After the excitement of Wimbledon tennis and a cricket World Cup final, Londoners were back to their favourite conversation topic last week – house prices. But now the news has become bittersweet as the price decline starts to accelerate.
As the London Evening Standard headline confirms:
“The London property slump has dramatically accelerated with prices falling at their fastest rate in a decade, official figures reveal… The latest “punishing” downward lurch means that more than £21k ($26k) was wiped from the value of the average London house over the period, according to the Land Registry… The number of sales is still in decline with just 5947 recorded in March, down from 7350 a year previously.”
‘Reversion to the mean’ is always the most reliable of investment guides, and the chart shows prices could have some way to fall before they reach this level – and, of course, prices often over-correct after the type of sharp rise that has been seen over the past 20 years:
- Most people have to buy houses on a mortgage, where the ratio of price to income is the key factor
- As the chart shows, prices and ratios have seen 2 distinct periods since 1971 (when records began)
- Prices (inflation adjusted) have had an upward trend since 2000, with today’s 11% fall the worst
- 1971-1999 saw more violent swings – eg between 1983-1993 they doubled and then halved
- The average ratio since 2000 has been 9.3, which would bring prices down by a further 23%
- The average ratio between 1971-1999 was 4.8, which would bring prices down by a further 60%
WHY DID PRICES RISE?
London prices have been boosted by 4 main factors since 1971:
Demographics. Most fundamentally, the BabyBoomers (born between 1946-1970) began to move into their house-buying years. This dramatically increased demand (as I discussed last week), whilst supply was slow to respond due to planning restrictions etc.
In addition, women began to go back to work after having children, creating the phenomenon of 2-income families for the first time in history. The younger Boomers saw the benefit of this as affordability rose; those who followed them paid the price in terms of higher prices.
Buy to let. London became the capital of ‘Buy-to-let’. UK tenancy law changed in 1988 and by the mid-1990s, parents realised it would be cheaper and better to buy apartments for their student children, rather than paying high rents for shoddy lodgings. Others followed in the belief that property was “safer” than stock markets”.
Falling interest rates (they were 15% during the 1992 ERM crisis) made the mortgage payment very affordable – particularly with tax relief as well. But since 2017, tax relief has been reducing, and disappears next year. And today’s ageing UK population, where nearly 1 in 5 people are now aged 65+, means the Boomers no longer have spare cash to spend on buying property.
The global city. After the financial crisis, London property appeared an oasis of calm as the Bank of England supported house prices by cutting interest rates to near-zero, dramatically boosting affordability. Everyone knew by then that “house prices only increased”, as memories of the 1970-1980s were forgotten, and so capital gains seemed assured.
This made London, along with other “global cities” such as New York, very attractive to Russians, Arabs, Asians and anyone else who was worried that their government might try to grab their money. Europeans also bought as the eurozone crisis developed. And then the success of the 2012 London Olympics made it the city where everyone wanted to live, especially as its financial sector was booming due to central bank stimulus programmes.
WHAT WILL HAPPEN NEXT?
The question now is whether these drivers will continue. Brexit, of course, has already cast a shadow over the idea of the UK as an island of stability in a troubled world. And whilst the collapse of the currency since the referendum makes property more affordable for foreign buyers, it means that those who bought at the peak are nursing even larger losses.
And, of course, the fall in the actual volume of sales is another worrying sign. Volume usually leads price, up or down. And housing markets aren’t like stock markets, where you can usually trade very quickly if you want to sell. Instead you have to wait for a buyer to appear – and even then, the UK’s property laws make it possible for them to pull out until the very last moment.
All in all, it would therefore be surprising if prices didn’t continue falling, back to the average house price/earnings ratio of the past 20 years. A temporary over-correction, where they went even lower, would also be normal after such a long period without a major fall.
Whether they go lower than this, and return to the 1971-99 ratio, probably depends on what happens with Brexit. If those who believe it will open up a new ‘golden age’ for the UK economy are right, then prices might well stabilise and could even rise again, after the initial disruption. But if it proves an economic disaster, then a return to the troubled period of the 1970s would be no surprise at all.
London’s housing market was always going to have a difficult 2017. As I noted 2 years ago, developers were planning 54,000 new luxury homes at prices of £1m+ ($1.25m) in central London, which would mainly start to flood onto the market this year.
They weren’t bothered by the fact that only 3900 homes were sold in this price range in 2014, or that the number of people able to afford a £1m mortgage was extremely limited:
□ The idea was that these would be sold “off-plan” to buyers in China and elsewhere
□ They had all heard that London had now become a “global city” and that it offered a safe home for their cash
□ There was also the opportunity to “flip” the apartment to a new buyer as prices moved higher, and gain a nice profit
Of course, it was all moonshine. And then Brexit happened. As I warned after the vote, this was likely to be the catalyst for the long-delayed return of London’s house prices to reality:
□ “Many banks and financial institutions are already planning to move out of the UK to other locations within the EU, so they can continue to operate inside the Single Market
□ There is no reason for those which are foreign-owned to stay in the country, now the UK is leaving the EU
□ This will also undermine the London housing market by removing the support provided by these high-earners
□ In addition, thousands of Asians, Arabs, Russians and others will now start selling the homes they bought when the UK was seen as a “safe haven””
Confirmation of these developments is now becoming evident. A new study from the Bruegel research group suggests up to 30,000 bank staff and £1.5tn of assets could now leave London, as it becomes likely that the UK will not retain the vital “passport” required to do business in the Single Market after Brexit. This would be around 10% of the estimated 363k people who work in financial services in Greater London.
They will also likely be more senior people, able to afford to buy London homes with cash from their annual bonuses, rather than the more junior people who need to rely on a mortgage based on a multiple of their income. And there is no shortage of tempting offers for these bankers, with Frankfurt, Paris, Amsterdam and Dublin all lobbying hard for their business.
Now, another threat has emerged to prices, in the shape of China’s new capital controls. China has seen its foreign exchange reserves tumble by $1tn over the past 18 months, due to its revived stimulus programme. January data showed they were now just below $3tn, perilously close to the $2.6tn level that most observers suggest is the minimum required to operate the economy. As we have reported in The pH Report:
□ China has now banned the use of the annual $50k foreign currency allowance for foreign real estate transactions
□ It has also banned State-Owned Enterprises from buying foreign real estate valued at $1bn+
The rationale is simple. The country can no longer afford to see money disappearing out of the country for purposes which have nothing to do with the real needs of business. And the impact on London’s property market (and that of other “housing bubble” cities such as New York, Singapore and Sydney) could be huge, as Chinese have been the largest buyers of new residential homes globally according to agents Knight Franks – and were responsible for 23% of commercial deals in central London last year.
Central London prices fell last year by 6%, and by 13% in the most expensive areas according to agents Savills. And now London’s Nine Elms development (pictured) at the former Battersea Power Station has just revealed a serious shortage of new buyers.
It was intending to build 3800 new homes, and originally found an enthusiastic response back in 2013 when the first 865 apartments went on sale. But 4 years later, just 1460 homes have been sold in total – and yet residents are supposed to be moving into the first phase later this month. Even worse, 116 of these original sales are now back on the market from buyers who no longer wish, or can afford, to take up residence.
Some of these buyers have already taken quite a hit on price. As property journalist Daniel Farey-Jones reports, one anxious seller originally listed his apartment for sale at £920k. Having failed to sell, he had cut the price by Friday to £699,995 – a 24% reduction.
Nine Elms is just one of many sites where developers are anxiously watching their cash flow, and hoping a flood of new buyers will rush through the doors. Sadly, they are not the only ones who may soon be panicking.
In recent years, large numbers of home buyers – many of them relatively young and inexperienced – have been persuaded to buy unaffordable homes on the basis that London prices could never fall. I fear that, as I have long warned, they are now about to find out the hard way that this was not true.
London’s house market has been slowing for some time, as I noted last year. The issue is affordability. Artificially low interest rates make the monthly payment seem cheap. But the key question is whether your salary will allow you to repay the capital borrowed over time.
Sadly, this has become increasingly impossible for many actual and potential buyers, due to the Bank of England’s increasing use of stimulus policies since 2000.
The chart shows house prices on the left, and the ratio to earnings on the right. (Prices are adjusted for inflation since 1971, to enable long-term comparison):
Prices used to fluctuate between ratios to earnings of 3x to 6x
The market would bottom when prices were around 3x average earnings, and peak at around 6x earnings
But after the dotcom crash in 2000, the Bank deliberately allowed prices to move out of line with earnings As the Governor, Eddie George, later told the UK Parliament in March 2007:
“When we were in an environment of global economic weakness at the beginning of the decade, it meant that external demand was declining… One had only two alternatives in sustaining demand and keeping the economy moving forward: one was public spending and the other was consumption….
“We knew that we had pushed consumption up to levels that could not possibly be sustained in the medium and longer term. But for the time being if we had not done that the UK economy would have gone into recession, just like the economies of the United States, Germany and other major industrial countries. That pushed up house prices and increased household debt. That problem has been a legacy to my successors; they have to sort it out.”
Of course, as the chart shows, George’s successors did the very opposite. Ignoring the fact that a bubble was already underway, they instead reduced interest rates to near-zero after the subprime crisis of 2008, and flooded the market with liquidity. Naturally enough, prices then took off into the stratosphere.
Back in January 2015, I suggested in an interview with the UK’s Moneyweek magazine that:
“We’ve seen price falls in the housing market in the past in the early 1990s and they went down 50% in real terms, and I think that we’re at the start of that kind of decline now …it’s just something we have to go through to get to reality.”
The problem, of course, is that a bubble of this size, deliberately encouraged by a major central bank over more than a decade, does not just unwind of its own accord. It needs an external catalyst. And as I suggested at the end of June, the Brexit vote seems to have become such a catalyst:
The interest rate rises that Brexit has already caused have now led major lenders to increase their mortgage rates
Buy-to-let sales, which were the main force behind the ascent to such dizzying heights, have fallen by over 50%
A further hit is on the way, as Airbnb has agreed to limit landlords’ London lettings to no more than 90 days/year
Transaction volumes (usually a good leading indicator for prices) have also plunged from 15 to just 9 per surveyor
Prices have not yet started to fall on a widespread basis, but the top end of the market is already seeing falls of up to 40%, as a leading broker told Bloomberg last week:
“It’s a substantial reduction, fully reflecting the challenging post-Brexit market of today”
With prices now collapsing at the top end, it is likely that prices further down the scale will soon start to be impacted.
This is, of course, unlikely to happen overnight. As in the past, it will take years for the full collapse to take place. The reason is that buyers tend to disappear when prices start to fall and interest rates start rising. Anyone owning a home may therefore have to wait a long time until a buyer appears – even if the price has been greatly reduced.
This will be a disaster for many buyers, who believed the assurances of the experts that prices would always rise, due to London having now become a “global city”. First-time buyers will be badly hit, as they have less equity in their homes, and will discover they have bought at prices which were up to double normal price/earnings ratios:
They probably never knew that Nationwide data showed first-time buyer ratios in London were as low as 3.7 in 1983
Nor did they know that ratios fell to 2.6x earnings at the bottom of the last major downturn in 1995/6
Instead, they were encouraged to buy at ratios ranging from 6.2x in 2010 up to this year’s peak of 10.4x
Plenty of people are already angry about the housing market, due to rents having soared due to the bubble that has been created. I fear this anger will seem like a child’s tantrum, however, if prices do now start to fall back to their normal ratios to earnings.
Most people, if they are lucky, never get to see a property bubble during their lives. But those of us alive today have seen two distinct types of bubble in action:
- The first has been the Ponzi-type bubble sponsored by government lending policies, as seen in the subprime era and now in China. These take house prices well beyond the levels that buyers can repay out of income. Instead, the illusion develops that prices can never fall, and so buyers rush to take advantage of this ‘new paradigm’. Switzerland is another quite overt example of this type of bubble in action, with banks happily lending for 50 or 100 years – well beyond the borrower’s lifetime.
- Then there is the bubble where prices in the capital city go out of reach of the locals. Only foreigners, and those who work with the foreigners, can now afford to buy. This is very rare – last being seen in Japan and Thailand in 1991. But as the chart shows, it is happening today in London. Ratios of prices to salaries for first time buyers, for example, have moved to all-time record levels (red line), whilst ratios for the rest of the country have never recovered from the ending of the first bubble in 2008 (blue).
- Equally, as the Financial Times has reported, “whole sections of London have become completely unaffordable” for even solidly professional middle class families, whilst “ 34% of resale transactions in prime locations now involve international buyers, who also account for almost three out of four sales of new-build homes in prime central London.”
Leading investor Mark Faber described this phenomenon in a Barron’s article in July 1992, which the blog kept for historical interest as it had seen the problem develop in Bangkok and Tokyo whilst working in Asia at the time. Faber suggested it was the 4th stage of a 6-stage investment lifecycle, and was a rebound after the initial market collapse:
“The rebound in this Phase is very tricky. The economy is still doing well, and the rally is usually powerful enough to induce even the sceptics back into the market. If the fall from the previous market high has been very severe, many investors will be convinced that the market has already reached its ultimate low and is now recovering.
“I believe that time and psychology are important factors in determining whether this is true. A quick recovery within 6 to 18 months after the high (as is the case in London today) is a sign that the excesses have not been fully wrung out of the system. In terms of psychology, there is also a noticeable difference.
“People remain optimistic and confident about the economic prospects. Whereas at a true bottom, pessimism is rampant as a result of total wealth destruction.
“Usually the transition into the final collapse is very subtle. Usually there is no panic selling, but prices begin to drift lower and remain in a low-volume downtrend for an extended period, before credit deflation takes hold.
“Phase 5, which follows this, feels like a hangover after the previous financial orgy. Because the boom has been built on a major error of judgement and usually a lot of credit, on the day of reckoning speculators suddenly realise their past miscalculations and, because their dreams of huge profits fails to materialise, harsh reality sets it.”
However, though the end result may be the same, London’s current speculation has a different cause from Tokyo’s or Bangkok’s in the late 1980s.
Today’s foreign buyers in London (and New York, and other ‘global cities’) come from Asia, the Middle East and Eastern Europe. Many are not trying to profit from a new ‘hot’ destination. Instead, they fear social unrest and possible financial uncertainty at home.
Thus they are not investing for profit, but to avoid loss. As one foreign buyer told the blog – “I know I will probably lose money on my London apartment, having paid $10m for it But even if I lose 90% of the money, I will still have successfully moved $1m into Europe to support my family for the future.”