices inevitably drop the landlord will think very seriously as to why you are holding onto an asset that drains their monthly income and is also decreasing in value. Surely it would be far better to get out now and buy back in when the market bottoms? The buy to let market is a business, there is no sentimental attachment to a family home. This scenario is very likely – despite the demand outlined above buyers outside the buy to let market are not able to gather enough of a deposit to enter the market. New home builders and housing associations can cover this by offering to cover the deposit which you just pay off at the end or when you sell the property. This type of offer will generally not be in the power of small private investors to offer.

Why do I think this is going to happen? Just look at the facts – the housing market is way out of kilter, to be in a situation where it costs more on a monthly basis to rent a property than to own it is just not practicable, it is there because house prices are artificially high coupled with the need for larger initial deposits.

The curious thing about this upcoming correction is that it is going to start in London. Throughout my lifetime, prices have always started to drop outside of London initially and only as the crisis worsens, work its way down to London. This time London is going to lead the way, the reason for this is simple, house prices in London are higher than the rest of the UK generally. The higher the Landlord bought the property for, the higher his mortgage payments will be and the more the housing benefit cap is likely to affect them.  

Please note that for all of the above I am not including the properties of the mega rich, as with all things related to the rich – they follow their own rules which are outside of what I have outlined above.

So here’s a question – is this a bad thing? In attempting to answer this I am going to try and remain non-political and only look at things from an economists point of view. I confess now I am a Liberal and when I say liberal I mean in the true sense. I believe that Governments are there to regulate and provide a society in which people operate within rules and generate wealth, have self-determination and the right to make errors. Housing benefit has eschewed the housing market, Governments are paying more than  what is currently a realistic market rate for property rental, expensive areas are having their prices held artificially high. If Mr X (working) wanted to move his family to live in an expensive central London location he may not be able to afford it – prices are too high for what he earns. Therefore he would make the choice to move to a cheaper area, given that wages are not exactly rising (unless you drive a tube train) more and more people would have to make this choice, eventually supply and demand would lead to Central London Landlords to reduce their rent, the market would correct and rental prices would reflect the current economic circumstances, when the Government is footing the bill this is not a situation that occurs. The landlord brings in his Social Housing tenants and price levels are maintained.

Now you will hear people in the media complaining that this will make people homeless, undoubtedly this will happen (with much press coverage) but look below the tip of the iceberg and the real benefits far outweigh this. Firstly there is the ethical question, if you are working, paying taxes and in the unsupported housing market, there will be restrictions as to where you can live, you will have to rent relative to your means not to your wants, you will have to live further out and maybe travel into work. It is understandable then that such people will feel little sympathy for a person who is having their rent paid for them out of taxes not being able to live in such a location also – especially if that person does not need to be tied to an area for work reasons (though not always the case). But there are ways for the Government to set aside a contingency budget so that those who are forced to move can do so with minimal fuss.

Once the initial teething pains and relocations (please to God this is done with sympathy and common sense) then the market will correct. House prices will come down as explained above and therefore come into the reach of more people, rentals markets will reflect economic reality and not Government Social policy, additionally the tax bill will be reduced. So for the non-landlord it is a win win situation, less tax and more sensible house prices. Maybe people will start to buy shares again and enable companies to invest in machinery and R and D to create more jobs? Come to think of this no wonder every time I hear this subject talked about on radio phone ins, it is always the Landlords ringing up and complaining!

I have never been a fan of the UK housing market – everyone is obsessed by house prices going up. In positive economic times it seems that all people do is poor their money into ever greater mortgage payments, if interest rates drop then people get bigger mortgages, never thinking they may go up again in the future – somewhere in their head they think “sure interest rates may go up but at least the value of my house will be greater” never thinking to link the fact that when interest rates go up house prices will drop – this is because people are mortgaged to the hilt and an increase in interest rates leads to a flood of people offloading houses they can no longer afford the mortgage for. The only people who have benefited where people selling mortgages.

House prices often outperform other investments by many multiples. They also, when it turns ugly, underperform at a rate of knots with income and capital gains falling in unison. To be honest if it wasn’t against my free market principles I would suggest we index link house prices – how marvellous would that be – no more over borrowing by individuals, money saved would be used on buying consumer goods and investing in shares of genuine wealth creators and no more dodgy property developers driving around town in expensive cars. We need to get back to the fact the a house should primarily be a home and not an investment, nowadays so many families seem to buy houses with the intention of using them as an investment and not a home. Even if it is an investment it is fairly pointless with only builders gaining employment, jobs they would have anyway as houses will still need to be built.

People who benefit the most from a greatly increasing property market are the developers and old people selling up to move to Spain (where they lose all their money on a dodgy Costa development that gets torn down later because it lacked proper approval) or a smaller house. The rest of the population – struggling with children and a multitude of bills just end up paying more for a larger house if they move up the ladder (think about it, an increase of 10% means you may sell you £100k house for £10k more but it is going to mean the £200k house you buy is going to cost you £20k more).

A more stable house price structure will enable people to plan for their future with far more accuracy, a house is the biggest thing that most people purchase in their life, for such a structure to suffer from such volatility is crazy, medium term financial strategies and the reduction of inflation is always talked about for the economy of a country and yet we still allow ourselves to be trapped by wild swings in prices as individuals on our houses. But it is nearly impossible to convince the average person on the street of this fact – the same person watches the news and thinks when GBP gets stronger against the USD it is only a good thing (well it is if you are an importer or going on holiday there).

So reducing Government impact on the rental market will help reduce the distortions affecting it and that may not be such a bad thing (unless you are a landlord).

Back to cycling now.


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