Guardian: Hold on, this could get bumpy

Money > Special reports > house prices

Hold on, this could get bumpy

Ashley Seager
Monday August 8, 2005
The Guardian

You may think that the housing market, whose foundations having been
looking increasingly shaky over the past year, would be shored up by
last week's interest rate cut from the Bank of England.

After all, you may say, rising interest rates did for the housing
market last year and so the cut, the first for two years, must have the
opposite effect. If money is cheaper, people might borrow more and
start buying property again.

That is a dangerously complacent view. The house price bubble, the
biggest this country has ever seen, was pricked last summer and has
been losing air ever since. But it has barely begun to deflate in a
serious fashion. It seems unlikely that the puncture can be patched up
by an interest rate cut or two, let alone the bubble re-inflated, as
some estate agents hope.

Let's be clear about this. House prices in Britain were massively
overvalued, by as much as 50%, last summer when they finally stopped
rising. As they have stood more or less still since then, the extent of
that overvaluation has barely fallen. Prices had gone up 200% in the
previous seven years even though inflation more generally was running
at around 2.5% a year.

As a result house prices are still around six times average salaries,
compared to a long-term average of 3.5 times. If prices were to stand
still, it would take at least eight years for the long-term
relationship to be re-established. It is hard to see that happening.

Since Mervyn King, the Bank of England's governor, warned in June last
year that there was a danger of prices falling, prices have either been
static or, in the case of London and the south-east, have begun to
fall. Sellers are clinging to hopes of high prices, but are only
selling if they drop their price.

And buyers are reluctant to buy now because they scent that the ball is
back in their court and also because prices are still very high, which
means a huge deposit. While an interest rate cut makes a mortgage
slightly cheaper, it makes no difference to the size of the deposit
required.

Interest rates were cut very sharply in the early 1990s but it took
several years for house prices to turn up again.

The current housing market indicators are not universally gloomy,
however. There is some evidence that the decline in activity - measured
by buyer inquiries and mortgage approvals - may have bottomed out. But
it is far from clear that this heralds any kind of upturn. It may just
be a pause on the way down.

In fact, as Ed Stansfield at consultancy Capital Economics points out,
there is a clear parallel between what has happened to mortgage
approvals over the past year and what they did in the early stages of
the last housing market crash - a strong fall, a gradual recovery for a
while, then a slump. "It is absolutely spooky," he says.

The Royal Institution of Chartered Surveyors' monthly survey of
surveyors - one of the most reliable housing market indicators - is
still pointing to sharp price falls. And now, the main price indicators
from the Nationwide and Halifax are showing annual price inflation
slowing rapidly. The Halifax reported on Friday that prices were only
2.3% higher than a year ago, a nine-year low.

Fairly soon, probably in October or November, this annual rate could
turn negative. There is no reason for it to stop at zero. Then any
lingering pretence that bricks and mortar remain a rock-solid
investment will have gone.

This could be a key psychological blow to the housing market. Over the
past year, you could hear people saying things like, "My house price
may have dipped this month but it is still 10% higher than a year ago."

And the knock-on effects on the economy could be grave. Already
household spending has slowed sharply, as has mortgage-equity
withdrawal, where people add to their mortgage to spend on other
things. This has hit the retail sector hard and has slowed the whole
economy down faster than the Bank of England had expected. This is why
the Bank cut rates last week. Slower growth leads to slower inflation
and its remit is not to let inflation slow too far.

So why should house prices fall? After all, say the optimists, there is
no economic recession and no obvious trigger such as a sharp rise in
unemployment or a sharp rise in interest rates, especially as they have
now been cut. People don't have to move and so will just stay put and
wait for prices to pick up.

I am not convinced by that. Prices, as in all markets, are set at the
margin. In housing, about 7-8% of the market changes hands every year.
Within that are always people who need to sell including, for example,
builders of new developments. Recent results from housebuilders show
that they have cut their prices 10% or more in some cases to lure in
buyers. In private, many house builders are very gloomy.

Moreover, unemployment has started to rise, on the claimant-count
measure at least, and employment has fallen slightly. That will not
increase confidence in the housing market. And people are still saving
very little of their income in historical terms. If people decide to
save more, the economy and housing market could weaken further. If they
think house prices are falling, they will be reluctant to buy.

To get a broader perspective on the house price bubble, it is worth
looking at other countries. Britain's bubble is far from unique.
Indeed, it is clear that the wave of interest rate cuts around the
world in the wake of the bursting of the dotcom bubble five years ago,
which saw shares tumble 50%, created a boom in housing instead.

All across the rich world, with the exception of Germany and Japan,
house prices have been booming. The United States, France, Spain and
Ireland are just a few of the countries that have seen double-digit
property price rises in recent years. The resultant increase in
(largely illusory) wealth has been bigger than the dotcom bubble.

And the correction now seems to have started in Britain, Australia and
the Netherlands. Prices are still steaming away in France and the US
and many other countries, but the warning signs are flashing. Prices in
Sydney are down 16% in two years, according to international
comparisons done by the Economist. Why shouldn't that happen in London,
where prices are already down 3-5% on some measures?

But any way you look at it, it is clear the correction has only just
begun.

In Britain the slowdown in consumer spending has occurred with house
prices standing still. If and when prices start to fall, there could be
trouble for the economy. The Netherlands is stuck in recession after
its house price boom turned to bust a few years ago. The Japanese
property market has been falling for 14 years since its bubble burst.

And don't be fooled by the apparently modest pace of the price slowdown
in Britain over the past year. House prices moves tend to be slow
rather than rapid. But once they have started, they gather momentum.
Further gradual declines seem the most likely course and that is no bad
thing, especially if you are a buyer. People need to be aware that
asset prices can go down as well as up.

Rents, meanwhile, are likely to rise as house prices move sideways or
downwards, pushing up rental yields from their current lows. A few
people may choose to tuck a rental property into one of the new
self-invested pension plans to be launched next spring but I doubt that
will be enough to encourage a big wave of buying-to-let, which has
fallen hugely in popularity this year as hopes of capital gains have
faded.

It is, of course, possible that things really are "different this
time", as the housing market optimists like to say. But all bubbles in
the past have burst, and this one looks no different.