Tuesday, 14 October 2008

What's wrong with falling house prices?

One of my shallowest joys of the last few years has been the smug feeling that FatBigot Towers has increased in value by thousands of pounds every month. I bought FatBigot Towers in 1993 when the market in London was completely flat following a huge crash in 1989-1991, last year it was valued at more than three-and-a-half times what I paid fourteen years before. Had it followed the Consumer Price Index the increase would have been somewhere between 50% and 55%. The balance is made up of genuine house price inflation and hot air.

Genuine house inflation exists just as genuine inflation exists in the price of eggs and steak. As the population increases so demand for housing increases, supply does not necessarily increase at the same rate. Even without a shift of attitude in favour of buying rather than renting, an increase of demand over supply will force prices up. The bubble comes from adding unsustainable demand. Giving loans to people who cannot afford to repay them created the unsustainable demand that sent UK house prices to artificially high levels. If part of the demand is unsustainable, so is the price rise caused by that extra demand.

A frequent target of the slobbering left is the so-called "buy-to-let" market. This comprises people who buy houses or flats as a business venture rather than as a home. Tony and Cherie Blair did it in Bristol and many thousands did it all over the country. Being the Blairs, they could not resist the temptation to involve a crook in the process, but the underlying transaction was no different to what has happened for generations. There is and always has been a demand for rental property. Students, immigrant workers, young couples saving to buy their own property and many more categories of people want to rent a flat or house. That flat or house must, by definition, belong to someone else - their landlord - and the landlord must acquire it somehow. Where demand for rental properties is high it is a sensible business proposition to buy suitable houses or flats and rent them out for a profit. It is no different from any other business, you put in some capital, buy an asset and utilise it to make a return.

The problem with the buy-to-let market is that many have been tempted to buy properties in the hope of making capital gains rather than income. Even if the rent pays less than the repayments on the loan you took out to buy the property, if the property itself increases in value by £10,000 a year you are laughing. A profit from the rent plus a capital gain is even more attractive. At a time of apparently increasing house prices many were drawn into the market in the hunt for a quick capital gain thereby creating even greater demand for the limited stock of housing for sale and forcing prices higher still. The part of this market representing genuine long-term investment was genuine demand, the speculative part was false demand and added to the bubble.

No one really knows how much hot air the house price bubble contains. Some suggest average prices at their peak were double true value but most commentators I have read suggest a figure for the artificial increase in value of somewhere between 30% and 40%. This represents an awful lot of money, £60,000 or £80,000 of a property currently valued at £200,000, but it is not really a loss at all because the £60,000 or £80,000 was fictitious, it represented an artificial value above true value. For those of us who have no intention to sell and no debts secured on our properties there really is no loss, except to our level of self-satisfaction. Unfortunately the loss is real for many and a problem in waiting for others.

A statistic I find very interesting is that the average rate of house price increases in the UK over the last five years is roughly equivalent to the probable size of the bubble - they have increased 30-40% and the bubble is about the same proportion of current prices. Since the bubble itself formed over the last 12 years or so (starting in mid to the late 1990s once the economy was put on a sound footing after the ERM debacle), a part of house prices has been artificial for over a decade. Everyone who bought a house or flat during that period paid over the odds. This might seem to make the problem seem much larger than it is.

Say you bought a flat for £100,000 in 2000, its true value might have been somewhere between £99,000 and £98,000. General inflation since 2000 would make it worth something like £160,000 today so a nominal deficit on purchase has been lost in the mists of time, all the more so since genuine house price inflation has run ahead of general inflation. Say you bought the same flat for £120,000 in 2003 and the bubble element was £10,000, the asset you bought for £120,000 is still worth a minimum of £160,000 today. That it might have been valued at more than £240,000 last month does not mean you have lost £80,000; in fact you have lost nothing, whatever value someone gave it does not change the fact that its true value is around £160,000, a minimum capital gain of £40,000. Of course you have had to pay the mortgage and maintain the property, but you had to live somewhere and you haven't paid rent to anyone. And, most importantly, there is no loss or gain at all unless you sell.

It is probably true that no one who bought more than five years ago will suffer a substantial loss through the bubble bursting. Those who have bought since then will only suffer a real loss if they are forced to sell. One of the factors creating the bubble was the willingness of some banks, building societies and other lenders to make advances to people without the means to repay. Those people are the most likely to suffer a loss because the properties they own are the ones most likely to have to be sold, either voluntarily to cut their losses or following repossession. Despite the risk the lenders took many of these loans perform well, the borrowers want to keep their house and make sacrifices to pay the mortgage. Defaults are higher than historic averages but they are still just a minority.

There is, however, another class of losers - those who used their homes as security for additional borrowing. So bulbous has the credit bubble grown that second mortgages have been taken out at record levels over recent years. A second mortgage is simply a loan secured against a property which already has another loan secured against it. They were taken out for home improvements, cars, holidays and all sorts of treats, the loans were at higher rates of interest than the existing mortgage and seemed a good idea at the time. As recession hits many people in this position will find that the combination of the repayments of the mortgage and the repayments on the additional loan are unaffordable.

We must then add those who were relying on the value of their home to fund retirement. Their flat in London is worth £750,000, their ideal country cottage is £175,000, costs of sale and a few refurbishments of the retirement idyll leave them £500,000 in the bank in addition to their existing retirement funds; all is rosy. A sale price of £100,000 less than could have been achieved at the peak of the market will make a big difference, but it is not a loss it is simply a gain of £100,000 less than would have been achieved at the peak.

As house prices fall back towards their true level many will suffer a loss on paper. For some it will be a true loss as the value of their home falls below the value of loans secured on it, but for the vast majority the loss will simply remove an artificial profit which should never have existed in the first place. Even for those with "negative equity" in their houses and flats, that only turns into a loss if they have to sell. The looming recession will cause many people to suffer real losses as they lose their jobs and are forced to sell, but I would venture to suggest that the problem is nowhere near as great as some would suggest. For the vast majority the loss will be only on paper and will be wiped out by general inflation in years to come.


Alan said...

And then there are people like me that released that profit before the bubble popped and is now renting, with a nice deposit in the bank. So for some of us, this housing bubble went exactly as predicted and is very nice indeed.

Didn't sell because I wanted to release the profit, but because I had to move hundreds of miles for my job. But there as no way on earth I would have bought straight away....

What is wrong with falling house prices? For me, nothing!

TheFatBigot said...

I suspect many did likewise Mr Alan, more power to all your elbows.