House Price/Earnings Ratio

I made up a little graph the other day to look at the house price/earnings ratio over the last 25 years or so. I was actually interested in creating some kind of affordability index based on prices, earnings and interest rates, but that didn’t produce anything with clear trends. However, simply looking at average UK house prices against average earnings gave surprisingly smooth trend lines.

The p/e ratio was 3.05 in 1982 and 1983, a low. Then, EVERY SINGLE YEAR, it increased to a peak of 4.32 in 1989. Then it decreased EVER SINGLE YEAR, finally hitting 2.64 in 1996. Then, once again it increased EVERY SINGLE YEAR up to 5.69 in 2007. The question now is if it drops in 2008, as seems likely, then does that mean a drop EVERY SINGLE YEAR until we hit a low, somewhere around a p/e ratio of 3? If so then that means a real drop of about 47% which is something in the region of how much the International Monetary Fund said UK houses were overpriced by. Also, given that we’ve been so far over the long term trend, it doesn’t seem beyond the bounds of reason that we may drop below a p/e of 3 for some time as part of mean reversion, which could easily result in a drop of more than 50%.

Unless there is a economic crisis or extreme interest rate rise I don’t see how this is going to happen in just a few years (not even the 7 years of the last downturn). It seems more likely to me that we’ll have a property downturn for a decade or more finally resulting in fair value, before we start the march up again.