Is there going to be a house price crash?

Simon Lambert, This is Money

Created 2 November, 2007 - Prediction updated May 2008

Predictions of a potential property slump are coming thick and fast, but is Britain on the cusp of a house price crash?

Warnings of a house price crash have flowed thick and fast as the credit crunch has unfolded. Sages as diverse as Alan Greenspan, the IMF and the Government's housing expert Kate Barker have all warned on UK property.

Meanwhile, the chances of a house price crash are being talked up by a growing band of house price sceptics.

But property cheerleaders have been fighting back claiming the house prices are due a soft landing but no dramatic slump.

So where does the truth lie? This is Money shows how to spot a slump, and investigates whether a house price crash is about to hit...

A snapshot of the property market

After two years of robust house price inflation, the market appears to be cooling.

The Land Registry reported monthly inflation for England & Wales of 0.3% for August and 0.4% for September – down on the 0.7% average over the past 12 months and considerably below the rises of around 1% per month seen earlier this year.

Elsewhere, property information specialist Hometrack said prices fell for the first time in two years, dipping 0.1% in October and that yearly gains had slipped back to 4.4%.

Nationwide's figures for October showed a surprise monthly increase of 1.1%, but the building society's chief economist Fionnuala Earley said it would be 'misguided' to read this as a sign house prices were not weakening.

The suggestions that the market is cooling have been supported by a report from the Bank of England showing mortgage approvals for homebuyers slumped in September to 102,000 – the lowest level for two years and 10,000 below the recent monthly average.

Meanwhile, the influential Royal Institution of Chartered Surveyors, a group that was among the first to spot the Nineties property crash, published a report showing there were signs that even the runaway London market was cooling, with first-time buyers treading tentatively and interest in pricier properties waning.

Hometrack's report said some of the biggest price falls in October were in higher value areas of London, such as central London and the City (-0.5%) and south-west London (-0.4%).

How mortgage lenders pushed up house prices

According to the Land Registry, the average home in England and Wales cost £183,896 in September, 2007. Halifax puts cost of the average UK home at £198,500, with its measure including Scotland and Northern Ireland in its data.

Whichever index you use the cost of property has risen sharply since Autumn 2005, before which house prices had been relatively subdued for a year. The Land Registry shows a 15% rise in the cost of a home since October 2005, while Halifax shows a 18% rise.

The swift pick up of house price inflation from autumn 2005 came despite experts warning of a prolonged period of stagnation the previous summer following yet more reports of falling prices. The general consensus in summer and autumn 2005 had been that as prices had risen by 165%, from an average of £61,000, in 1995, to £162,783, in 2005, according to the Halifax, the property market was due a soft landing.

The return to robust house price inflation came as most banks and building societies switched to offering larger mortgages by basing lending on affordability rather than traditional income multiple levels. This allowed homebuyers to take on loans of five times individual and joint salaries, rather than the typical three-and-half times individual salary or two-and-a-half times joint-salary measures.

Combined with the lower rates delivered by the Bank of England's rate cut to 4.5% in August 2005, affordability lending helped push property inflation back up, especially in London where a shortage of property on estate agents books helped send prices spiralling.

Why are prices slowing?

There are a number of theories as to what has applied the brakes to the property market.

Some experts point to the Bank of England hiking the cost of borrowing five times in less than a year. First from 4.5% to 4.75% in August 2006, and then ratcheting rates upwards to hit the current 5.75% level in July 2007.

Other pundits highlight banks and building societies tightening lending criteria, especially those dealing with poor credit borrowers, due to the knock on effects of the US subprime mortgage crisis.

These events have coincided with the first run on a British bank in more than 100 years during the Northern Rock crisis, which severely dented public confidence, and the arrival of home information packs, which estate agents claim are distorting the market and deterring speculative sellers.

Another major factor is that prices have continued to rise to record levels compared to income and even with affordability-based lending there is a limit to how much people can pay back.

The average house price of £198,500, according to Halifax, stands at 8.5 times the average salary of £23,300, according to the Office of National Statistics. Meanwhile, Council of Mortgage Lenders figures show that in the second quarter of 2007 mortgage interest repayments stood at an average of 16.2% of income – the worse affordability levels since 1992, when the bank rate was at 8.88%.

Confidence

The crucial driver of house prices, as with that of any asset, is confidence. When confidence is high, prices will continue to rise and people will continue to buy. But once uncertainty sets in demand slows. The public's confidence in the property market has taken a knock during 2007.

A This is Money poll from November – December 2006 showed 55% of people believing prices would rise over the next year; a similar poll in April – May 2007 showed this had fallen to 41%; while an October 2007 poll shows just 17% believing prices would rise. (The polls had received 1,500, 4,100 and 1,000 votes respectively at the time each snapshot was taken.)

These polls provide a good barometer of public opinion, and sentiment can be more important than what any expert, report or study thinks. It is the general public who will be buying property.

Inflation will no longer pay off your home

One of the effects of the rapid inflation in house prices since the 1980s is that it has paid off a generation's mortgages.

Those who bought a home in the 1980s, or early 1990s, and held on through double-digit interest rates and the dark days of the slump, have emerged with properties that have risen to be worth five to ten times their mortgage.

The average UK property cost £30,898 in 1983, according to Halifax, and £198,500 in September 2007 – an increase of 642%. A homeowner who purchased the average home on a 25-year repayment mortgage in 1983, with a 10% deposit, would have borrowed £27,800, a sum that 22 years later is seven times less than their property is now worth in the year before that homeloan ends.

For a similar effect to be delivered to a modern day homebuyer purchasing a home with a 25-year mortgage, the cost of the average property would need to stand at £1,275,000 in 2031. This requires property inflation to continue at a rate that is far higher than wage inflation, which as the last 24 years has shown is not impossible.

Salaries have risen at a much slower rate than property prices and were both house price inflation and wage inflation to continue at the same rate, the gulf between the two would be enormous.

In 1983 the average wage according to the Office of National Statistics was £7,700, today the most comparable measure stands at £23,300, an increase of 303%. If both property and salary inflation are sustained at the same rate, the average wage by 2031 will be £70,600 but the home will cost 18 times more, this compares to the average home costing four times the average wage in 1983.

A first-time buyer or young family hoping that inflation will pay off their home in the same way that it did for their parents is likely to be seriously disappointed.

The importance of buy-to-let

The emergence of buy-to-let has heavily underpinned the housing market and made many people view property as a money-spinner.

Figures from the Council of Mortgage Lenders show there were 938,500 buy-to-let mortgages existed in the first half of 2007, worth £107.8bn, this compares to 120,300 loans worth £9.1bn during the same period of 2000.

The rise of buy-to-let has reflected the increase in house prices and most landlords who have been in the market over the medium and long-term have made strong capital gains on their properties. Demand has remained strong for buy-to-let despite property prices rising much faster than rents, with a 13% year-on-year increase in mortgages recorded by the CML in the first-half of 2007.

But the continuing popularity of buy-to-let has masked problems bubbling under the surface. New landlords are struggling for rental income to match mortgage repayments, the new-build flat sector - sold heavily to amateur landlords - has seen prices fall in many major towns and cities, and buy-to-let lenders are having to ease lending criteria to attract business.

A slump in buy-to-let demand or widespread sell-off would release a large amount of property on to the market and could lead to prices dropping, especially for those sectors favoured by landlords.

Will demand and supply support house prices?

To listen to the sceptics you would believe that the outlook for property in the UK is dismal, but this ignores the fact that housing is not stocks and shares.

Owning a home is an emotional desire and the demand for property in Britain remains high. If prices fell by 10%, many aspiring buyers would see this as a good purchasing opportunity. There is also a shortgage of supply of property in the UK compared to demand, fuelled by household growth, immigration and investment.

This has failed to be met through Government development targets and for as long as these continue to focus on quantity rather than quality the situation will continue. Estate agents across the UK report a shortage of good quality family houses, which in turns pushes up the cost of property lower down the ladder, a comment reiterated by the Government's housing experts in a recent report.

Target-led development has encouraged major scheme developers to concentrate on flats and small properties in order to deliver the most homes at the cheapest price. This development has been combined with aggressive selling to buy-to-let landlords and has led the cost of the average new flats to rise by just 5.3% between 2000 and 2006, according to the Land Registry, while the cost of all property rose by 89.5%.  

Britain is a small and relatively crowded island and restrictions on development will remain at the same time as the country is likely to see continued immigration and increase in households.

However, immigration, household growth and buy-to-let demand are unlikely to continue at the same rate over the next two decades, with buy-to-let returns dropping off and mass EU immigration tailing off as the arrival of new member states slows.

How do you spot a house price crash?

The term house price crash is an evocative one, conjuring up images of stock market-style collapses - but, of course, this is not the way that property prices work.

The Black Monday stock market crash, 20 years ago, saw the Dow Jones lose 23% and the FTSE 100 lose 11% of their values in one day, with the FTSE 100 losing a total of 26% during the month of October.

When house prices crash you do not walk past the estate agents one morning to find every price has been cut by 10% overnight. For starters, it is an illiquid asset - most people live in their homes and are unlikely to sell them because the price will fall.

Instead, a property slump starts with a steady drip of monthly negative growth or stagnation that is compounded over time and further exacerbated by inflation.

The 1990s property crash saw this happen, with Halifax average prices peaking at about £70,000, in 1989, before a long run of stagnation and monthly losses – with average prices generally falling by less than 1% a month. By the time this run finished in 1995, the average house price stood at £61,000.

This £9,000 fall over six years represented a 13% drop in prices, but inflation of 34% over the same period left people's homes worth much less in real terms. Furthermore, a slump will affect certain areas harder than others – in the 1990s crash the cost of the average London home fell by 25%.

Will there be a house price crash?

The big question is could this happen again? There are definite parallels between the UK property market now and before the 1990s crash, with rapid house price rises and seriously stretched affordability – back then it was high interest rates that were the issue, now it is huge mortgages.

But the crucial difference is that current economic prospects look benign compared to the early 1990s, when people were forced to sell their homes as prices fell, unemployment soared and negative equity took hold.

Currently if prices stagnate, which they have already been doing in some areas of the UK, sellers can afford to sit tight rather than cut their price substantially. With employment high and the economy continuing to grow, homeowners should be able to hold on and those who have owned their home for longer than five to ten years should be protected from negative equity.

Any correction is likely to be a slow fall in values in real terms, as house price inflation dips below consumer price inflation (or retail price inflation for those who disbelief the modern day 'official' measure of inflation.)

The biggest threat to the property market today is from debt. The UK has a personal debt mountain of £1.3 trillion - double the amount five years ago - and although Bank of England figures show a slowdown in mortgage approvals, homeowners are still borrowing £1bn per day.

There are indications that borrowers are increasingly struggling to pay mortgages and personal debts, with repossessions and bankruptcy on the increase. If inflation picks up substantially, forcing further rises in interest rates, many more people could be in trouble, especially if lenders are found to have been dishing out cash recklessly, as many believe.

A similar scenario triggered the slump in the US property market but a vital difference is that Britain has tighter controls on new building and is more dependent on second hand housing stock than America, which has seen boom areas witness vast urban sprawl.

If the UK property market slumps, it will be those around the edges that feel it most – mainly recent buy-to-let landlords and first-time buyers, especially those with city centre new build flats.

What may happen is a big drop in transactions and market stagnation, with sellers sitting tight, buyers staying away and buy-to-let landlords proving more resilient than sceptics think and content to sit on what they see as their pension.

The This is Money prediction

Making predictions is a mug's game, but as This is Money's property expert it falls to me to stick my neck out.

Housing is overpriced and in areas such as London, the South East and Northern Ireland, greed has led to a property frenzy, with sellers and agents taking advantage of a shortage of properties for sale and hiking prices. These areas are in danger of a significant drop of perhaps 5% - 10%.

However, barring a major economic shock I would suggest house prices will rise at about 2 - 3% annually for the next few years, posting little real increases in value, with interest rates of around 6% here to stay.

Update

May 2008

By Simon Lambert

I wrote this article in November 2007, at a time when the signs of a slowdown were clearly on the horizon, but the property market had a very different look to it.

I said in my article that the availability of mortgage finance had been the key driver of house prices upwards over recent years (see How mortgage lenders pushed up house prices above). At that time, despite the credit crunch and Northern Rock collapse, mortgage lenders were still happily lending to individuals, with a slightly more risk averse outlook but with no problems lending 95% to 100%.

This continued into the New Year until the major economic shock that I mentioned above occurred. This was the collapse of Bear Stearns. This completely pulled the rug out from under banks as their worst fears about the credit crunch were confirmed.

It is easy to underplay the Bear Stearns collapse from our viewpoint in the UK, and refer to it as the US's Northern Rock. However, Bear Stearns' collapse was much bigger than Northern Rock going under and affected the entire global financial system.

My original prediction was that prices would rise by 2-3% for the next few years, with property potentially falling in real value, barring any major economic shock. I believed there was enough latent demand in the UK for buying property, from frustrated first-time buyers, homemovers and even buy-to-let landlords, which would keep prices rising slightly over the next 12 months - even if they fell away in the first six months of this year and dipped again in future. I can no longer see this.

That major economic shock I mentioned occurred and its effects in the UK can be seen in the sudden carnage wreaked in the UK mortgage market. Without finance people cannot buy homes and until banks return to lending money house prices will fall. And unless banks do this soon, prices will fall long after the mortgage market comes unstuck and the prospect of 5-10% falls over the next few years will remain very strong.

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