Average property prices in the UK are at historic highs and this is not good news for future house price gains.
Why? The short answer is that trees don’t grow to the sky. The longer answer is a bit more complicated but very interesting.
But first, a question: Why am I – a stock market investor – talking about house prices?
The answer is:
- I’m interested in market valuations in general and that extends to the property market.
- I think stock market investors can learn a lot from property investors.
- The housing market valuation methods which I cover in this article are directly applicable to the stock market as well, with just a couple of minor tweaks.
Okay, enough with the introduction; let’s take a look at the UK housing market:
House prices always go up, right?
Here’s a chart of average house prices for England and Wales based on data from the Office for National Statistics and Halifax (okay, England and Wales aren’t the whole UK, but they’re the bulk of it and it’s the data the ONS had on their website):
As you can see, average property prices in the UK have gone up a lot, from £27,000 in 1983 to £225,000 in 2017. That’s an average annual gain of about 6%.
A lot of that is due to inflation, but people rarely adjust for inflation when calculating investment returns. Most people would just look at the chart above and say “see, property goes up by 6% almost every year.”
So property prices have gone up a lot, but what about their value? In other words, I could pay someone £100 for a peanut, but that doesn’t mean the peanut is worth £100.
Price and value are two entirely different things. However, there is obviously a close relationship between the two (which is why people don’t usually pay £100 for a peanut).
How do we measure the true value of a property or its intrinsic value? The simple truth is that we can’t.
There are too many factors and value is ultimately a subjective thing. But we can still make a pretty sensible estimate based on historic norms.
For example, house prices in a country are obviously going to be related to the earnings of the people who live in that country because they’re the ones who pay mortgages to banks or rent to landlords.
Average house prices share an unbreakable bond with average earnings
Here’s a chart of average earnings in England and Wales:
Like house prices, average earnings have gone up and up and up. Again, inflation is a big part of this, but even so, the average gain of 4% per year since 1983 outpaces inflation by a reasonable margin.
So what exactly is this relationship between house prices and earnings?
In simple terms, it’s just the ratio between average house prices and average worker earnings.
What’s interesting about this ratio is that it’s both mean-reverting (i.e. tends to return to its historic average every few years) and range-bound (i.e. exists in a relatively tight range rather than flitting between one and one million).
Why is the house price-to-earnings ratio mean-reverting and range-bound?
Imagine that the average UK worker earns £30,000 and the average house costs £30,000. It would be very easy for most people to own more than one house. You could buy a house, pay it off in ten years and then buy another one to rent out or put the teenage kids in. That would push up demand, which would push up prices.
At the other end of the scale, almost nobody earning £30,000 per year could pay off a £3,000,000 mortgage (100 times earnings) in their lifetime. Banks don’t like to lend when the borrower can’t pay back the loan, so demand for houses would fall and that would push down house prices.
Obviously, there’s a bit more to it than that, but that’s the basic picture.
In fact, we can do much better than simply saying that the house price-to-earnings ratio stays in a range between one and one hundred. That’s because the amount people are willing to pay for a house relative to their earnings, or to pay to rent one, doesn’t change by anything like a factor of one hundred.
Here’s a chart showing the house price to earnings ratio since 1983, based on the same data as the previous two charts:
Since 1983, the house price-to-earnings ratio has an average value of just over five, a minimum value of just over three and a maximum value of just under eight. Today it sits at an all-time high of 7.8.
This is all interesting stuff and it means we can begin to build up a picture of where house prices might go if the house price-to-earnings ratio reverts to its historic average as it has always tended to in the past.
But before we think about where house prices might go, let’s have a look at where they are today.
UK house prices are in a bubble
I think the conclusion that house prices are in a bubble is pretty obvious, but the argument still needs fleshing out.
Here are a few definitions for the house price-to-earnings ratio:
- Depression PE = 3.3 – This is about where the market fell to in the early 90s. Prices need to increase by 50% to go from depression to fair.
- Fair PE = 5.0 – This is close to the historic average of the last 35 years.
- Bubble PE = 7.5 – This is close to the highs of the late-2000s housing bubble and the subsequent era of super-low interest rates. Prices need to increase by 50% to go from fair to bubble.
I think that’s a pretty reasonable guestimate of reality. Some people might argue that the current price/earnings ratio of 7.8 is sustainable, or that it could go even higher to ten, or 20, or who knows where. But I think they’d be wrong.
The UK housing market currently has a number of massive tailwinds, none of which are likely to be sustainable over the long term. The main ones are:
- Record-low interest rates
- Massive amounts of money that was pumped into the system by the Bank of England in an attempt to motivate banks into lending more money to more people
- Crazy government schemes like Help to Buy which appears to have been created with the singular goal of pushing up house prices
When these tailwinds are removed I think it’s highly likely that the house price-to-earnings ratio will do what it’s always done, and that is to revert to its historic average on the back of house price declines.
Of course, I could be wrong, but history suggests I’m not (although I have no idea when any of this will happen).
For example, here’s a chart of house prices laid over a “rainbow” of house price PE ratios, where red is expensive, yellow is fair and green is cheap (relative to historic norms):
Over very long periods of time, the ratio of house prices to earnings stays within a relatively narrow band. When it goes far above the average, it falls back. When it falls far below average, it recovers.
I think that pattern is very likely to continue and that the pull of mean-reversion is going to outlive the push of short-term government stimulants.
The upshot of all this is that as far as I’m concerned, the medium-term future for UK house prices does not look good.
UK House prices are likely to stay flat for at least two decades
In 2007, average house prices reached £174,000. Today, more than ten years later, the average stands at £225,000.
That’s a gain of 30% in ten years or less than 3% on an annualised basis. If you take inflation into account then the average house price has stayed virtually unchanged in more than a decade.
If you look at house prices through the lens of housing PE mean reversion then this shouldn’t surprise you at all.
In 2007 house prices were at record highs relative to earnings and the gap to “fair value” was as large as it had ever been.
To a mean-reversionist, the likely outcome was a big decline in house prices over the following decade, or at the very least a long sideways market while inflation pushed up the “fair” level of house prices.
What we got was a sideways-to-slightly-upwards market, largely thanks to those massive government-driven tailwinds.
This means that the gap to fair value hasn’t diminished at all, so as far as I’m concerned price declines or zero growth are still by far the most likely outcome.
If we look at a ten-year time frame then there are a few things we can say:
- If earnings increase by their historic average of 4% per year (a reasonable if somewhat optimistic assumption) then average worker earnings will grow to £42,000 by 2028.
- If the house price-to-earnings ratio reverts to its average value of five, then house prices will fall to £214,000 by 2028.
If that happens then we will have the mid-2000s credit boom to thank for two decades of almost zero price growth in the housing market.
Just as we have the late-90s tech boom to thank for two decades of almost zero price growth in the stock market.
On the plus side, at least ordinary people will be able to afford ordinary houses once again.
Hi again John, good work on the article. Just a slight typo I believe it should read £300,000. here: “Imagine that the average UK worker earns £30,000 and the average house costs £30,000.”
Hi Tom, not a typo I’m afraid! The point I was making is that if average wages are £30k and average house prices were £30k then it would be super-easy to own more than one house because they’re so cheap.
That would push up demand which would push up prices, so if we ever do see a housing PE of 1 it probably wouldn’t stay that way for long.
Hi, I like your posts generally, but not convinced by this one.
Some counter points would be :
– interest rates are likely to stay low IMHO. Any near term rises will be undone when the next recession comes along (I agree help to buy is mad – no surprise the Tories helped their own supporters instead of doing something sensible.)
– Historically mortgages were hard to get, and mortgages to let properties even harder, this is a one time change making properties easier to buy now.
– I believe fair HPE ratios change with interest rates, another one time change, we are simply in a new world compared to before 2000.
– I suspect earnings have risen faster for property owners than the population as a whole making whole population HPE ratios less relevant. In fact perhaps earnings in general are not very relevant for people who live off assets rather than earnings.
Overall I think we have gone from a time when property was cheap to it being more like fair value or only slightly expensive. If yields are similar to the stock market but property is better understood by the general population and also available with leverage then perhaps it is still cheap?!
I’ve always struggled to find data on rental yield, but if available somewhere a chart against stock market yield and interest rates would be interesting.
Hi Mark, no problem, counter-points are always welcome.
All your points are entirely reasonable, so I’ll just reply to a couple of them:
1) Interest rate rises – I’m a mean-reversionist so my basic assumption is that most things do return to long-term averages. In the world of economics it’s impossible to know for sure, but I am sure that most people in the inflationary 1970s thought we’d ever see interest rates effectively at zero. In other words, I wouldn’t be surprised if interest rates were 10% ten years from now.
2) Relevance of non-homeowner earnings – Non-homeowners pay rent, so if all property in the UK was owned by one person their rent would come from non-homeowners, i.e. the whole population. So the income on the property investment would depend on non-homeowner earnings, and therefore so would property prices (unless the landlord didn’t care about yield, which in a world of “efficient markets” would be an odd position to take).
Thanks again for the counter-points, the last thing I want around here is some kind of intellectual totalitarianism!
Another way to value house prices is by inverting the rental yield to give the PE ratio. A rational investor will presumably invest in a higher yielding or lower PE asset if one is available. My research indicated the FTSE average PE is about 18 . Compare that with the average net rental in my area, after expenses but before tax and comparing with house prices and I get 21, which puts the housing market slightly overvalued vs equities. Realise this is a bit of a back of an envelope calculation.
Hi Andrew, it’s an entirely valid approach. The only reason I don’t use that method is I don’t have the data (although I’m sure I could find it somewhere) and I’m used to using the house price to worker earnings ratio.
But you’re right, the basic principle of net income yield applies to housing and companies alike.
John, I basically agree ………and have thus been waiting to buy a bigger house for 10 years !! Hey ho!
However, two major shift that needs accounting for are:
i) the increased prevalence of 2 income households enabling larger mortgages to be sustained
ii) the size and quality of housing – whilst I believe new houses are getting smaller, many houses in the housing stock have had extensions and despite the headlines, I would believe the quality of housing has gone up as eg outside toilets have almost vanished.
Of course regional variations also make a big difference with the average being driven up by the London effect (which may finally be unwinding).
However, too much analysis can hide the big truth: houses remain too expensive and we should expect supply (govt action to subsidise/enable new builds; conversion of retail/offices to residential) and demand (move to renting) cause lower relative prices to emerge – probably via a mix of some steep declines (vs rapid interest rises) and slow erosion (real price drops via static prices in inflationary periods). Trouble is: will this happen in 3 or 10 years!
Hi Peter, I feel your pain! I sold my house in 2004 and put the equity into equities and have been waiting to buy back in ever since! I’m not too sad about it though as I have lived in some fantastic houses that I could never have afforded to buy.
There have certainly been a lot of demand pressures over the last couple of decades. Increasing population (apparently just over 65mn now!), increasing one person households, increasing two-wage households, etc.
However, as more and more of the population are priced out, and as they get older and more politically active (i.e. start voting) I think housing supply might actually become a serious political issue rather than just another can to be kicked down the road. This may already be happening. This is anecdotal, but where I live they’re building houses everywhere and about to start work on a Garden Town of about 10k houses.
As for timing, one thing I’ve learned about the housing market is that it moves much more slowly than the stock market. That can be either good or bad, depending on your point of view!
Hi John,
Great article, made me think which is always good. A couple of points:
Someone once told me that a home is not an investment and thus don’t treat it as such. I was thinking of selling up in 2004 but was talked out of it, glad I was as it is a massive gamble with a basic need in life.
I am a market timer and a cycles fanatic. Whether people believe in that is up to them. The property market topped in 2007, was weak until 2011 and we are now in the mid cycle dip. The next top is 2024 and then we’ll get the next crash through to 2028 (a similar, yet different 17.6 year cycle). That’s when you may see your PE washout IMHO, which aligns with your thinking. I am planning to sell my buy to let in the lead up to 2024 to reinvest in equities, which by my cycles will top in 2034. The blow off equities top will be partly driven by people preferring equities over property, which we haven’t seen since the 1990s.
I’m positioned for a post Brexit boom, where interest rates lag inflation. The BoE will be late but will eventually kill the party. The low interest rate environment has skewed metrics like price to earnings because what we need to compare is mortgage costs to earnings, which are very low.
Regards,
Kerry
Hi Kerry, I do think cycles are important, although the cycles I’m thinking of are less rigid than yours. What I do like is your long-term perspective and planning to switch from housing to equities in 2024 certainly fits that description!
If I’m around in 2034 it will be interesting to see if your prediction comes true (or even vaguely accurate would be impressive). I can easily imagine a world that hates housing but loves stocks and shares because that’s kind of what we had in the 90s. The more things change…
John
Great post.. in-line with the book House Prices, Banking and the Depression of 2010. This describes the 18-year cycle – 1992 crash, 2010 next except the authorities cheated with . So, 2008 – almost.
True the BoE will be late on the inflation curve like the late 70s (fearing another recession causing inaction) and late 90s (causing a housing bubble) but the world central bank is the Fed. And they are hawkish with the corp tax reduction there, inflation risk and de-dollarisation of commodities. The Fed will cause a slowdown here too.
Hi John,
Really interesting article and comments as well – always enjoy reading your posts and the different views that come up.
Following on from Peter’s comment about two income families, another possible factor holding up prices worth mentioning is the ‘bank of mum & dad’, a top 10 UK lender.
Baby Boomers who have bought at the bottom are leveraging their equity to help get their children ‘on the ladder’.
As ‘helping out the kids’ is becoming more and more the established norm, could this have a permanent increase relative to average earnings for first-time buyers? Or would you see this as a tailwind likely to drop off when housing becomes more affordable again?
That’s an interesting point Ben. I can see this in my own family where my parents were lucky enough to buy in the early 80’s and again in the early 90’s (both cheap periods) whereas their grandchildren who are now old enough to think about buying have no chance whatsoever unless some of that equity is passed down.
I don’t think BOMAD is likely to be a permanent effect though. It all comes back to whether house prices can continually outpace earnings growth and I don’t think they can.
Even at elevated levels, house prices will eventually stall relative to earnings, and at elevated levels their net rental yields will be low and unattractive (especially if/when rates normalise). So you have an asset which has a low income yield and low capital growth, and that is just not attractive to investors. Gradually it may become more widely accepted that housing is not a good investment and so people won’t buy multiple homes (and stop gobbling up supply). And when investors leave, prices fall, which would make housing look like an even less attractive investment. And that would continue until the cycle turned.
Obviously it’s not as simple as that, but that’s the basic picture. One key point though is that in the housing market this can all take a very, very long time to work out.
Hi John,
I like the article and think you make some good points; but I think there are some key points missing from the above, most importantly the regional differences for property prices.
For example in the article (see https://www.economicshelp.org/blog/5568/housing/uk-house-price-affordability/) property prices in the north of the U.K. are at slightly above 3x earnings which is roughly the same as in 1990. This seems pretty affordable and certainly not in “bubble territory”.
On the other hand in London this is at around 10x which pushes up the U.K. average. The key point about London (especially more prime London) is that the majority of buyers are actually investors (mainly overseas) so the key metric here should be rental yields which do look very low. I agree that London is overvalued and will grow at a slower rate (or go sideways) than the rest of the U.K. in the coming years and will as you say “mean revert”. But the other regions of the U.K. excluding London and the south east seem to be at their mean price to earnings (or slightly above).
The other major impact is with regards to supply and demand. There’s basically been a decade of underactivity since the financial crisis as supply has failed to keep up with demand. The government release planned build figures on what levels would be required to meet population growth etc. We’ve consistently been under these levels and we still are.
I personally believe there’s a long way to go in the current housing cycle and the major gains (excluding London and the south east) are still to come. If you look at property cycles like some business cycles there is the idea of an “18 year property” cycle which if we follow history will likely end in 2025-26.
Given that interest rates aren’t going to be hiked over night and the impact from any rate rises takes its time to feed through to mortgage rates (banks are making a decent spread in comparison to peak interest rates) I can see prices continuing to increase in the rest of the U.K. specifically since in most areas monthly mortgage repayments is cheaper than renting.
Personally I’m bullish on property prices in the U.K. (excluding London and the south east) over the next 7-8 years and think the best is yet to come in terms of price rises particularly for key northern cities such as Manchester, Birmingham, Leeds etc.
Here’s an interesting article on the 18 year property cycle;
https://www.propertygeek.net/article/the-18-year-property-cycle/
Hi Luke, yes I completely agree that regional variations are important, but alas I don’t want every blog post to be 6,000 words long (!) so I have to limit the subject area. In this case I was just looking at the whole market in the same way that I’d look at the FTSE 100 or FTSE 250. In fact, the same argument about “regional variance” applies to the stock market, where many stocks were cheap even in the dot-com bubble, and I’m sure a handful were still expensive in the 2009 crash.
The best summary of regional variation I’ve seen is on the Retirement Investing Today blog, although for the life of me I couldn’t find it just now. Hopefully RIT is reading and he can point us towards his regional variance chart (also with red/amber/green colouring).
As for your bullishness, you could be right. There’s obviously a lot of uncertainty about the future and if people didn’t have different opinions then we wouldn’t have much of a market! In fact, just to make it interesting I’ll bet you £1 that house prices are down over the next decade…
I like the comparison John but interesting to note that investors such as Buffett managed to make excellent returns after the bubble burst by sticking to the undervalued areas of the market. I would relate this to the North in terms of value.
In terms of your bet I would happily make that bet on U.K. property prices (excluding London – although I do believe that London prices will be up in 10 years compared to today).
The other thing to note is the fantastic effects of inflation and leverage for property investors. I.e. if an investor has a £100k property with a £75k interest only mortgage and inflation runs at 2.58% (the average over the last 20sh years) even if real house prices show no growth that property will be worth £129k in 10 years showing a return on equity of 116% (excluding the effects of inflation). I.e. the house price has gone up but the mortgage amount remains the same.
Ultimately I think it’ll prove to be time in the market rather than timing the market that will result in the long term wealth creation from owning property (much like the stock market) and over a 30 year period whatever the starting position the gains will be very satisfactory (especially as the supply/demand issue worsens).
“The other thing to note is the fantastic effects of inflation and leverage for property investors”
Yes, leverage can produce big gains, but it also produces big risks.
If your BTL investor with an interest-only mortgage suddenly found themselves in a world of 10% interest rates, perhaps their interest payments wouldn’t be sustainable, i.e. not covered by their tennant’s income. And if interest rates were 10% then the property would probably fall in value, so they end up locked into a bankruptcy-inducing debt spiral where they can’t afford the interest payments and they can’t sell the property without losing their all deposit and more.
(sorry if this sounds like a tit-for-tat argument; it isn’t mean to be. I’m just playing devil’s advocate).
I think one more factor needs to be take into account here. We live in deflationary times and as a result interest rates are likely (in my opinion) to stay low for decades to come. In the past when economic growth was strong workers demanded good pay increases and as a result inflation took off. Interest rates were increased to cool off the economy and then cut when the inevitable recession appeared. That was the 1970s/80s and even 90s cycle that influences our thinking today.
But now we have AI on the horizon and millions of jobs are going to be automated away in the coming years. Driverless vehicles and checkout-less shops are just the beginning – wages in general will be under pressure as machines will work harder and smarter than humans and for no wages! So deflation will be the theme for decades to come and interest rates are likely to stay very low as a result.
As for the effect on house prices – well, lower wages are not supportive of higher house prices but “lower for longer” interest rates certainly are. So my guess is that prices drift sideways and some regions do better than others as has been pointed out in various replies.
Love the post and the discussion – cheers!
Nice post, John!
Thanks for writing this post and I appreciate the rainbow chart on home prices.
My main with average earnings is the advancement of technology and machinery. I think Elon Musk or Bill Gates said that 70% of all existing jobs will be lost to technology in the next ten to 15 years. Plus, given that education are too focused on social studies, not innovative science the new industries are hard to come by, unlike during the industrial revolution. I feel earnings will be subdued or the government will fund universal income which will lead to higher national debt.
Thanks for the post.
Hey Walter, good to hear from you again. As you point out, we do live in interesting times, and very unpredictable ones too. But to be honest I think that has always been the case.
John:
Excellent article, I tend to agree with your premise, yet the data charts do not appear to support this. If price/earnings ratio is mean reverting, and that means ” tends to return to its historic average every few years” as you state, where do you see evidence of that in your PE chart? In the 35 year span shown, there has been only a single extended downturn in prices (in the early 90s). Other than a blip in 2009, prices have been up and away since then. The chart may fuel your (my) fear that trees do not grow to the sky, but I don’t see the evidence of mean reversion in the data. That would require periods of time where the ratio overshot and undershot your (somewhat arbitrary) bands of normality, and that has just not happened in your data range with anywhere near the predictability as would be needed to call the ratio mean reverting.
Best,
JH
You’re right Jim, the data back to 1983 is a bit limited. After a brief hunt around the web I found a few reasonably self-reinforcing references to older data.
I’ll start with the headline results:
According to the Sun (whose data seems to match up with other sources):
https://www.sunlife.co.uk/blogs-and-features/the-price-of-a-home-in-britain—then-and-now
In the 1950s, the average house price (across the whole decade) was £2000, average earnings were £500/yr giving a ratio of 4.
In the 1960’s the averages were £2500 and £1000, giving a ratio of 2.5.
In the 1970’s house prices went from £5000 to £20,000 thanks to high inflation. Earnings went from £1500 to £6000, giving a ratio of 3.3 in both cases.
The 1980s is where the ONS data I used starts, and there the ratio starts at around 4.
Between 1950 and 1980 the ratio was somewhere between 2.5 and 4, rather than the 8 we have today. So I think it’s reasonable to say that 8 is an outlier and something closer to 5 is probably more appropriate.
As for data sources, Nationwide has an excellent set of data on house prices going back to 1952:
https://www.nationwide.co.uk/about/house-price-index/download-data
https://www.nationwide.co.uk/-/media/MainSite/documents/about/house-price-index/downloads/uk-house-price-since-1952.xls
You can see a chart of that data here:
https://www.allagents.co.uk/house-prices-from-1952/
And here’s a fun website showing prices of various things at various points in time:
https://www.hillarys.co.uk/back-in-my-day/
I think the longer-term evidence suggest that price/earnings is mean reverting, and that the mean is far below 8. And I would call my valuation bands an approximation rather than arbitrary!
Having said all that, you’re basic point is correct. The data to 1983 do not really support my argument, so thank you for pointing that out and prompting me to look for older data.
John:
Thanks for the additional data. However, it feels like we are trying too hard to strike a direct mathematical relationship between homeowner earnings and house prices, while leaving out the key variable of interest rates. I suspect the “average” buyer is more concerned about his/her monthly mortgage payment than the absolute price of the house. When home shopping, the spouse doesn’t say to the other “We can’t afford another 20K on the house price.” The spouse says “we cannot afford another $150 per month.” It’s no surprise that the bull market in housing prices is more or less coincident with the great bull market in bonds (bear market in rates) over the past 30+ years. Put another way, I suspect that the house prices in your ratio have been greatly distorted by easy/cheap credit. During this run up in prices, homebuyers have been able to buy more expensive homes (captured in your ratio) for less in payments (not captured in the ratio). As a master real estate investor once told me, “I will pay you whatever you ask for your property as long as I get to pick the terms” [i.e. the payments]. If interest rates return to the level that prevailed before the great bond bull market, property values will surely crater, but I would not label that phenomenon mean reversion.
And, of course, the lowering rates that drive home price increases create a positive feedback loop that encourages homebuyers to speculate in real estate and stretch to devote a larger portion of their incomes to mortgage payments. We had a great party in that regard here in the US that ended badly.
It would be interesting to see a chart of the percentage of income devoted to mortgage payments in the UK over a long time horizon. I would expect that to show stronger mean reversion tendencies than income to house price.
As far as predicting when rates will rise significantly, it would be valuable to look at the stakeholders in that decision process. I believe your UK debt is about 87% of GDP, and servicing it (at an average rate of 2.7%) consumes about 8% of your tax revenue. The situation here in the USA is roughly comparable. If the rate on your debt doubled to an average of 5.4% (a modest rate by historical standards), the fiscal consequences would be severe. Surely the BOE and others will do whatever they can to forestall that day (although in the end the bond vigilantes would prevail).
Basically a long-winded way of stating that UK house prices will likely remain flat to slightly down unless (i) rates go significantly lower (unlikely), or (ii) households are willing to use an even greater percentage of their income for the mortgage payment in order to double down in the casino (also unlikely as I would guess the share of income devoted to house payments is already on the higher side). And look out below if/when rates spike.
Jim H
Thanks for the excellent comments Jim. I think we’re on exactly the same page except this bit:
“If interest rates return to the level that prevailed before the great bond bull market, property values will surely crater, but I would not label that phenomenon mean reversion.”
I would call that mean reversion because I think interest rates are also mean reverting. If you look at Shiller’s data for the US over the last 130 years, interest rates have ranged between about 2% and 16%, spending almost all that time in a smaller range between 2% and 5%.
All of this mean reversion comes down to the simple fact that we live for something like 50 to 100 years, so we want a certain return on our investments that ties in with that lifespan. If we lived for 1000 years no doubt we’d be happier with lower returns, lower interest rates, lower yields on property investments, etc. But we don’t. We live for up to about 100 years so we want about 10% per year return on investment, and that sets the discount rate, bond yields and all manner of other things.
Back to property, I agree with your likely flat-to-slightly down prognosis.
Agree with pretty everything you said but my interpretation is different. So according to your graph, we have been PE of over 6 since at least 2002/2003. That’s at least 15 years of very high prices. I personally think they will be kept at high prices for as long as possible and until at least the next government. Factors include:
Likely to keep interest rates low. Esp with Brexit, I can’t see BOE hiking rates massively or quickly. I think more likely ’emergency situations’ arise and rates are kept artificially low almost indefinitely or rise much slower than everywhere else. Don’t rule out more QE if bad Brexit scenarios arise.
No government want a house price crash. So they will do whatever they can possibly do to keep them inflated artificially high. Having affordable house prices is great, for those who buy, it’s terrible for the general economy though because everyone with wealth in housing feels less well off and stops spending, leading to a vicious recession. Low house prices is great if you are buying, go back to 2008, no one was saying it was great in the US with all the repossessions, defaults and 40% drop in house prices. In fact, they might go low, but peoples ability to buy them might also be low due to the recessions that will accompany a similar drop.
My best guess would be that the can is kicked down the road, with house price growth but lower than wager/inflation growth.
Hi Andrew, all good points and I have no special insights into any of them, other than to say that in the end mean-reversion tends to win out.
Or perhaps I should heed the immortal words of Dr Manhattan:
Adrian Veidt: …It all worked out in the end.
Dr. Manhattan: ‘In the end’? Nothing ends, Adrian. Nothing ever ends.
Slightly off topic but something I can never get my head round is the fact that when comparing houses as an investment with the stock market it’s always very biased. The HPI doesn’t take into account the fact that people spend money on improving the housing stock sometimes hugely. It also only measures houses that are sold Not what the stock of housing is worth. Maybe only expensive houses actually get sold. It also doesn’t take into account stamp duty and all other costs of selling. Neither does it include any of the costs of home ownership like insurance and repairs.
Take all of these into consideration and HPI doesn’t stack up nearly so well. I say this because so many times people seem to forget they spent £100k extending their house when bragging about how wise their investment has been.
To be honest, while I think stocks and property are theoretically comparable and I enjoy making comparisons, I don’t think they’re comparable in the real world. They’re just too different.
For example, most people are super-concentrated in housing, with almost all property owners having less than three properties. And then of course they’re typically leveraged up to the eyeballs, which most people would never do with stocks (how many people borrow £100k or more and put it all in stocks?!? Not many I think).
But you’re right nonetheless; property investing is typically much more expensive in terms of time effort and money compared to stocks, but it’s hard to reflect those sort of soft costs in an index.
As a footnote, I guess property crowdfunding is narrowing the gap somewhat by lowering barriers to entry and increasing liquidity, but I’m not sure we need a property market which behaves more like a stock market.
Housing is definitely going to become an intense political issue in the near future.
I can already see that Housing is a super hot topic merely by the amount of people commenting on this post compared to how many usually comment.
In my area of east London im seeing huge amounts of new apartment complexes being built everywhere, when 2 bed flats are going for 400k everyone who owns even a sq ft of land wants to cash in on it by building flats there.
Who is going to live in all these flats they are building ( i.e. how many can afford 400k a pop )? What jobs are they all going to have in order fund that 400k purchase? Are there that many high paid jobs going around?
And what if the people living in all these new flats want cars… where are they going to park? London roads are already horribly overcrowded.
“Who is going to live in all these flats they are building ( i.e. how many can afford 400k a pop )?”
If they build too many then they won’t be £400k. It’s the law of supply and demand, although “too many” many be an awful lot if foreign investors think the London market can only go up (which it does, until it doesn’t).
It reminds me of the great Commodity Supercycle, where Chinese growth was supposed to keep supply tight and commodity prices high for 30 years. Prices were high for a decade, but that sucked in massive of capital which was put to work building oil rigs, mines of all sorts, steel production etc. Eventually supply exceed demand, prices collapsed and the expected riches these oil rigs were supposed to produce turned into big fat losses.
Things move much slower in the property market, but the same forces are in play and I think the outcome could be the same, eventually.
It is a curious fact that, only in the last couple of entries above, has the concept of Supply and Demand been alluded to as a relevant issue.
The truth is that Supply has been artificially constrained for a long while through the mechanism of the rules concerning Planning Permissions while Demand has been increased (primarily) through the mechanism of immigration.
The Planning Permission rules are fundamentally ill-based in as much as there is no fundamental shortage of land; the rules have been implemented with the direct purpose of constraining Supply in order that those who currently own property shall benefit financially. This is beautifully encapsulated by the acronym NIMBYism.
Immigration to our land is, in the absence of our choice to adequately procreate, a highly desirable process if we are to maintain the way of life to which we have become accustomed.
As noted above, Planning Permission rules are being loosened, leading, at last, to an increase in Supply.
Meanwhile, Brexit is leading to a reduction in immigration.
Thus, the current trend is for Supply to increase at the same time as Demand decreases.
This should lead to the price (under any static exogenous economic conditions) decreasing. Which agrees with the trends enumerated above based upon anticipated changes in those exogenous economic conditions.
Perhaps a crash will occur? Although, I agree that any Government representing primarily the NIMBYs will take extraordinary measures to prevent such a thing. On the other hand, any Government representing primarily those who are presently disbarred from the economic benefits of home ownership might well be positively in favour of a reduction in prices; I would say that this type of Government holds the moral high ground and might be voted in partly due to this moral stance.
I bought my present property in 1976 for ~£13k; if I apply inflation from then to now it should have a price of ~£112k but I am told that it is ~£400k. Its insurance re-build value is also ~£125k.
I see the difference between £112k and ~£400k as fundamentally unjustifiable; in my mind I am accommodating the possibility that its price could well revert to £112k.
Hi Oldy, I pretty much agree with everything you said. My only difference is on the point of immigration, or population to be more specific.
[Warning: This is pretty off-topic!]
In the long-run population must reach some maximum level as it cannot increase indefinitely. Therefore it seems reasonable to think about how we can have a thriving economy without the need for ever more young people to drive it forwards. And it seems reasonable to think about how we can reach that maximum population point when that population is sustainable over the long-term, rather than reaching an unsustainable maximum and then having to live through a probably unpleasant period of adjustment, as the population falls back to sustainable levels.
So I’m not anti-immigration per se, but I am against the idea of never ending population growth. Either we decide when the UK population stops growing, or nature decides for us.
A few thoughts.
For a view of UK property prices over the longer term, “Safe as Houses?” (Neil Monnery) is worth a view; if nothing else, he lays his methodology for calculating the real rate of growth open to criticism.
Caution needs to be exercised applying “reversion to the mean” (based on naturalistic data, e.g. human height, weight, IQ) to a social phenomenon (house prices). See Taleb Nassim for full critique. Having said as much, intuitively every extra pound out of the average pocket spent on mortgage is one less pound available to ‘spend’ on supporting UK PLC, which ultimately pays most of our wages, so it would seem reasonable to assume that there is some relationship between house prices and average wage growth.
Mention has been made about monetary policy, i.e. interest rate. Financial bodies have been attempting to manipulate the money supply for almost as long as money has been around. So far, no-one has managed to create money “out of nowhere” indefinitely without some form of crisis; on the contrary, attempting to delay the inevitability of outside market forces make the impact of the ultimate day of reckoning even worse (again, see Nassim for the dangers of ‘tinkering’).
I will make one prophecy on the future – it will turn out nothing like any of us predict (except in those few cases attributable to sheer luck).
Hi Polar Bear, I think your point about mortgage/rent cost as a percentage of wages is a good one.
People can only spend less than 100% of their monthly income paying for their house, so there’s an upper limit. If house prices are to outrun wage growth indefinitely then landlords must expect ever thinner yields. That looks a lot like the Greater Fool theory, where you expect to sell to some fool who will pay an even higher price than you did. But eventually the world runs out of fools, somebody has to sell for a fair price and the whole sham collapses.
Also, thanks for mentioning “Safe as Houses?” I haven’t read it but it looks like an interesting book.
John – Off topic, just started buying Ted Baker – be interesting to see an article from you on this – especially as it fits nicely with some of the coverage you have given for Next.
LR
Hi LR, Okay. Give me another nudge if I don’t do a Ted Baker write-up by the end of the month.
I do not think that mean reversion applies at all for house prices. What mean reversion suggests that there is some sort of information from the past which could be used to determine the house prices in the future. Like the drunckman who left a pub to go home is more likely to end up in another pub on the way home.
Future housing prices depends on the land price, the number of thd houses being build (offer and demand), interest rates and access to lending.
The problem we have is a high demand and the supply is only half of the demand. The problem with supply is a complicated planning permission process, and not having enough qualified builders. Just try to find a bricklayer for an extension in your area and you will find he is booked 2 years in advance.
There are certain ways the Goverment could influence the demand part of the equation, by stopping Overseas investors to buy UK properties as a way to store wealth. Far East investors do not even try to rent these properties, they believe that if kept empty the property is still new and has a “higher value”.
Because of its illiquidity feature, residential property has some sort of demand elasticity which helps their pricing. In the end if property prices fall a little, many people do not have to sell them.
I try not to make big assumptions on property prices. I think thet will carry on to keep up with inflation as they are part of the inflation index. With a yield anywhere from 2% to 6% depending of the part of the country, they will carry on to give a real investment return over a long investment period – 20 years. I do not think there is a risk of overbuilding too many properties at this moment, something similar with Spain in 2007.
My opinions only!
Hi Eugen, I agree with a lot of that but I can also imagine a government getting into power on a mandate of lowering house prices for ordinary people and creating jobs for ordinary people by starting a massive house building scheme (and I mean proper houses, not “affordable” houses).
Eventually that might lead to price declines, and then the “flighty capital” of foreign investors would leave just as quickly as they arrived, desperate to get out before prices collapse (and therefore speeding up the price collapse).
Obviously that’s just one possible scenario, but it’s still a possibility. And as a mean reversionist, I think it’s more likely than a scenario where house price growth outpaces earnings growth for the rest of eternity!
The problem for that Government is that it will not find enough builders to do the construction work.
It will also need funds to build those houses and it is unlikely to find them.
Foreign investors could get scared, but not that easy! They are after storing wealth, not after yield, so as long there is no try to nationalisation, they would still find the UK legal system very good.
There are not many opportunities either for flying capital, look at Auckland, Sidney, and Vancouver property prices!
A very interesting article, I think a lot of what you wrote applies just as well to the property market over here in Australia. Our 2 biggest markets, Sydney and Melbourne (nearly half the country’s population combined) have hit ridiculous house-to-income ratios. Sydney’s houses are somewhere in the stratosphere at 12-15 times avg. income, apartments around 10 fold income and Melbourne’s ratios not far behind.
House prices were for a while the number 1 political issue and are still extremely controversial. The main reasons for it are record low interest rates, just like in the UK and also like the UK ‘crazy government schemes’ – negative gearing and capital gains tax concessions introduced in 1999 which mostly target older, asset rich baby boomers. These concessions have been put on turbo-mode in the low interest rate environment.
House prices have now started to fall in Sydney and Melbourne, as the regulator’s finally clamped down a bit on the banks’ crazy levels of lending to ‘investors’ (who mainly use the above-mentioned tax schemes).
What’s happening here could be the near future for the UK, especially if your government withdraws their house-price propping-up schemes, or interest rates go up.
Just to clarify, negative gearing and capital gains tax concessions existed in Australia before 1999, but they were tweaked in that year to make them much more attractive for property investment/speculation
Hi Tim, sadly it seems like most governments love a good property boom (i.e. bubble). It helps them get re-elected, and with a bit of luck the bubble won’t burst until after they’ve left office.
You can say what you like about property prices but one thing to consider is that it is a massive allocation of a country’s wealth.
With an average house price of £200k – that would mean that a town of 10,000 houses if “worth” £2,000 million pounds of just houses. That’s money that could be put to use in different ways.
If we invested in our infratsctructure as much as we do in our property, we might have better roads, parks, hospitals and broadband.
I couldn’t agree more. Not sure about infrastructure specifically, but the excessive amount of money that goes into buying and renting property would be much better spent in far more productive areas of the economy.
Great article John , thanks for sharing this.
This was a really interesting read as this is something I have invested interest in.
Hi John.
So what would you advise? Is it best to rent or buy? As a 1970 baby I can just about get on the ladder and have budgeted for a 7% interest hike in 2024. From your article though house prices will decline and so I worry in 5 to 10 years I could lose a lot of equity in the house if I had to sell it.
However as a current renter, rentals will go up too. So would buying now be a better decision as at least I would have a home rather than renting in retirement in a less dedireable area I may be forced to live in due to it having a lower rent?
Hi Pedro,
Unfortunately it’s not as simple as that. The UK market is overvalued, largely thanks to crazy prices in the South East, but that tells us nothing about how or when the market will return to sensible valuations (although I think it will, eventually).
For example, in some areas far from the South East, prices are already reasonable, so it depends on location.
But even in the South East, prices could crash over the next five years, or they could stay flat for 20 years, or they could keep going up to even crazier levels if the government continues to roll out schemes to prop up the market (e.g. Help to Buy) or fails to build the houses the UK desperately needs.
So in that regard the housing market is very much like the stock market. It’s easy to see when the market is expensive or cheap, but it’s impossible to know what that means for future prices, other than that they’ll probably return to normal levels at some point in the next 10-20 years or so.
But over 5 to 10 years house prices could easy fall by 50%, or they might double again (which seems a tad unlikely).
As for renting in retirement, I wouldn’t want to but it depends on personal circumstance (as always).
If property prices don’t correct themselves in the next 20 years then there will be a vast wave of retirees who privately rent, which the taxpayer will have to partially (significantly?) fund:
Pensions aren’t the ticking timebomb: Rents are
“Dan Wilson Craw of campaign group Generation Rent says: “The common perception is that retirees either own their home outright or have a council tenancy, so the government will be in for a nasty shock as more of us retire and continue to rent from a private landlord. Many renters relying on pensions will qualify for housing benefit which will put greater strain on the public finances.””
So unfortunately there are no simple answers when property prices are sky high. If you buy you risk negative equity for years, and if you don’t buy you risk never getting on the ladder. It’s a big mess basically.
Personally I chose to sell my house in 2005 and put the proceeds into the stock market. I’ve been renting and investing ever since, and although I’d now like to buy again (I’m approaching 50), I’m loathed to pay current prices.
Hi John,
I have been looking out for your 2019 house price and FTSE 100 outlook but presumably most of the fundamentals havn’t changed in a year and so the forecasts still stand?
Hi Owen,
Yes, it’s pretty much the same. I will do a housing ‘forecast’ sometime soon though. It’s fun even if nothing has really changed.