UK housing market will struggle to make headway
UK house prices, having recovered about a third of the value lost during the credit crisis, will likely struggle to make further progress from here. Price gains will be restricted by a weak labour market and a lack of credit growth. Given the coming fiscal consolidation, we would expect regions where the government is a major employer to underperform. Segments that are reliant on first-time buyers, who will struggle the most with restrictive credit, also look more vulnerable. Meanwhile, those regions which are attractive to overseas investors look set to outperform.
One of the key arguments for forecasting renewed price falls in the UK housing market is that price-to-income ratios are still close to peak levels. However, this measure doesn’t take into consideration the level of interest rates. Prices can stay high relative to incomes for extended periods of time provided interest rates, and thus mortgage-interest payments, remain low.
We prefer to look at the broader measure of affordability to assess potential demand. Affordability, taking into account earnings and interest rates, looks at the cost of servicing the debt required to pay for the house. Given rock-bottom base rates, the cost of the average mortgage is at or below 4%. In fact, according to the Council of Mortgage Lenders affordability is back to levels last seen in 2004 and in the decade before. That period saw house prices more than double. We would therefore argue that affordability would suggest that houses prices are cheap, at least as long as current interest rates persist. We expect them to as the Bank of England acts to ease the process of fiscal tightening.
However, the number of transactions remains very low. This brings us to the issue of access to credit. Following the financial crisis, mortgage loan offers are on more rigorous terms, with 75% loan-to-value ratios being standard. Transactions have recovered only modestly from their low point last year and are still below the levels seen at the worst of the 1990s housing-market slump.
A key consequence of restricted credit is the limited number of first-time buyers. With the average house price at 4.7 times average earnings, a first time buyer able to borrow only 75% of the house price faces having to put down a deposit equal to their entire annual salary. Houses may look affordable, but only to those with capital. We expect an increase in demand for quality rental property and a rise in the age of first time buyers.
The supply side of the market has been just as constrained as demand. A key feature of this recession has been the relatively moderate increase in unemployment compared with previous recessions. Government measures to support mortgage-payers and the very low interest rates have kept a lid on forced sales and foreclosures.
So in conclusion, the constraints on credit militate against further substantial house-price gains and especially restrict the ability of first-time buyers to enter the market. Prices have not collapsed to the extent seen in previous recessions, and should remain supported, given supply has been constrained, while houses are generally affordable. With unemployment levels having been low relative to previous recessions, this has meant there have been few forced sellers.
Expanding on these themes, we would favour segments and regions of the market that have limited exposure to first-time buyers and those attracting the interest of cash-rich overseas buyers who are less constrained by access to credit. That implies multi-bedroom houses rather than flats and especially one-bedroom flats.
Unemployment remains a key risk. While the UK economy is out of recession and private companies appear to be hiring again, budget cuts will mean lower employment across all levels of national and local government.
In a previous Daily Theme (UK spending cuts: impact on regions and cities, 8 April 2010) we explored the vulnerability of regions to government spending cuts. This highlighted Wales, Scotland and the North East as the regions most vulnerable to budget cuts, with over 30% of jobs in the public sector and another 9% linked to those sectors of private industry most dependent on government spending.
By contrast, the figure for London was up to ten percentage points lower. The five most vulnerable cities, on our work, are Durham, Liverpool, Canterbury, Preston and Cambridge, which all had some 45% of jobs in the public sector or dependent private sectors. At the very least, a civil service pay freeze would reduce any improvement in affordability from rising incomes in these areas.
The conclusion that the best prospects are for family houses in London seems counter-intuitive, if the existing high prices in absolute and relative terms are used as the starting point. However our analysis suggests that other factors are more important in the current UK housing market.
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