House price epiphany -PT 2

“I now realise why they have continued to rise.”

Inexpensive
This has been down to one simple reason. Namely, that they have remained inexpensive. I have fallen into the same trap of many pundits and investors. That is of relying too heavily on historic methods of measurement and comparison. I’m referring to specifically is the average house price to average income multiple. This measures the relationship between house prices and individuals incomes. It has been used for years as the basis of economist’s long-term house price projections and has allowed them to judge when prices have been cheap or expensive. The long-term average has been about 3.5 or 4 from 1973-2005. The current level is about 6. Several times in the last 30 years a rise to multiples significantly above this has been followed rapidly by a sharp correction in prices. It is this stretched multiple that has been concerning me for some time.

New trends
The reality though is as I now understand, that the world and the UK economy has changed. I’m not a great believer in ‘new trends’. You only have to look at what happened during the ‘dotcom boom’ for the danger of adopting ‘new’ standards’ too quickly. You will probably remember that in the ‘dying embers’ of the last millennium a whole new way of valuing companies sprung up to justify why they were worth billions of pounds, but had no assets or had never made a profit. We can all recall what happened when the ‘emperors new clothes’ of corporate valuation was finally revealed to be a sham and values plunged accordingly. Clearly the similarities between residential property which is an asset in itself and these shares are limited, but you get my point about the premature adoption of new valuation techniques.

‘Attainability’ vs ‘sustainability’
Academics highlight the fact that there are two aspects to house price income. There is the advance income multiple also known as the income multiple to which I have referred to above. The other aspect is the deposit income ratio, which refers to the size of the deposit required. There is no doubt that this ‘attainability’; that is the ability of buyers to finance the initial purchase is being stretched and has held back prices.

However, we are already seeing that purchasers are finding ways around these funding constraints. This is helped by banks offering mortgages with higher income multiples, together with the cascade of existing housing equity such as where parents loan money to their children for a deposit. However, to me the more important aspect of understanding the direction of house price direction is ‘sustainability’. This is the costs to the purchaser once they have secured their property.

The reality is that house buyers judge housing and it’s price far more by ‘sustainability’ factors than the affordability measures mentioned above.

Proportion of income
The reality is that by looking at figures provided by the Council for Mortgage Lenders (CML) the proportion of income spent by homeowners and even first time buyer on their mortgage repayments is still not high by historic measures.

The reason for this is that whilst interest rates have gone up, they are still relatively low. The competitiveness of the lending environment has narrowed lending margins (the difference in the cost to the lender of borrowing money and how much they charge to the borrower). This has effectively helped to reduce the costs that lenders charge borrowers.

At the end of the third quarter of 2006, the proportion of income spent on servicing borrowing costs by existing borrowers was just under 15% of income. This was considerably above the low point reached in the 2nd quarter of 1996 of 10.2% but well below the high reached in 2nd qtr of 1990 of 26.7%. Even for first time buyers, where you would expect ‘sustainability’ to be more stretched it is only running at 17% in qtr 3 2006 compared to the peak of 28.1% in qtr 3 1990.

The conclusion from all this is that whilst prices are not cheap, they are still not historically expensive.

Structural change
In my view the recent moves by lenders to increase the income multiples they will lend is far from being irresponsive as some pundits maintain. It is in reality part of the structural adjustment to changes in the UK economic environment that has occurred over the last 8 years. This is namely the removal of high inflation from the system. The result is a low inflation, low interest rate economy.

The banks now feel confident enough to lend at this higher multiple because whilst the loan amount are higher, affordability in terms of the proportion of an individuals income is not at unsustainable levels. Ironically, these moves may in the long-term be positive for the economy.

Why? The reason is that they build in further economic discipline to the UK system. This is because, with higher and higher levels of debt being taken on; Governments cannot allow their spending and borrowing to get out of hand and risk pushing up inflation. This would put even more pressure on interest rates with unthinkable consequences for the housing market and the wider economy. This constraint should keep public spending down and economic growth higher, which all translates into more robust house prices.

Investment strategy
As you have seen, I am a cautious investor by nature. But experience has taught me that if you don’t understand something and in the ‘crazy mixed up world’ and there is much that I don’t. It is always better to walk away than invest in something just because other people tell you it’s a good idea.

The result of my house price epiphany is that I shall be re-evaluating my investment strategy for the New Year. Now I understand what is going on I feel more confident about putting my money where my mouth is.

Look out for an update on the strategy in the coming weeks.

HAWKEYE – a unique perspective on property investing