How low will the house price crash go?
Landlords and property investors are waking up to the new reality – house prices just don’t go up in value. Some pundits have been predicting this house price correction for many years, such as HousePriceCrash , but the speed and the severity of this potential house price crash has taken us all by surprise.
The problem is that when asset bubbles burst, they rarely deflate in a controlled manner. The residential property market had clearly become a bubble. The deflating of this bubble and the downward spiral in property values is likely to be dramatic and could gain a momentum of its own making it very difficult to call the bottom of any house price crash.
Over heated markets where prices have over shot fair value on the way up, will often over correct and fall below what is their long-term fair value on the way down. Just as investors become overly optimistic on the way up; as has happened with the current housing boom. On the way down the same property investors who had been stung by the experience then become ultra pessimistic and overly cautious and price in further falls taking the market below what market fundamentals would suggest is a reasonable price.
Warnings of an impending house price crash
Some landlords may remark that: ‘if you thought house prices were over valued why didn’t you tell us?’ Well - we did!
I remember publishing this story and been e-mailed by an editor of another less reputable landlord website pushing bad discounted property investment deals and property investment clubs, who accused me of being mad. I suspect that there are a number of landlords who wished they had taken this advice and bolted for the exit at least in relation to some of their portfolio.
Fair value for house prices
Now that landlords and property investors have taken off their ‘rose tinted spectacles’ and are looking at residential property values in the cold light of day. What are their buy-to-let investments really worth?
Anecdotally, I would say that house prices were probably fully valued some time in 2004 when the average house price in the UK according to the Halifax stood at around about £150k compared to the peak of just under £200k reached late in 2007. I decided late in 2004 to sell a number of properties in my residential investment portfolio feeling that the market was fully valued. Looking at this graph it’s possible to see how the market slowed into 2004 but then kicked again to reach a final peak in late 2007. Imagine how miffed I was to watch the values of my sold property investments carry on upwards making other landlords and property owners money!
The difficulty with judging a fair value for property investments is that the housing market is not a single market but several markets within one. There is the main market where owner occupiers buy and sell and then there is the property investment market where landlords buy in accordance with their investment criteria; finally there is also the holiday home market.
All co-exist but the way buyers and sellers value residential property differs considerably. Given that 90% of residential property is transacted by owner occupiers, then these valuation metrics have the greatest impact. What are the main metrics used to value residential property?
Affordability can be measured in several ways. Traditionally, the key metric has been the multiple of average earnings to residential property prices. Historically this has been just over 4 times according to the Halifax; it now stands at just under 6. Some economists argue that this measure is no longer relevant because of a paradigm shift downwards in interest rates making higher multiples more sustainable.
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In the 1980s interest rates were for the most part in or near double figures; in the 90s they probably averaged 6-7%. Early in this decade they fell as low as 3.5% in mid 2003. They have since risen and now currently stand at 5%.
What some housing experts argue is that what is more relevant in judging housing affordability is the proportion of household income paid out each month on servicing housing debt. They argue that, people don’t think of multiples or margins when judging whether they can afford a property; their first thoughts are how much their mortgage will cost per month. For an indication of this we can go to the statistics provided by the Halifax .
These statistics make interesting reading. The latest figures for interest payments as a percentage of income was 24.73% in April 08 which is well below the 36.7% reached in the first part of 1990 just before the house price crash of the early 90s. However, it should be remembered that this high rate was prompted by interest rates which reached 15%. The current figure however is likely to rise even if the base rate remains at its current rate of 5%. This is because mortage lenders continue to increase the lending margins they require from mortgagees as they reprice risk as a result of the fall out from the ‘credit crunch’. Expect therefore that this figure will rise beyond 25% in the coming months. The long term average is just under 20%.
2. House price rises have outstripped the long-term trend.
The Nationwide has generated a time series analysis of house prices since 1975 that accounts for inflation. Using these figures they have produced a trend line that indicates an average price rise per annum of 2.8% above the rate of inflation for this period. This long run trend ‘suggests’ that the average house price today should be £143,691. The actual figure is £179,363. This analysis suggests that house prices are on average 20% over valued in respect to this projected long-term trend.
3. Gross rental yields
Landlords and property investors have traditionally used the gross rental yield to value the relative historic value of residential property.
For landlords with a good memory, they may be able to recall when gross yields on some investment properties were in double figures. It was also up until relatively recently that many landlords could secure a reasonable level of income from their residential investment properties. However, for many residential landlords those days have gone. Small rental increases have not been sufficient to keep pace with rising capital values and rising interest rates. The result is that the last Association of Residential Letting Agents (ARLA) review indicated that gross yields were less than 5% as a UK average although figures from Paragon would suggest they are actually a little above 6%.
So how low can house prices really go!
Given all this information what does it tell us about the fair value of residential property?
Affordability projections would suggest that new home owners are likely to be paying 25% over what is the long-term average proportion of their income on mortgage payments.
Taking the figures from the metrics and the long term trend line from the Nationwide Building Society data showing house prices 20% above the long term average, these sets of data roughly support my anecdotal view about the extent of the house price correction required.
A 25% fall in capital values would mean that an investment property currently generating a 6% gross yield would see its gross yield rise to 8%. In my view about right given the current interest rate.
However, as I pointed out at the beginning; asset bubbles tend to over correct rarely settling back neatly on trend. The extent of this change will depend largely on how quickly prices correct. If the fall is steep, then this over correction is likely to be more significant than if it occurs slowly. The key factor for the UK housing market is employment. If this stays strong then the correction is likely to occur steadily over 2-5 years and real price fall will be mitigated by rising incomes. However, if unemployment rises significantly resulting in the high rates of mortgage repossessions experienced in the early 90s then the price correction could turn into a crash and prices could fall significantly more than 25% over several years.
The upside of a house price crash
A couple of positives for landlords to cling on to amongst all this gloom:
1. What ever happens to house prices in the next couple of years the British will never fall completely out of love with residential property and to that matter property investment. An Englishman’s home will always be their castle.
2. This latest housing boom will be the last EVER housing boom and bust! This is until the next one which by my calculation is due for around about 2020 so landlords something to look forward to.
3. Over the long-term residential property values will continue their inexorable upward journey.
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