An excerpt from Graeme Leach’s article, ‘The Future of UK Housing Market’.
In this paper Kingsgate examines the outlook for that most iconic of sectors, the housing market – and house price change in particular. Whether you are an owner occupier mortgagor, renter, landlord or Airbnb operator, the housing market touches you personally, but its economic impact is far wider and deeper. The housing market has very significant personal consequences and an even greater corporate impact. Big swings in the housing market will directly influence corporate strategy across multiple sectors. Consider some of the ways in which housing market change impacts the wider economy:
House price change on consumer confidence.
Wealth effects on consumption from house price change.
Equity release.
Level of inheritance.
Housing construction.
Supply chain for building products.
Housing transactions.
Durable goods consumption.
Bank and building society lending.
Negative equity.
Bank solvency.
Inter-relationships between the housing market and monetary policy - the setting of interest rates and quantitative easing (QE) or tightening (QT).
Inter-relationship between house prices and the planning system and the barriers this creates for first time buyers to get a foot on the housing ladder – due to very high price to income ratio multiples.
Rental market - buy to let and build to let.
This far from exhaustive list shows that understanding the housing market is a very important component in getting to grips with the economy as a whole. Whilst the feedback effects run both ways; the housing market shapes the economy and vice versa, having a strong understanding of the housing market is critical to an understanding of the general economic outlook. In so many ways housing is a bellwether sector. When it’s good it’s really good, and when it’s bad, it really is.
So how good or bad is the outlook for the UK housing market, and what are the implications for the wider economy? In order to begin to answer this question a little history is required.
A Short History on the UK Housing Market
Figure 1 shows the ups and downs of the housing market in the UK over the past 35 years – based on the Nationwide house price index. UK house prices surged in the second half of the 1980s, rising in double digits for 5 years in a row, peaking around 30% (year-on-year) at the end of 1988 and beginning of 1989. But then the proverbial wheels fell off, and UK house prices fell for 4 years in a row, not returning to their previous peak level until the beginning of 1998 – almost 10 years later.
The period from 1997 to 2004 was characterised by a similar house price boom to that seen in the second half of the 1980s, with very strong sustained double digit house price growth. These were heavenly years for home-owners. House price growth slowed over the 2005-2007 period, but remained strong. Of course, we know what happened next, the Great Financial Crisis (GFC) hit and the housing market began to implode over the 2008-2009 period, falling around 15% peak to trough. The market then flatlined over much of the 2010-2013 period, and would have fallen further without the introduction of QE and low interest rate policies. But as we will see, actions have consequences, and these central bank interventions have come at a price, albeit with a long lag.
Solid price growth was maintained over the 2014-2016 period, but then the momentum slipped over the 2017-2019 period. Prices were still growing, but not much. Then the housing market was hit from left field by the pandemic at the end of 2020 Q1. But far from falling, house prices began to slowly accelerate over the course of the second half of 2020 and into 2021 – supported by the Stamp Duty holiday. By 2021 Q2 house price growth was in double digits and maintained this rate of growth until the Autumn of 2022.
By early 2023 the house price cycle had turned for the third time in 35 years, with prices falling 3% (year-on -year) in 2023 Q2. By August 2023 UK house prices were falling 5.3% (year-on-year) and were down the same amount from their peak in 2022.
Table 1 illustrates one of the most profound changes in the housing market associated with the rise in prices. There are various measures of housing affordability. Table 1 shows official ONS estimates of the ratio of house prices (for existing dwellings) to residence-based earnings.
Table 1 is simply staggering. Over the past 20 years the ratio of house prices to earnings has increased from 5.1 to 8.3 in England (reaching over 9 in 2021). In the South-East it has soared from 6.1 to 10.4 and in London it has exploded from 6.9 to 13.3 – an astonishing doubling!
If the rise in the multiple were attributable to a fundamental shift in underlying economic performance, reflecting an increase in earnings (from higher productivity) and an ability for households to allocate greater resources towards housing provision, then it might, just might, be justifiable. But as we have shown in previous Kingsgate Insight papers (The Future of Productivity) UK productivity growth has weakened not strengthened over the past 20 years.
The explanation for the surge in the ratio of house prices to incomes has a very simple explanation rooted in ‘easy money’. This is because there is another equally significant measure of affordability, namely debt servicing costs. Near zero interest rate policies permitted very low mortgage rates by historic standards, and these lower mortgage rates facilitated far higher house prices. The CEIC economics statistics service estimates that over the 1999-2022 period the household debt service ratio in the UK averaged 9.6%, with a peak of 13% in September 2008 and a low of 8.5% in September 2022. So even record highs in the house price income ratio didn’t prevent a record low in the debt service ratio. But as Figure 2 shows, the world had changed, and the UK base rate was on the rise from 0.1% to 5.25%.
This is the sting in the tail. As Edward Chancellor shows in his magisterial overview of the history of interest rates, The Price of Time, every ‘easy money’ in history has ended in tears and this time is very unlikely to be any different. Indeed, such has been the scale of ‘easy money’ over recent decades – prior to the recent tightening – the fall out could be massive and the negative consequences unprecedented. The reason being that the necessary adjustment from excessive ‘easy money’ prior to the GFC was suppressed by subsequent QE. We therefore face the need for a double- down adjustment resulting from pre and post GFC monetary policy errors, with painful consequences. This is not guaranteed, there is an escape lane, but as we will see, the path to it is desperately narrow.
Explaining the Ups and Downs
In the wake of the GFC, central banks around the world dramatically reduced interest rates, with the Bank of England’s reaction shown in Figure 2. A decade of zero interest rate policies had been initiated, with the creation of ‘easy money’. This money had to go somewhere, and the first ports of call were asset markets: equity and property. Despite the introduction of QE, this didn’t initially trigger an acceleration in economy wide inflation. This only came later with the explosion in money printing during the pandemic, when broad money growth in the UK reached 16% (year-on-year).
The pandemic surge in house prices was influenced by the combination of the Bank of England reducing the base rate to a historic low of 0.1% in March 2020, and HM Treasury announcing the introduction of a Stamp Duty holiday from July 2020 until the end of March 2021. Base rates influence sterling overnight index average swap rates (SONIA) which determine fixed rate mortgages. The higher the swap rate the higher the fixed rate because lenders see it as the base for their cost of funding.
Between the beginning of the rate rises at the end of 2021 and the middle of 2023, the Resolution Foundation2 estimates 4.2 million households saw their annual mortgage payments increase by an average of £1,500. The Resolution Foundation also estimates that based on market interest rate expectations in the middle of 2023, household mortgage payments will be £16 billion per annum higher by the end of 2026, compared with when the Bank of England started raising rates at the end of 2021. Moreover, as of mid-2023, three-fifths of the increased mortgage pain was still to come, with £5 billion of the fixed rate mortgage payment increase set to impact in 2024. The Resolution Foundation estimates that by the end of 2026 almost all households with a mortgage (7.5 million) will have moved on to a higher rate, with average bills £2,000 per annum higher.
Ironically, even though interest rates peaked at 15% in the early 1990s – in the wake of the late 1980s housing boom – the impact on households was actually less than at present. The increase in repayments was only around £1,200 in today’s money – for the typical mortgage holder. In other words, around 2.4% of household income compared with 3% today. The greater impact today, despite lower interest rates, is of course accounted for by the much higher level of mortgage borrowing in the wake of higher house prices. Financial Conduct Authority statistics show that between 2007 and 2023 total outstanding residential loans to individuals rose from £1.06 to £1.66 trillion.
Rental Market Dynamics
According to official figures, the share of the UK housing stock which is privately rented has almost doubled from 10% in 2000 to 19% today. This means that the impact of the privately rented sector on the overall housing market has to be considered more carefully than previously. Ordinarily this would not matter much, but right now the dynamics between the owner occupied outright/mortgaged properties and the private rented sector are somewhat different. The overall market is being weakened by the rise in mortgage rates. But the rental market is experiencing strong growth in rents. In one market the demand curve is moving left (mortgaged market) and in the other it is moving right (rental market).
Two influences suggest that the rental sector will not prevent overall falls in house prices. Firstly, the privately rented sector is smaller than the mortgaged sector. Secondly, the landlords in the privately rented sector will most likely be mortgaged as well, thereby facing higher interest costs. This means that the overall housing market is still constrained by the double affordability problem:
House price to income ratio.
Debt servicing and rising mortgage rates.
However, the impact of these combined effects will be dampened by rental market factors. Nominal earnings growth of around 7% has facilitated private rental growth of around 5% in 2023. This growth rate is taken from official sources. Unofficial sources suggest an even higher rate of private rental growth. It would seem that the private rental market is likely to delay the retreat in house prices and dampen the magnitude of it, without shifting the direction of change.
What Does This Mean For House Prices?
An audit of house price forecasters reveals contrasting views on the interest rate and hence housing market outlook. Nationwide, Zoopla and Knight Frank forecast a 5% house price decline in 2023. JLL predicted a 6% fall. Lloyds Bank predicted a 7% fall in house prices in 2023. Capital Economics an 8.5% fall, whilst Savills predicted a double digit 10% fall. The Office for Budget Responsibility also expected house prices to decline 10% by 2024. The latest August 2023 HM Treasury Panel of Independent Forecasters shows a very wide disparity in house price expectations for 2023 Q4, ranging from a fall of 0.2% (year-on-year) to -11.7% (year-on-year). The HM Treasury panel displays an even greater disparity for 2024 Q4, ranging from a high of +5.2% to a low of -10.8%.
Thus far, if house prices decline in the second half of the year along the same lines as in the first half, then house prices will fall by between 5% and 10% in 2023. If prices continue to fall in 2024 then the peak-to-trough decline, could be on a par with the 15% crash seen over the 2008-2009 period. The uncertainty of course lies with what will happen next, because there are 4 potential scenarios:
Money boom & bust scenario - Money supply growth is flat or contracts, and interest rates and mortgage rates fall back faster and further than expected, but without a banking crisis. Stagnant, flatlining market 2024-2025, with recovery thereafter. Peak-to-trough house price decline of 10%.
Sticky prices scenario - Inflation remains ‘sticky’ and interest rates and mortgage rates fail to fall back and/or rise even further. Lagged effects of mortgage rate hikes (and potential further tightening) kick-in over late 2023/2024 period. Peak-to-trough house price decline of 15% on a par with the GFC.
Mean reversion scenario - The adjustment in the house price income ratio is much deeper than predicted. Peak-to-trough house price decline of 20%+.
Day of reckoning scenario - The end of easy money is far more painful than expected with banking sector difficulties and a sharp contraction in mortgage lending which drives deeper house price contraction. Peak-to-trough decline in house prices of 30%+ with strong negative feedback loops from banking crisis and negative equity.
The money boom & bust scenario is the very narrow road because it entails a very sharp slowdown in the growth of the broad money supply without associated difficulties in the banking system. The reason this is narrow is that the sharp monetary slowdown itself is most likely driven by bank perception of counter party risk, with the threat that the banking sector’s action will in itself increase the downward pressure on house prices, which increases perceptions of counter party risk in a mortgage doom-loop – and higher mortgage rate spreads. However, if the banking sector doom-loop can be avoided much weaker money supply growth should reduce inflation well below the 2% symmetrical target (meaning that base rates are reduced when the CPI is expected to be below 2%) and permit lower interest and mortgage rates.
The sticky prices scenario reflects headline consumer price inflation which measured (CPI) rose 6.8% (year-on-year) in July. The August HM Treasury Panel of Independent Forecasters shows an average prediction of 4.5% (year-on-year) for the CPI in 2023 Q4 with the base rate at 5.6% i.e. a further increase on the current 5.25% rate. Under this scenario house price falls continue through 2024.
One of the economic surprises of this year has been the slowness with which headline inflation has fallen back, given the very sharp slowdown in M4x broad money growth which fell to zero in July. A slowdown of this order of magnitude suggests a problem of deflation not inflation. However, during the pandemic the scale of largesse was so huge – peaking at 15% year-on-year growth in early 2021 – that the monetary overhang (as measured by the ratio of money to GDP) has persisted and is only now being worked off. Other mitigating factors have included the ‘forced saving’ which occurred during the pandemic and thereafter was drawn down on.
The mean reversion scenario is when things begin to get a little scary. Historically, ratios such as the house-price income ratio should have a tendency to mean revert if they are based on debt servicing costs. They might even overshoot below the long-term average, in a downward direction. This suggests house price declines of 20%+ might be possible. Of course, if CPI is back on target the Bank of England would then be able to reduce the base rate and so there is an escape release valve here as well. What is difficult to know in advance is whether or not other factors might also be at play which result in one measure of affordability (the house price income ratio) swamping the other (debt servicing costs). This leads us to so-called Austrian Business Cycle (ABC) and the final scenario.
ABC theory holds that the economic cycle is driven by central banks artificially lowering interest rates below their natural rate – the rate at which the supply and demand for loanable funds is equalised. The lowering below the natural rate is seen to distort the market for capital, resulting in so-called malinvestments. Historically, we can see this in the association between easy money and booms and busts in the residential and commercial real estate markets.
This reduction below the natural rate distorts the market and kick-starts the economic cycle with the easy money and expansion in the money supply resulting in so-called Cantillon effects whereby the money doesn’t flow out evenly across the economy but instead the impact is seen most where it goes first – which is very often into equity and real estate.
It was only when monetary easing exploded – as in 2020-21 – that more general economy wide inflationary consequences ensued. Because the Bank of England has a 2% inflation target it responded to the higher CPI by tightening monetary policy and raising the base rate and it is this increase in base rates which then exposes the underlying problem in the housing market. Mortgagors had spent almost 2 decades focussed on their debt servicing costs and as long as they remained manageable house price income ratios could go on rising. But once they become unmanageable at higher mortgage rates, house price income ratios will have to adjust downwards.
Over the past 25 years we have experienced the greatest spell of easy money in history. Globally, interest rates have been at their lowest sustained level in 5,000 years. As previously stated, every period of easy money in history has ended in tears, with asset price declines, default and banking sector solvency issues. If this were to occur again, the curtailment of mortgage lending could force even greater house price declines, perhaps 30% peak-to-trough, taking the house price income ratio back to pre-GFC levels.
ABC theory holds that a day of reckoning is inevitable but dating that turning point in the economic cycle is where the Austrian school acknowledges that nobody really knows. It will happen but it can be a long time coming. ABC theory predicted a day of reckoning after the GFC, but then massive central bank intervention kicked in and the housing market got a massive boost. The problem however is that ABC theory predicts that the bigger the boom the bigger the bust. The longer and greater the period of easy money the greater the resulting adjustment required to purge the malinvestment from the economic system and restore a sustainable ratio of house prices to incomes, based on mortgage rates closer to their natural not artificially lowered rate. The very fact that all the housing market scenarios above are in play, illustrates just how significant the housing market is and will be, for so many companies.
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