How much are houses really worth?

If you want to know the value of something there is, in theory, a simple way to find out. Put it up for sale, advertise it as widely as you can and see what offers you get. If you do this with a television set or an ordinary piece of furniture you can be sure the offers will give a pretty fair reflection of the item's true value because there are no distorting factors to encourage anyone to offer more. Of course it is somewhat artificial to talk of any piece of property having a single true value because you can never expose it to sale to everyone who might want to bid or who might find some flaw in it that others have missed. Nonetheless, giving it fair exposure to a reasonable range of potential buyers will give you a very good idea of what it is worth in the real world.

An interesting twist of the recent credit boom is that it did not fuel price inflation in any field other than housing. In part this was due to increased consumer credit in the UK coinciding with increased availability of the very types of goods people wanted to buy on credit - flat screen tellies, computers, clever music machines and other electronic gadgetry. No scarcity of supply meant there was always another seller who would undercut anyone charging over the odds. Another popular purchase made with borrowed money was foreign holidays. The holiday companies knew an increase of demand was most profitably met by making more available rather than keeping supply static and trying to charge extra. In each of these fields low prices and readily available credit were only part of the story, keeping up with the Joneses also had an effect. Wayne had a flat screen telly, so Darren wanted one, Darren's mate Ryan couldn't be left behind, and so it went on. When it was only a few pounds extra a month on a credit card it seemed easily affordable.

In relation to housing, supply and demand operate rather differently. Obviously you can't turn on a tap in China and create loads of new houses and flats, equally obviously the decision to buy a house or flat involves many factors not relevant when deciding whether to upgrade your fridge. Once prices start spiralling upwards the whole thing becomes a self-fulfilling prophesy. You feel you must buy now because this time next year you won't be able to afford to, equally you see a potential profit over that same period and if you don't make that profit someone else will. Spending £5,000 of your £25,000 salary on interest seems less painful if you think you'll make a capital gain of a greater sum than you spend. We all know now that lending people four or five times their gross salary does nobody any favours in the medium to long term. Some of us have known it for many years because we saw the effect when it was done in the mid to late 1980s. Exactly the same happened then as now - lenders faced huge losses when borrowers defaulted and thousands lost their homes because they could not afford to keep paying such a huge proportion of their income in interest.

Every house and flat must have a true value, be it a precise figure or a bracket of a few thousand pounds. If that were not so there would be no talk of a house price bubble, but how can we know what the true value is and how much is artificial? It seems to me that the true value must reflect affordability. There are always ups and downs. Someone gets hit with a bit of bad luck and can't afford the mortgage any more. Banks take the occasional hit through a customer being unable to repay a debt. These are unfortunate incidents but are not signs of a troubled economy or of the country paying too much for houses. When the level of defaults increases to such a level that banks lose money hand-over-fist you know too much has been borrowed against too little security - the prices paid for houses and flats were not affordable and, therefore, those prices did not reflect true value.

One can analyse affordability in various ways, it seems to me there are essentially two elements to it. First, one has to ask what proportion of income can be spent on a mortgage loan without stretching the household budget so far that default is a widespread risk. Historically the banks restricted mortgage loans to two-and-a-half times the gross income of the main earner plus the gross income of any second borrower involved in the transaction and they required a minimum fifteen percent cash deposit. There is nothing very scientific about these figures, they just proved to be a good guide to what people could afford without stretching themselves too far. This just gives you a figure for how much people can afford to borrow, in other words it tells you what they can afford to spend. It does not tell you what they can buy with that money. The second stage is to look at what one might reasonably expect different people to be able to buy. There are starter homes - small flats and one-bedroomed houses in which one might normally expect to find young single people or young couples. From there you can look to modest two or three-bedroomed houses to which you might expect those young couples to move some years later when they earn more and need more space for children. Then there are larger properties with good sized gardens usually bought by those earning substantial incomes. However many categories of houses and flats you compile, the true value of each is what can be afforded by those buying that level of property for the first time.

For example, take a young couple earning £25,000 and £20,000 respectively. The amount they can afford to borrow is about £82,500 and they must put down at least fifteen percent of the price of their first property. That means they can afford a property costing about £97,000, call it £100,000. As a very general rule of thumb, in areas where those salaries are decent rates of pay for people of their age, £100,000 should be the true value of a modest starter flat. We don't have to go back further than about twelve years to find just that figure being the average price of reasonably sized nice one-bedroomed flats in the area of Islington in which I live. The same flats averaged over £250,000 in the Spring of 2007.

Then take a single doctor aged 30 who has just been made a partner in a GP practice and earns £50,000. He can borrow up to £125,000 which, with the required fifteen percent deposit, puts his purchase price at about £150,000. That is the benchmark for the type of property one would expect someone in his position to buy, perhaps a two-bedroomed flat in a decent road. I haven't designed these examples to relate to the environs of FatBigot Towers, it just so happens that £150,000 would have bought a very nice two-bedroomed flat in a quiet road this area as recently as about ten years ago. A good £350,000 would have been demanded in Spring 2007.

All sorts of other factors affect house prices. I am, however, sure that the strongest factor is the amount of money potential buyers have available to them. Something is only worth what someone is prepared to pay for it, and what anyone is prepared to pay is limited by the amount of money they have at their disposal. If, as I hope will be the case, banks and other mortgage lenders impose tried and trusted limits on the amount they are prepared to lend we should return to much lower house prices and, indeed, prices which reflect true value. They will be a long way below what they are today.