UK housing market valuations are at record highs. That’s probably not much of a surprise to most people, but the negative implications for future house price growth could well be.
I’ll spell out those implications as clearly as I can:
My expected outcome (or best guess) for the UK housing market over the next decade is that house prices will fall in both real and nominal terms.
I realise that being a housing market bear is contrary to popular opinion but, as I see it, the evidence suggests that falling house prices is a far more likely outcome than continued growth.
There are two main reasons for this pessimistic outlook:
Reason 1: The house price-to-earnings ratio is at record levels
According to the latest data from the Halifax House Price Index, the average house price in the UK is £214,811. At the same time, the average homebuyer earns £37,552.
There is of course an important link between average house prices and the earnings of the average person in the UK:
Houses are paid for out of earnings, whether the house is bought or rented, and so houses must in some way remain ‘affordable’ for the average person, although ‘affordable’ is a pretty vague term.
Currently, the ratio between house prices and homebuyer earnings is 5.72 and by itself, that’s a fairly meaningless statistic. However, 5.72 is only just below the all-time high for that ratio of 5.83, reached at the height of the pre-crisis credit boom in July 2007.
The long-term average house price to homebuyer earnings ratio is much closer to four, and if you ignore the high valuations of the past ten years the price-to-earnings ratio’s natural level is probably even lower than that.
The chart below shows how homebuyer earnings have increased since 1983 and how house prices have fluctuated up and down in relation to those earnings (yes, house prices have indeed fallen in the past, on multiple occasions).
Here’s a quick guide to reading that chart:
- The ‘rainbow’ – Shows where house prices would be at various house price-to-earnings ratios
- The yellow zone – where house prices would be if the house price to earnings ratio was at historically average levels
- The red zone – where house prices would be if the house price to earnings ratio was very high (as it is today)
- The green zone – where house prices would be if the house price to earnings ratio was very low (as it was in the mid-90s)
So house prices are currently very expensive relative to historic norms, which is bad enough. But valuation mean reversion raises the spectre of negative equity for millions of homebuyers.
Reason 2: Price-to-earnings ratios tend to mean-revert
In the chart above, the average house price-to-earnings ratio is four. This average is important because price-to-earnings ratios, for both the housing market and the stock market (e.g. the FTSE 250), tend to return to their long-run average values (the yellow zone in the chart above) at least once every ten years or so.
In other words, when the housing market price-to-earnings ratio was close to three in the mid-90s it was very likely that the ratio would reach four by the mid-2000s. And that was precisely what happened, as it had in most previous ten-year periods.
Although mean reversion isn’t a law of nature it comes pretty close, and for that reason, my expectation is that the UK house price-to-earnings ratio will decline back to four by 2026.
What would house prices look like in 2026 if the price-to-earnings ratio did indeed fall back to four?
Assuming inflation of 2% and real wage increases of 1%, the earnings of the average UK homeowner would increase to £50,467 by 2026. If house prices were indeed four times that level then the average house price in the UK would hit £201,867 by 2026.
That’s an expected house price decline of 6% over a decade in nominal terms or a fall of 23% adjusted for inflation.
Of course, I don’t actually think the future will pan out exactly like this, nor do I think this scenario is the most likely outcome; the future is far too uncertain to make such deterministic statements.
Instead, you should look at this as a sort of best guess of what the future holds. It won’t be exactly right, but it is a scenario that investors and homebuyers should take seriously.
Hi John,
I love your rainbow charts, but I have a few thoughts:
how about using Land Registry data rather than Halifax? The former includes all sales and the latter just those with mortgages, and I think that makes a difference in some locations.
house prices are intensely local, and while I buy into your analysis, I don’t know how to apply it to my street.
I also think inflation is key. House prices are sticky and people don’t like to sell at a nominal loss. If we could get some decent inflation the adjustment would be a lot easier.
Keep up the good work.
Mike
Hi Mike
Land Registry – Okay, I’ll have a look. If it’s significantly better (or easier to use) then I’ll switch over, but generally I’m after a big-picture overview rather than getting caught up in too much detail.
Local intensity – I agree that house prices are massively affected by locality. With this analysis I’m just looking at the overall UK, so of course it lacks some granularity. The best localised review of prices I have seen is on the Retirement Investing Today blog:
http://www.retirementinvestingtoday.com/2015/05/valuing-housing-of-england-and-wales-at.html
He redoes the review each May, so the 2016 version is due soon (hopefully).
Sticky prices – Yes, very true, unless people are forced sellers because they can’t afford the mortgage payments (e.g. if interest rates hit double digits). Also when people inherit a home the purchase price is effectively zero, so their main motivation could be to cash in today because they fear that prices will continue to fall.
But generally, yes, house prices are sticky unless there is a significant kick to the house price apple cart. What that kick is, I do not know, but I’m pretty sure it’s out there somewhere.
House prices are dropping!
mean reversion is compelling
however, constraint on supply is also critical
something that someone said stuck with me – ‘if theres only enough houses for 50% of the people, then only 50% of the people need to be able to afford them’
maybe the metric that needs to be computed is what is the P/E ratio for the actual houses sold and the people who are actually doing the buying? This may be a lot lower than your calculation of all people vs all house prices.
It may be the case that the ‘real’ P/E ratio is at a historically normal level..
Hi Rhino, I would say that if only 50% of the population could afford housing, the other 50% would probably cause some sort of political upheaval such that more housing was made available!
In the long-run I think the same arguments are likely to apply in the real world. Younger people who can’t afford to buy will eventually get peeved off enough to vote for whoever promises to increase housing supply massively.
As for ” the P/E ratio for the actual houses sold and the people who are actually doing the buying”, that is exactly the data that my analysis is based on. The Halifax figures are, I believe, for houses sold through them and the earnings of the related buyers.
There are some “standardisation” adjustments to take account of the fact that no two houses are the same, which you can read about in their Index Manual, but basically my understanding is that it is what you suggested – actual houses sold and actual buyers.
Also, I have looked at the ratio between homebuyer earnings and UK average earnings (i.e. including those who are not homebuyers) and the ratio is fairly static over decades. Homebuyers on average typically earn about 50% more than the population at large, and this has only varied up and down by about 5% either way since the early 80s. For whatever reason that doesn’t appear to be a particularly sensitive (or useful) metric.
good stuff! much more informative than just average house price/average wage.
There will be some sort of housing revolution (revolution with a small ‘r’) that will occur when Gen Y and millenials start to represent the lions share of MPs and the baby-boomers have largely left the building.
Gen X don’t fully suffer with the problem as enough of them snuck into the housing market while the going was good – so they won’t fix it.
Probably won’t be a conservative revolution..
As a Gen X’er I did indeed snick into the property market, at the mid-90s low. So yes, Gen Y are beyond probably the ones that will drive any changes.
Great article and analysis, John.
I wonder if house-price-to-home-buyer-earnings is as important as monthly-mortgage-payments-to -home-buyer-earnings in driving the ultimate price of houses?
Maybe the ultra-low interest environment is the greatest prop for house prices and it could take a decent hike in interest rates to change the market and drive house prices lower.
If so, does reversion to the mean of interest rates seem seem like an event that needs to precede reversion to the mean of the house-price-to-earnings ratio?
Kind regards,
Kevin
Hi Kevin, yes exactly; low interest rates and a change in bank lending criteria from house price multiples (e.g. 3x earnings) to affordability (interest payments/earnings) are the big drivers. That plus a love of property ownership in the UK and a general desire to minimise new developments.
Interest rate mean reversion is probably the most obvious cause and leading indicator of a future decline in prices, but there could be others such as restrictions in lending for regulatory or business reasons.
Only time will tell, but unfortunately the property market moves like a snail compared to the stock market, so it could be a few years yet.
2 other reasons that house prices may fall:
– Interest rates will eventually rise – and maybe even revert to the mean! Despite the currently high PE, if you can get a mortgage affordability is good.
– reduced demand from BTLs as a tax deduction for interest payments is removed
Hi Colin, I’d agree with that. I think the interest rates are the big unknown. How Japan pans out may give a good indication as we’re basically copying their policy response to their 1990s property/stock market collapse.
Hi John,
You give no weight to the level of interest rates. If rate expectations become reality i.e. 10year bonds at 1.62, interest rates will remain low for at least another decade. With the resulting effect if making mortgage payments affordable at higher prices than previously. This will suggest that the historic averages might be less indicative of future averages i.e. 5.83 could be the new normal.
Regards,
Anthony
Hi Anthony, I think that is indeed the mainstream position. However, I don’t put much weight in rate expectations and think that the current high valuations are only possible under a narrow set of circumstances, i.e. a super-low rate environment (making current interest payments affordable) combined with a 20-year property bull market (feeding the erroneous notion that property prices only go up).
I think high valuations are typically unstable and any change to this narrow and delicate environment will cause them to revert to more historically normal levels.
But exactly how and when that reversion will occur is of course unknowable.
Just happened that Barings the fund managers released a 10 year prediction for UK property and stock markets with both predicted to give similar returns around 6% (see link below). Difficult to say but if history is anything to go by (and it probably isn’t) property may be the better investment play especially with chronic lack of supply and another 3 million migrants expected to move to the UK and not to forget rising rental incomes.
The outlook for US equities doesn’t look too good either and perhaps its time to be buying emerging markets again.
http://www.telegraph.co.uk/investing/news/the-10-year-predictions-that-suggest-where-to-invest/?cid=sf25324559&sf25324559=1
Thanks for the link. I’m a bit more bullish than that article about UK equities and the FTSE 100 in particular over the medium to longer-term. But property, no, I’m going to stick with my bearish outlook for now.
As for the US, I also think it’s very expensive and has weak expected future returns, while emerging markets may be a good but perhaps higher risk choice. My approach has been to buy some UK stocks that have emerging market exposure.
Thanks for the reply and I like your approach. I don’t suppose there is an investment trust or fund out there that I could buy into this type of strategy? I just don’t have the time to do it myself
Not sure what you mean about an investment fund or trust? If you’re talking about a property fund then no, but if you’re talking about stocks then there are various funds that are similar to my defensive value approach (e.g. Woodford) but none that are exactly the same.
Thanks and I meant an equities fund that uses your defensive value style
Could you perhaps suggest some others I should look at? Woodford looks interesting and I wanted to compare if thats OK? Thanks
Hi bc1050, no there isn’t an equity fund which uses my approach. Woodford’s is probably the most similar that I can think of. Fundsmith and the funds run by Nick Train are vaguely similar, but they’re more focused on defence than value. There are other value funds but I would hesitate to say they’re particularly close to my defensive value investing approach.
John
Its a nice analysis but misses two important details.
The UK is not one housing market, and this analysis needs to be carried out for every housing district around every large job market. this analysis would highlight that some areas are even more over valued, and might even show some areas which are still undervalued. (and have potential for gentrification)
Human psychology does not easily allow people to crystalise a loss on their main asset. So as market prices fall and people are in negative equity, they stay put or maybe rent the house out until inflation gets them back into positive equity.
If anyone is up for modelling all this detail, Id love to collaborate…
Hi Ben,
Sorry for missing out some key points, but with a sub-1000 word article it’s a bit difficult to fit everything in! As for your points:
District/regional variation – Yes, I agree. This is a market-level analysis, much like valuing the FTSE 100 or other indices. Even if the index is high or low there will of course be individual stocks that are the opposite, and the same is true in the housing market. See my previous comment mentioning Retirement Investing Today’s regional analysis:
http://www.retirementinvestingtoday.com/2015/05/valuing-housing-of-england-and-wales-at.html
Sticky prices – Agree on this point as well. However, history suggests that prices do fall in nominal terms, as the chart suggests. People sell for various reasons, they move because work forces them to, or they leave the country, or they die. For example, I bought my first house in 1995 from somebody who had recently inherited it and just wanted a quick transaction in order to get hold of the cash. The fact that they sold the property for about 30% less than it had been worth a few years before was irrelevant to them.
As for modelling all this, I hope you find a collaborator but it won’t be me! Looks like far too much hard work and I have enough on the go analysing the stock market. But it could be an interesting project nonetheless.
“The problem for my friend and for all those looking to buy or sell is that at present we are parachuting in the dark. We don’t know how fast we are falling and we have no idea where the bottom is.”… GULP GULP GULP GULP GULP!”
http://henrypryor.com/blog/2016/04/housing-market-on-the-edge/
It is already on, like Donky Kong! Thank God.
Thanks for the link. I must admit I like Henry’s take on the property market as in many ways it’s the same as how value investors view the stock market:
““you make money when you buy, not when you sell. We’re not trying to make a friend, we’re trying to buy an asset. If the agent isn’t weeping as you confirm your terms then you’re probably bidding too much!”
One variable we are not including here is foreign investors who is buying the houses in cash. Last 12 Months i have heard a lot of stories about Chinese and Arabic migration where rich migrants moving their assets from China to UK. In one story a businessman offered £650K in cash for a house offered to market at £600K. We can’t deny the fact this migration will continue for next a few years. If UK population was to stay as it is and if there was no variables from outside then we could rely on mortgage numbers. So i am really not sure about prices going down and i am betting towards house prices to go further up.
Except it is not cash. It is loan from abroad. Even “sold” doesn’t mean sold http://www.standard.co.uk/business/chris-blackhurst-truth-behind-sold-signs-as-foreign-buyers-go-cold-on-luxury-london-homes-a3177251.html
As with the peak of every other speculative bubble in history, aggressive marketing, hype and out right fraud abound.
Hi Muratanur, I would say that foreign buyers may be a factor in prime market areas such as London, but I doubt that they have a significant impact across the whole UK market.
Perhaps a more important point with foreign buyers is that, assuming they rent out the property rather than live in it, they exacerbate both upward and downward price movements.
As investors rather than inhabitants, they are far more willing to sell if prices start to fall. As such they are known as “flighty capital” (because they take flight at the first sign of trouble) and are likely to look to sell up fast in order to get out before everyone else when prices decline.
So I don’t see foreign buyers as a reason to think that prices will keep going up. Instead I see them primarily as a potential driver of a housing crash.
The property market is a bit frothy at this moment and it may be about to pose some negative returns, but overal I would not be so concerned. Apart from Brexit, which may generate an immediate correction, there will be probably a soft landing.
I expect the Bank of England to remain acomodative with interest rates or even move to negative interest rates to prop up the property market.
The property market is very important for Britons in terms of confidence to spend. If it turns sour we are going into recession before we realise. Time to sell those discretionary stocks, Next included. And do not own any banks!!
Hi John, The theme of your article is close to my own sentiment. I also think the figures are even a little too optimistic, as I’m not backing the household earnings number as the guide to drive the ratios.
My understanding is that it has always been the principle earners salary that is used as the yardstick.
On that basis the average salary in the UK is about £26,500 and this makes the ratio even more extreme at 8.1X which is more than twice the long term (100 years) average.
I also, like you, would to some extent dismiss regional arguments and any attempt to position population or demand as an argument.
The market is all about affordability and this could massively change if inflation (and interest rates) rise rapidly.
This happened when Norman Lamont stood on the steps of the Bank of England and announced we were withdrawing from the exchange rate mechanism. Interest rates and mortgage rates shot up overnight.
Demand is also not an argument, as we would all be driving expensive cars like Rolls Royce or Ferrari for examlple – clearly this is not a practical measure.
Hi LR, yes I think affordability is the primary factor by far. Current levels are only affordable in a low interest rate environment, so the range of environments in which current prices are affordable is narrow. If rates go up, prices will fall, and that’s all there is to it. There could be other factors that drive down prices, such as a change in sentiment, but rate rises are the most obvious and powerful.
There’s an old song that used to be sung frequently on the Kopp at Anfield :-
“I’m forever blowing bubbles, pretty bubbles in the air”
Looks like Barclays are singing it now :-
http://www.telegraph.co.uk/personal-banking/mortgages/barclays-no-deposit-mortgage-lets-you-borrow-55-times-your-incom/
LR
Funnily enough Barclays were the one I remember from the previous bubble when they introduced a mortgage that was so massive your kids would have to keep paying it after you died. Anything to keep the wagon rolling eh?
Great analysis and tend to agree that what goes up must come down.
Two other factors why prices have remained high is that banks have started to / or simply been allowed to lend again at the higher rates, which just gives prospective buyers more ammo to outbid each other. Which is pretty stupid really and a vicious circle. As are all the government schemes like help to buy and ISAs and all of that junk. If you give all first time buyers an extra £5k for example does that not just push prices up by £5k across the board?
Cheers!
Help to buy has to be near the top of any list of stupid ideas. Of course, if you help people to buy that will just support or raise prices, so in five year’s they’ll have to help even more, and more, and more. Yes, very sensible use of taxpayer’s money.
Anyway, why doesn’t the government help people to buy Ferrari’s? I’d like a Ferrari so why doesn’t the government help me with £5k towards a deposit?
Let’s not go over the top, Help to Buy and LISA have not influenced the property prices, they have just been introduced. They are incentives to save and this should be applauded.
First time buyers do not get a good treatment from lenders, because they are riskier. Basel 2 did not helped them at all, it created another barrier.
On this one I would disagree. I don’t like endless attempts to ‘help’ first time buyers, if ‘helping’ them just means encouraging them prop up an overheated housing market.