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.