Another item has been added to life’s certainties of death
and taxes. It is London
house price inflation. The sentence ‘It will never go down’ has been uttered in
every single recent conversation on the subject. It is usually followed by ‘I
should have bought earlier, now it’s unaffordable’. The oxymoron of perpetually
rising prices and increasing unaffordability amongst the top income decile
seems to escape notice.
Graph 1: London
house prices have been going up for what seems to be a lifetime
Graph 2: Fall in demand shifts the demand curve to the
left and reduces prices
Believers dismiss such an eventuality by invoking the myth of unlimited demand. To them the demand curve, rather than shifting to the left (i.e. reduction in demand) is expected to shift to the right (i.e. increase in demand). Events seem to have borne them out asLondon
property’s ‘safe haven’ status has led wealthy individuals from across the
globe to park a part of their wealth there. Once again the bias to extrapolate
from recent history is apparent. However the ‘unlimited demand’ argument cannot
be dismissed this easily. It requires further deconstruction.
London
has been a major beneficiary of the developed world’s move towards FIRE (Finance,
Insurance, Real-Estate) economies. It contributed almost half of UK ’s gross
value added (GVA) from finance and insurance sectors in 2009 and almost a fifth
of GVA from real estate. The high and more rapidly increasing income from these
sectors underpinned the high and rapidly increasing house prices (Graph 3).
Graph 3: Paying with FIRE
Source: ONS
Moreover these sectors generated a lot of jobs until the credit crisis (Graph 4) and also created ancillary employment in other sectors (Graph 5). A combination of job creation and a liberal immigration policy attracted immigrants enhancing the demand for housing for both purchase and rent.
Graph 6: Relative changes in income, jobs and house
prices
Graph 7: Conditions for secured lending by households
across UK
Graph 9: Supply reduces even as demand reduces
preventing price fall
Graph 11: High debt-burden without the benefit of a reserve currency
Graph 12: Real house prices on the Herengracht Canal ,
Amsterdam
(1628-1973)
The reason for an almost unshakeable faith that London house prices will never
go down is predicated on their observed behaviour. For the last 17 years, barring
the credit-crisis induced meltdown, house prices have only gone up (Graph 1).
Moreover, believers’ faith was further strengthened by the swift recovery from
the crisis.
There are two main rationalisations for the belief in
perpetually increasing house prices. The first is the argument of limited
supply. The second is the argument of unlimited demand. Limited supply is an argument made in support of house
prices for almost every city. It is especially valid for the capital of an
island nation beset by stringent planning laws. However, prices are determined by
both supply and demand. Even if the supply curve is completely inelastic, a
fall in demand will lead to a fall in prices as Graph 2 simplistically shows.
Believers dismiss such an eventuality by invoking the myth of unlimited demand. To them the demand curve, rather than shifting to the left (i.e. reduction in demand) is expected to shift to the right (i.e. increase in demand). Events seem to have borne them out as
Demand for London
property can be bifurcated into internal and external demand. The former is due
to people employed and primarily resident in UK . It may be as a primary
residence to live or as a buy-to-let investment. The latter is due to external
residents buying property for investment, capital preservation or as holiday
homes. Internal demand largely depends on demographics and performance of the economy.
As long as jobs are plentiful, wages rising and population increasing, the internal
demand for housing will rise. This has been the case since the mid-nineties.
Source: ONS
Moreover these sectors generated a lot of jobs until the credit crisis (Graph 4) and also created ancillary employment in other sectors (Graph 5). A combination of job creation and a liberal immigration policy attracted immigrants enhancing the demand for housing for both purchase and rent.
Graph 4: Employment powered by FIRE
Source:
ONS
Graph 5: London unemployment
dropped faster but is now rising faster than UK average
Source:
Labour Market Statistics, ONS
This natural demand was supercharged through access to easy
credit apart from an influx of wealth from abroad. It led to house prices
increasing at a faster pace than increasing employment and income would warrant
(Graph 6).
Total
Income = Average FIRE Pay x Total Jobs
Source: ONS, Author's calculations
After the FIRE economy consumed itself in the conflagration
of 2007-08 the dynamics of internal demand have changed. Cinders have fallen on all sectors as can be seen from the quickly rising unemployment which has increased more than the UK average (Graph 5). In FIRE sector employment is below the peak and as Graph 4 shows, jobs were again being destroyed
in finance and insurance in the first quarter of 2012. Anecdotally the second
quarter is going to affirm this trend. Real-estate’s bucking the trend may be
due to temporary factors such as the Olympics. Moreover in finance and
insurance stricter regulation and increased market volatility have reduced
revenue and return for institutions. This has resulted in employee pay trending
down (Graph 3). If this was not enough, politicians have decided to cater to
populist xenophobia by cracking down on immigration. Employers and skilled migrants, already
deterred by poor economic conditions, are further put off by the official hostility against immigration.
All the conditions responsible for a rising internal demand
for housing are now acting in reverse. In addition, the rocket fuel of easy
credit has burnt out with banks tightening lending criteria (Graph 7). Despite
demand from households, credit availability remains moribund, application
approvals are decreasing and mortgage interest costs are rising. Although data
for London is
not exclusively available, given the arguments above, it is unlikely that banks
are acting differently for Londoners. Especially in light of the fact that despite
high average incomes in London ,
price to income ratios are highest there (Graph 8). This implies banks either
need to offer higher loan-to-income mortgages to Londoners or ask for higher
deposits. And as graph 6 shows, loan-to-income ratios are being reduced across the UK.
Source:
Bank of England
Graph 8: London
house prices are the most overvalued compared to earnings
Source:
ONS, Land Registry
Even as internal demand started collapsing after the advent
of the credit crisis, external demand underpinned the market and reflated house
prices. This was despite external demand being much lower. The reason why a decrease
in demand did not lead to lower prices was because of diminished supply (explained simplistically in Graph 9). Bank of England’s rate cuts reduced the pressure on
homeowners to sell by lowering their repayments dramatically. The massive
reduction in the number of transactions (Graph 10) along with anecdotal evidence
supports this conclusion.
Graph 10: Completed transactions in London are at the lows
Source:
Land Registry
The additional external demand keeping the market alive has
been due to London ’s
status as a ‘safe haven’. London ’s
location, cosmopolitan character and British rule of law and property rights
have traditionally attracted wealthy investors. Recently, investors fleeing
from the European debt crisis have caused another burst of demand.
However as the history of sovereign debt crises shows, external demand
for a country’s assets is fickle and can turn in an instant. Houses may not be
as easy to sell as debt and equity but investor sentiment is the same. In fact,
due to the illiquid nature of the asset, prices can fall more dramatically. As
long as London
property can preserve capital and provide returns it will sustain foreign money
inflows. But in the absence of internal demand these flows become Ponzi like. The
pool of foreign investors needs to be constantly replenished to enable existing
investors to cash out at a profit. This causes prices to become dependent on
perceptions of the UK
economy and performance of the Pound Sterling.
Unfortunately the UK economy is not doing too well.
The outlook is not too bright either given the policy mix. Not only is fiscal
austerity combined with monetary debauchery going to fail but it is also
exactly opposite to investors’ interests. The former will snuff growth and
hence internal demand while the latter will cause a fall in the currency. Once
attention shifts from the beleaguered European Union, investors will notice an
island nation with a debt-burden[1] next only to peripheral Europe (Graph 11). Since defaulting will be politically
unpalatable and the strain of repayment socially and economically impossible,
fall in the value of Sterling
is virtually certain over the long term. Moreover the UK will suffer
enormously from an implosion of its largest trading partner, the Eurozone. In
such an event, it is a safe haven only in a relative sense – maybe the loss will
be only 70% compared to 90% in Europe.
Source:
Eurostat, IMF, Author's calculations
In conclusion, the analysis above lays bare the myth of
permanently increasing London
house prices. A broader look at history shows that even if supply is limited, periods of seemingly insatiable demand and rising house prices do not persist
forever. Data of house prices from another former colonial and European power makes this clear (Graph 12). The only sure things still remain death and taxes.
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[1] On Interest/Revenue and Debt/Revenue metrics. To see why these are more relevant than debt/GDP:
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