The London House Price Bubble: how might it burst?
by George Hatjoullis
The talk of a UK house price bubble continues but it is hard to find it in the data. Perusing the Halifax Data leads to much head-scratching. The Halifax Data (http://bit.ly/1jYSFfS) show that in Q4 2013 average affordability in the UK was 27.2. This number measures average mortgage repayments as a % of average earnings. The mortgage repayments include interest and principal and assume a loan-to-value ratio of 70%. The interest rate is assumed to be the Bank of England monthly rate for new advances. The data go back to Q1 1983. The highest level recorded is 65.5 in Q2 1990. The lowest level recorded is 23.6 in Q2 1996. The value for Greater London is 38.1, which may be the valid source of concern.
One problem that is immediately obvious is the assumed LTV rate of 70%. Although buyers may be able to afford the mortgage they may be unable to find the deposit. The average house price in Q4 2013 was £203k, requiring a £61k deposit. The BoE monthly rate for new advances ended 2013 at 3.06%. However, it is unclear whether this is a realistic rate available to the average buyer. Does it allow for fees ? Moreover, the charged rate increases rapidly if the LTV increases above 70%. The average house price in Greater London was £369k so the deposit requirement was £110k. Prices have risen further this year so the situation has not got any better and there is evidence that mortgage rates are firming.
The need for a large absolute deposit and the significantly higher mortgage rates charged for higher LTV ratios would seem to be the source of the stress in the housing market rather than historical affordability. This is consistent with the logic of the governments help-to-buy scheme which is targeted at making possible higher LTV ratios. However, the cost of such loans does not seem any lower. The problem in Greater London is particularly acute as the average flat price in Q4 2013 was £312k. This is a property a typical first time buyer or young couple might buy. They would need a £93k deposit at a 70% LTV. If they managed to get a 95% LTV loan it would not be at 3%. It would be closer to 6%. If one adds in the cost of service charges (which can be very high for leasehold properties in London), rates and utilities, one can see that the Halifax Affordability Index may not be telling the story, at least for Greater London, and indeed the South in general.
The Halifax Affordability Index for Greater London is 38.1. It is unclear from the Halifax website to what precisely the ‘earnings’ figure relates. It is evidently based on average male earnings but it is unclear if the calculation adjusts for average male earnings in London. It is clear that average male earnings in London are higher than the national average and that male earnings are higher than average earnings for both sexes. A lot of useful information is obscured in the ‘averages’. If the GL affordability data does allow for higher London earnings then the situation is serious indeed and especially for single women in London trying to buy a flat!
The London bubble will eventually burst. All bubbles do. However, there is no way of knowing when this will happen or how unaffordable GL property must become before it does happen. The dynamics of adjustment are quite complex. One area where the problem will soon manifest itself is in regional employment and pay. London-based employers will eventually find it hard to find staff for low paid work. This will boost pay differentials between London and the rest of the UK even further. It will also boost employment prospects in London for those that can find somewhere affordable to live. If the problem becomes very extreme many employers will locate out of London, in so far as they can. However, this process is not new so it is likely that those in London now are here because relocation is not an option. The problem becomes self-reinforcing as more hopefuls flock to London in search of work.
The government can enforce more relaxation of planning controls and, in particular, allow more high-rise blocks. However, this may not solve the issue if these properties are offered at very high prices to overseas investors (that may just leave them empty). The need is for affordable housing and developers are not interested in providing such housing as it is not profitable. Land in London is expensive! The requirement that developers allocate a portion of developments to affordable housing has not been strictly enforced by local authorities owing to pressure from the developers. After all they do not need to develop any land they own. How then can more affordable housing be introduced into a high growth and wealthy district where land prices are high and rising?
The low paid could be relocated to the periphery of the district but this only works if the commuting costs are heavily subsidised. London Underground is not cheap and nor are commuter rail services. The reality is that the only meaningful action the government can take is to part-socialize housing provision. The many approaches ( rent controls, council housing, ownership restrictions etc) all interfere with the housing market and a laissez-faire Conservative Government would find this hard to implement. A change of government might alter the situation as well may a change in Mayor of the GLC.
The main bursting factor would be a rise in interest rates and mortgage costs rendering the edifice in London unaffordable. However, this is at least 18 months away and perhaps even longer. Unemployment is no longer a factor in the Bank of England’s forward guidance and the CPI is below target. If the CPI keeps falling it would be hard to justify an increase in the base rate. Another related variable is the exchange rate. The stronger sterling gets the more expensive London property becomes to the foreign investor and the greater the incentive for investors to sell and repatriate their funds. Higher interest rates may well also boost sterling.
There may not be a house price bubble in the UK in general but something resembling one is developing is London. Bubbles always burst, it is a matter of when. The prospect of rising interest rates rendering the edifice unaffordable seems some way off. However, the employment and social implications of the London property boom is already having political repercussions. The risk to London property may be political and lie in the electoral outcomes of the next few years.
Daily Telegraph article (http://bit.ly/1gBk3ti) suggests political risk and strong sterling has already taken shine off London Property as an investment. Equities offer similar potential with substantial tax advantages and of course greater liquidity. Diminishing political risk elsewhere and growing risk in the UK may be the key driver though.