Have house prices surged to an unsustainable level? - Capital Economics
UK Housing

Have house prices surged to an unsustainable level?

UK Housing Market Focus
Written by Andrew Wishart

The surge in house prices and very high transaction volumes have led to concerns that the housing market is entering a bubble. After all, the house-price-to-earnings ratio has risen to a fresh all-time high. But because interest rates have continued to fall, mortgage affordability remains good. In fact, given we expect Bank Rate to remain at 0.10% for longer than most, we think that there is scope for house prices to increase by around a further 17% over the next four years.

  • The surge in house prices and very high transaction volumes have led to concerns that the housing market is entering a bubble. After all, the house-price-to-earnings ratio has risen to a fresh all-time high. But because interest rates have continued to fall, mortgage affordability remains good. In fact, given we expect Bank Rate to remain at 0.10% for longer than most, we think that there is scope for house prices to increase by around a further 17% over the next four years.
  • The performance of the housing market over the past year has been nothing short of remarkable, as policymakers overcorrected for the impact of the pandemic. House price growth has surged to a six-year high while the number of transactions recorded in March was the highest in any month since comparable records began in 2005, and almost twice the usual pre-pandemic levels. That has led to concern among some commentators that house prices are entering bubble territory.
  • Indeed, the surge in house prices over the past nine months has pushed the house-price-to-earnings ratio up above the peak that it reached in 2007. The last time valuations were this lofty, house prices fell by over a fifth.
  • But revisiting our affordability metrics suggests that the current level of house prices is not a cause for concern. That’s because mortgage rates have dropped from about 6% to below 2% since 2007, so the same house-price-to-earnings multiples that were unaffordable then are now sustainable.
  • Lower mortgage rates allow households to comfortably service bigger mortgages, making higher house prices sustainable for as long as interest rates remain low. Moreover, mortgage rates have not yet responded to last year’s cut in bank rate from 0.75% to 0.10%, as banks initially exercised caution. So as the economic recovery progresses, we think that mortgage rates are likely to fall a bit further.
  • As a result, loan-to-income ratios on mortgages could rise a bit further too. Combining that with our forecast for earnings growth suggests that house prices could increase by around a further 17% by the end of 2024 without too much cause for concern.
  • But that really would mark the end of the support to house prices from the secular reduction in interest rates. Further ahead, a rise in interest rates will start to put downward pressure on LTI and HPE ratios, leading to more subdued house price growth. Financial markets are pricing in a first hike in bank rate in 2022. But we think it is more likely to be 2025 before they start to rise, we believe there is upside for house prices in the short to medium term, before interest rates start to bite.

Have house prices surged to an unsustainable level?

On some measures, house price valuations have returned to pre-financial crisis levels, after which prices fell by over a fifth. However, the decline in interest rates since 2007 has allowed households to comfortably service larger mortgages. As a result, even after the latest surge in prices, house prices don’t look over-valued and there are no signs yet of a bubble developing.

Valuations return to pre-financial crisis levels

The performance of the housing market over the past 12 months has been extraordinary. After a dip in the first lockdown, house price growth has since surged to a six-year high despite the largest collapse in economic output since 1921.

This strong performance in the face of economic adversity is largely due to the extraordinary policy response to the pandemic. The furlough scheme and mortgage repayment holidays prevented households falling into financial distress. And the stamp duty holiday more than corrected for any drop in confidence. So policymakers not only stopped house prices from falling, but have stimulated demand to such an extent that there are now concerns that prices are rising too quickly.

According to Nationwide, house prices were up by around 6% y/y in Q1 2021 driving the average house price up to £232,000 in March, up from £216,000 when the pandemic began in February 2020. That is well above the pre-financial crisis peak in cash terms. Although real house prices (i.e. adjusted for inflation) are still 6% below the 2007 peak in house prices. (See Chart 1.)

Chart 1: Average House Price

Sources: Refinitiv, Nationwide, Capital Economics

However, pay has risen by less than consumer prices since the onset of the financial crisis. While the Consumer Prices Index has risen by 33% since 2007, mean full-time earnings have increased by just 25%. As a result, in real terms mean full-time pay is now lower than before the financial crisis. But as income determines the ability to pay a mortgage, this provides a better benchmark for house price valuations than consumer prices.

Strangely, headline pay growth has accelerated during the pandemic according to the official figures. But that is because job losses have been concentrated among lower paid and part time employees in the hardest hit leisure and hospitality sectors. Including fewer of these low salaries in the average has caused weekly earnings growth to accelerate to 4.7% y/y. The ONS have published estimates of “underlying” pay growth that adjust for this statistical quirk, which suggest actual pay growth is more like 0.2% y/y.

Using this figure, we find that the ratio of house prices to earnings has risen from 5.9 in Q1 2020 to 6.3 in Q1 2021 reversing several years of decline pre-COVID. (See Chart 2.) That level is higher than at the start of the financial crisis, which itself marked an all-time historic high. At face value, that suggests that house prices could again be worryingly overvalued.

Chart 2: House Price to Earnings Ratio

Sources: Refinitiv, Nationwide, ONS, Capital Economics

What’s more, we suspect house prices will rise further in the near term. Note that even if house prices held steady over the next three months, annual house price inflation would rise from 5.7% in March to a peak of 7.7% in June, as the impact of the short-lived dip in prices at the start of the pandemic exaggerates the annual comparison. And Rightmove recorded a further 2% increase in asking prices in the month of April alone. So the RICS sales to stock ratio, a good measure of market tightness and near-term price growth, is likely to be correct in anticipating a further increase in house price inflation into double figures over the summer. (See Chart 3.)

Chart 3: Stock to Sales Ratio & House Prices

Sources: RICS, Nationwide, Capital Economics

Bubble territory?

With intense competition between buyers bidding up prices, high mortgage lending and transactions volumes, and the economic recovery from the virus not yet assured, is the current surge in house prices a bubble that will burst when stamp duty is reinstated? We have revisited our measures of house price valuations to check.

Previously, we have argued that high house price valuations relative to incomes are justified by low interest rates, which allow households to comfortably service a larger mortgage. Mortgage rates have fallen consistently since 1990. (See Chart 4.) And in the period since 2007, when house prices were last at a similarly high level relative to earnings, the average interest rate on new mortgages has dropped from 6% to 1.9%.

Chart 4: Interest Rates (%)

Sources: Refinitiv, Capital Economics

The upshot is that even after the latest surge in house prices, mortgages remain very affordable. The black line in Chart 5 shows the proportion of an individual’s disposable income someone on the median wage would have to put towards an 80% LTV 25-year mortgage on a house worth the national average each month. Since the 1970s, it has averaged 43% of disposable income, with clear spikes in 1989 and 2007, before the two major corrections in house prices in recent history. At present, the mortgage repayments would cost just 36% of median income. While the house price to earnings ratio is high by historical standards, the debt servicing burden is low. So for as long as interest rates are low, house prices will remain sustainable.

Good mortgage affordability was why we thought house prices would merely dip rather than collapse at the start of the pandemic. And now we anticipate that unemployment will rise much less than first expected, there is less reason to think that house prices will fall.

Chart 5: House Price to Earnings Ratio & Mortgage Affordability

Sources: Refinitiv, Nationwide, Capital Economics

What next for house prices?

In the long run, household incomes and mortgage affordability determine the fundamental value of houses. There is a long-run relationship between loan-to-income (LTI) ratios and house prices. Chart 6 shows that borrowers typically commit around 25% of their income to mortgage payments regardless of the level of interest rates. So, when mortgage rates are lower, borrowers take out larger loans relative to their incomes, which pushes up house prices. This relationship has only broken down twice since the 1980s, when lending conditions became especially lax. On both occasions, LTI ratios reverted to their long-run relationship with interest rates after the credit binge, and the overvaluation was reversed by house price falls.

Chart 6: Mortgage Interest Rate & LTI Ratio on New Mortgages

Sources: Nationwide, Refinitiv, UK Finance, Capital Economics

While long-term interest rates have recently edged higher, UK mortgage rates remain dictated by short term rates. So as we set out here, mortgage rates are likely to fall over the next couple of years. Mortgage rates have not yet responded to the cut in bank rate from 0.75% to 0.10% in March 2020. This was because banks increased their interest margins to account for the increased risk of household mortgage distress due to joblessness and a possible fall in house prices. As the economic recovery progresses and banks become less concerned about house prices, we expect this margin to be reduced. Banks have indicated as much in the latest credit conditions survey. (See here.)

Moreover, we expect interest rates to stay lower for longer than most other forecasters. It will probably take until 2023 or 2024 for inflation to rise to above 2% and stay there, which the BoE has indicated it needs to see before hiking interest rates. (See here.) So rather than raising interest rates in 2022 as is priced in by financial markets, we expect the first hike in 2025. A base rate of 0.10% and improving economic conditions should allow banks to decrease mortgage rates from 1.9% to about 1.4% by end-2023. (See Chart 7.)

Chart 7: Bank Funding Costs & Mortgage Rates (%)

Sources: Refinitiv, Capital Economics

Combining our forecast for household income growth with the likely increase in the average LTI ratio due to lower interest rates allows us to plot out a path for the “sustainable value” of house prices over the next four years. Income growth is likely to be muted until the unemployment rate falls back next year. So it will probably be 2023 before pay growth picks up steam again. Meanwhile, assuming households continue to dedicate an unchanged 25% of their income to mortgage repayments, as they have done historically, that further decline in mortgage rates would be consistent with the average loan-to-income ratio of new mortgages rising to 3.9.

Table 1 shows that these projections are consistent with a 17% increase in house prices over the next four years, or annual growth averaging around 4%.

Table 1: Determinants of Sustainable House Prices

Mortgage Rate (%)

Implied Average

LTI

Earnings

(% rise vs Q4 2020)

House Prices (% rise vs Q4 2020)

2020

1.9

3.7

2021

1.8

3.7

2.3

2.3

2022

1.6

3.8

3.8

6.6

2023

1.4

3.9

7.3

13.1

2024

1.4

3.9

10.8

16.8

Source: Refinitiv, UK Finance, Capital Economics

We expect to revise up our 2021 Q4 house price forecast from +3% y/y to +5% y/y in our forthcoming Outlook given continued very tight market conditions. But as we think that a 17% increase in house prices is the most that can be achieved on a sustainable basis over the next four years, that would limit house price growth to a little under 4% in 2022-2024.

The risks are on the upside in the near term. There is a possibility that the end of the stamp duty holiday has less of a cooling impact than we expect on demand, and house price growth exceeds 5% this year. Buyer demand did appear to be resilient when the original stamp duty holiday was ending, and before the extension was announced. But larger increases in house prices this year would have to be offset by smaller increases in 2022 onwards for house prices to remain sustainable.

But further out, the skew moves to the downside. While we think that mortgage rates could fall a little further in the medium term, the big picture is still that the support to house prices from low interest rates is now close to being exhausted. The next move in rates will surely be up, even if it does not come until 2025. When it does come, it will put downward pressure on LTI ratios and weigh on house price growth.

Conclusion

To conclude, strong house price growth at present has pushed the house-price-to-earnings ratio up to a record high. But whereas the current house price to earnings ratio was unsustainable in 2007, because of the further drop in mortgage rates since, we don’t think that it is yet a cause for concern. Moreover, if we are right to think that mortgage rates will edge down a bit further in the medium term, house price growth is likely to continue to outpace earnings growth over the next few years. Indeed, we think that house prices could sustainably rise by a cumulative 17% by the end of 2024.

At some point, interest rates will start to rise. We don’t expect that until 2025, though on average investors expect the first increase in bank rate to come sooner. When it does come, that will put downward pressure on LTI and HPE ratios, and cause house price growth to slow. (See here.)


Andrew Wishart, Property Economist, +44 7427 682 411, andrew.wishart@capitaleconomics.com