[I'm not sure who to credit for this, as it was just part of an email Ben forwarded to me, so if anyone knows who wrote it, please let me know and I'll credit accordingly. In the meantime, a perfect summary of the current housing nightmare...]
Bull: I need to get on the housing ladder, Bear. The average price of a property is now 8.7 x average earnings and prices have risen at twice the rate of earnings over the last 10 years.* No matter how much I save, it’ll never keep up with price growth. If I can get a mortgage for 5 times my income, I could buy an understairs cupboard in a London suburb. I’d really like something bigger, if only I could afford it!
Bear: I see your dilemma, Bull. Why on earth have house prices boomed like this?
Bull: Simple economics, Bear. Supply and demand. There is a shortage of housing. Research by the National Housing Federation shows that 120,000 new homes are needed each year. Only 21,000 were built last year.*
Bear: Supply and demand… Well, I can’t argue with that. What supply are we talking about?
Bull: The number of houses in the UK, obviously. There aren’t enough to house a growing population.
Bear: What a disturbing prospect! So many people and so few houses… Rents must be going through the roof as well.
Bull: No, oddly enough, rents have been stable over the last 5 years. It seems there’s no shortage of rental property. In fact, a surprising proportion of rental property remains unoccupied – 50% of new flats in Leeds, by one estimate, for instance*.
Bear: That is odd. But I hate to even imagine the homeless statistics!
Bull: Well, the strange thing is that they have been stable too for several years at around 100,000, with a drop of 3% over 2006. In fact the figure for newly homeless people registering with councils for emergency accommodation dropped 22% in 2006 compared with 2005, while house prices rose almost 10%.*
Bear: That’s strange. Still, if not enough houses are being built… this situation was foreseeable in a country with a rising population and tight planning restrictions! Are you really attached to life in Britain, Bull? If you want to buy, surely you would be better off moving to live in France, whose population is falling, or the US where planning restrictions are near-nonexistent? I bet their housing markets aren’t booming like ours, are they?
Bull: You know, it’s the strangest thing. The US housing market has had even wilder growth than the UK, despite a more relaxed planning environment*. And France has almost as high house inflation as the UK, despite a falling population*. In fact the house price boom seems to be global in its scope.
Bear: Still, you can’t argue with supply and demand… But hang on, can you clarify something for me: If a significant proportion of homeowners, in a shared moment of eccentricity, decided to sell their house tomorrow, perhaps to rent or to move back with their parents, would not the supply of homes for sale have increased?
Bull: Of course.
Bear: Yet no more houses would have been built. So perhaps you’re mistaken in equating supply with bricks and mortar. The low rents and falling homeless figure shows that there is no shortage of places for people to live. The market boom is the same in new-build friendly America and shrinking France. What is in short supply is people who want to sell a house.
Bull: So why does the National Housing Federation research say that we need to build 100,000 more homes each year?
Bear: Because the authors are assuming that the only way supply can be increased by 100,000 is by building 100,000 new homes. But we’ll talk later about the possible triggers that people might lead more homeowners to sell.
Bull: Okay, so I grant you supply is not about how many buildings there are but about how many people want to sell them. But look at the pressure on demand for houses…
Housing Demand (1)
Bull: … All those humans need a roof over their head. It’s one the most fundamental biological needs. And as immigration swells their population, demand is perpetually increasing.
Bear: Immigrants are putting pressure on prices?
Bull: Of course, that should be obvious. They all need somewhere to live and this pushes prices up.
Bear: Are those minimum-wage Polish cleaners really getting on the property ladder? My friend Sean Sage, branch manager at Ocean Estate Agents, Bishopston, Bristol, says his branch hasn’t sold a single property to an Eastern European in 2006*. I don’t see much evidence that the immigrants are bidding houses up.
Bull: They may not be buying but the influx of immigrants means that people rent out their houses rather than sell them. This contributes to the property shortage.
Bear: Ah. So we’re talking about landlords buying, not immigrants?
Bull: Yes, if you like to put it like that. It’s not immigrants buying who are pushing demand up, it’s landlords buying to let to them. I don’t see that that it makes any difference.
Bear: Don’t you, Bull? Then Bear with me a little longer. Why do people buy houses to let? Is it out of a burning sense of philanthropy?
Bull: No, they let property because they think they can make a profit.
Bear: And where is the profit in letting?
Bull: Well, it gives you a regular rental income.
Bear: Mm. You’d think so, wouldn’t you? Yet the Buy-to-Let mortgage provider Paragon says that the yield on new Buy-to-Let property before insurance, maintenance & management expenses is now averaging 6%*. Once you consider expenses then landlords would make a better income by selling their house and putting the proceeds in a savings account, where at time of writing they could earn a risk-free 5.45%*. And if they’ve borrowed to buy the house!.... well, 6% minus expenses certainly won’t cover mortgage payments.
Bull: Okay, so it does seem that landlords who buy at today’s prices aren’t making a profit on rental income. But you’re forgetting, the landlords will profit when the value of the house goes up.
Bear: Exactly, Bull! That’s just the point! The landlords are speculating. They are paying a price for the property which has no relation to the income they can get from renting it out simply because they think value will continue to rise. Do you still think that immigrants are pushing prices up?
Bull: I’m not sure. They’re certainly improving the cashflow of speculating landlords.
Bear: And that’s the most you can say about immigration. But if houses were priced according to rental returns, you would expect their prices to be far lower than what they are now. Since Buy-to-Let now makes no financial sense without expectation of capital appreciation, we can say that the Buy-to-Let component of housing demand is entirely due to speculation.
Housing Demand (2)
Bull: So let me get this straight. You think that house prices are being driven up not by a shortage of accomodation but by speculation?
Bear: The sums show unequivocally that Buy-to-Let demand is now entirely driven by speculation. And speculation is hardly unknown to potential owner-occupiers. Your own attitude when you talk about needing “to get on the ladder” is another form of speculation. Because you are speculating that prices can only continue to increase, you are desperate to buy even an expensive broom cupboard.
Bull: That’s not fair. Speculation is about greed. I just want to own my own place.
Bear: I didn’t mean for a minute that you want to profit, Bull. I just mean that your decision making is determined by the belief – or in your case fear – that prices will continue to rise indefinitely.
Bull: Ah, what difference does that make to me, anyway? Whether demand is high due to speculation or accomodation shortage, I can’t afford to buy!
Bear: It matters very much to you, Bull. If any shock caused house prices to falter, do you think all those landlords who are making no profit on their rental income will happily sit on properties that are falling in value? I think you would find the supply of houses for sale grew pretty quickly, and buy-to-let demand (now accounting for 14% of mortgages*) would simultaneously disappear.
Bull: Hmm. That’s quite an interesting thought. I’m not feeling quite so desperate now. So do you really think that nothing but speculation is fuelling demand?
Bear: Those Paragon figures are remarkable: In today’s market, rents are cheaper than mortgage interest on the same property!* Interest, not interest and repayment! On the other hand, whereas speculation is the only explanation for continued demand in the Buy-to-Let market, I grant you there is one other factor to consider in the owner-occupier market: It could be that people’s desire to own a property is leading them to pay a premium for the benefits that come with being an owner-occupier.
Bull: You don’t have to tell me about it, this is why I want to buy! Owner-occupiers can’t be forced to leave…
Bear: (Unless they default on their mortgage) But do go on.
Bull: …They can decorate as they want, sublet rooms…
Bear: Of course these benefits must be balanced against the inconvenience of being responsible for the upkeep of the property, and unable to move easily if one’s circumstances changed – one’s job could require a slow and costly house move, for instance.
Bull: So it’s natural that people would be prepared to pay more to be owner-occupiers.
Bear: It’s hard to say whether such an “owner-occupier premium” is contributing to property prices today. For instance, in a booming market I don’t see how one could separate out such effects from speculative factors, of which we have clear evidence from the buy-to-let market (where by definition no “owner-occupier premium” is operating). However even if the convenience of owner-occupation is helping to maintain prices, it is important to note that it is a lifestyle choice. If financial circumstances required it, this “demand” would disappear far more readily than the biological imperative for shelter…
A summary of supply and demand.
Bear: … So to summarise, so far we have agreed that rents and homeless figures do not support the idea there is a shortage of accomodation. And although “supply” sounds like a quantity that can’t be increased without getting the JCB diggers out, in fact it could be increased at the drop of a hat if speculating landlords decided to sell up. Or if, for instance, interest rates increased to the point where a substantial number of owner-occupiers had to sell their houses, and move to renting instead (currently cheaper, as we have seen).
Bull: Yes, I suppose so.
Bear: And that although “demand” sounds like the undeniable human survival need for a roof over ones head, this need can be met in other ways – by renting, for instance. In fact “demand” comes down to a combination of factors – the survival need, the speculative profit people expect from owning a house and the lifestyle choice to live in smaller, owner-occupied households. These factors at present lead people to pay a premium for ownership over what they would pay in rent – but these factors are far more fluid than just the survival need per se.
Bull: Agreed, we’ve clarified what the nature of “supply” and “demand” in the housing market is. But you’ve still told me nothing about why you expect a crash.
Bear: Indeed not. But our exploration of supply and demand is not finished. Finally, we must consider further the nature of “demand”. We have focused on the factors which might cause people to want to buy a house. But this psychological desire is not “demand” in the economist’s sense. “Demand”, in the sense of “supply and demand”, means the willingness and the ability to buy at current prices. And we have not considered how a population has been able to keep buying – thus maintaining “demand” for an asset which is at unprecedented price levels relative to income. The explanation is a single word: Credit.
Bull: You mean loans? But that’s nothing new! For a long time now, people have used mortgages to buy property.
Bear: Actually, historically mortgages are fairly new, having come into common use in the 1930s. Before the 1930s, houses were bought for cash, even by first time buyers. Interestingly, I have been unable to find any account of booms in property prices before 1930. Today the situation is unrecognisable, with the level of mortgage lending at astonishing heights. The proportion of UK mortgages worth at least 4 times the mortgagee’s salary grew between 1985 and 2005 from 5% to 35%*. Some banks have now publically declared their willingness to lend 5 times salary*. Others will lend 125% of a property’s value*. Few require proof of declared earnings.
Bull: Obviously people can’t buy for cash at today’s prices. So mortgages are a response to prices.
Bear: Are they really? Think about it for a moment. If the banks refused to lend such astronomical amounts, prices would drop of necessity. “Demand” would be nonexistent if the money were not available, and the “market” would look very different.
Bull: So why are banks agreeing to lend ever increasing amounts?
Bear: The answer is at the heart of understanding the property market, and is the fundamental message I want to explain to you. Banks make profits from borrowers, not savers. In today’s globalised economy, banks must compete with each other to attract borrowers. Since the 1980s, the banks have lobbied governments claiming that removal of all legal restraints on lending were crucial to their survival. And so the last 20 years have seen progressive abolition of government controls on lending throughout the world. This is described as “financial deregulation” and this is what has fuelled the “loosening of lending criteria” described above, whereby ever greater sums can be lent.
Bull: What you’re saying does seem to make sense.
Bear: A simple thought experiment shows the strength of it: Suppose that the UK banks were willing to lend almost any adult human an unprecedented sum of money to invest, at low rates of interest. Imagine too that they insisted that only one asset class can be bought with that money, an asset class that (when bought at its historic average price) has been shown to give an excellent tax-efficient, low-risk return on investment. Is it surprising that the humans would then outbid each other in their race to secure these assets? This is exactly what we are seeing! (The fact that it’s an asset class which also satisfies the survival need for “a roof over one’s head” is less relevant than one might imagine, as the number of people mortgaging to buy-to-let shows.) Easy credit, not a shortage of bricks and mortar, is what has driven property to astronomical heights.
Bull: It seems intuitively possible. Is there any hard evidence?
Bear: Yes, there is. Global easy credit is the only conceivable explanation of why house price inflation is a global phenomenon, regardless of local “supply” of bricks and mortar and “demand” of population change.
Bull: Do you know, Bear, what you’ve said seems to make a lot of sense.So you’ve explained how we got here. But you haven’t explained why you think a crash is going to happen.
Bear: Debt is actually a synonym for credit. People call it credit when they feel it’s helping them but debt when it’s hurting them. I believe that the property bubble will burst under the pressure of bad debt. Total UK mortgage debt is now £1,100 billion, compared to £350 billion in 1993. Signs of strain in servicing debt have been growing in parallel with the increase in lending. Citizens Advice Bureau says the number of people seeking debt advice has doubled in 8 years. Personal insolvencies in 2006 were up 55% on 2005 levels, with Individual Voluntary Agreements (to reschedule debt) up 118%. All these statistics come from the Credit Action website, where many simialr figurescan be found.* If losses from bad debt forced banks to tighten their lending criteria once more, the supply of money holding house prices aloft would evaporate. No more 5x salary loans, no more “demand” for £200k broom cupboards.
Bull: But the banks budget for a certain proportion of losses. It doesn’t seem to be affecting the housing market at the moment.
Bear: Wait a minute, though. What we are seeing is a growth in bad debts during what Gordon Brown describes as the longest economic boom the UK has known for 200 years.* These are the good times! Too many people are overextended in debt. (And these are not the irresponsible credit card freaks, these are normally-cautious middle class young people who have been advised by all around them that they should buy property, whatever the price, or risk failing to “get on the ladder” forever.) If the economic good times come to an end, any number of shocks to the system could change the face of the housing market.
Bull: Such as?
Bear: Such as rising unemployment or interest rates causing people to default on mortgage payments. Banks would become more reluctant to lend such wild amounts at the same time that any repossessions would forcibly increase the “supply” of homes on the market. And not only would potential buyers be unable to borrow so much, but they would also be facing the same economic uncertainties that were causing problems for the sellers. Is it even conceivable that prices would not fall? Furthermore, remember that there is now a huge class of landlords whose rent after expenses fails to cover the interest on their loans, and who are relying on capital gains to provide their profit. Any initial price drops might stimulate these unprofitable landlords to sell, further adding to “supply”.
Bull: But there must be a reservoir of demand from all the people who are now priced out but desperate to buy. They will hold up the market, and we can expect a soft landing. This is where your “owner-occupier” premium comes in. People will still want to own even if renting is cheaper and they no longer expect speculative short-term profit.
Bear: So one might think, but history does not support this view. A glance at the graph showing the history of prices over the last 30 years, including 3 downturns around 1979, 1986 and 1995 shows no precedent for a “soft landing” after double digit house price inflation.* I can only assume that even those buyers who had claimed to be looking to get into property “for the long term” changed their minds when faced with the option of buying an expensive and depreciating asset. I see no reason to doubt that when the current boom ends, the supply of buyers will dry up as decisively as it did at the previous 3 peaks.
Bull: I think I understand what you’re saying. But I got a bit lost in the detail.
Bear: I’ll summarise. Easy credit is the cause of the house price bubble. It is a global phenomenon inseparable from the trend towards financial deregulation, and cannot be explained by local factors. With perfect symmetry, credit’s downside “bad debt” will destroy the house price bubble by forcing the banks to stop irresponsible lending. And history shows us that when a housing boom finishes, it has generally been followed by a “crash”, IE a return (typically taking around 5 years) to below long-term average price in relation to earnings.*
Bull: And how much of a fall would that be?
Bear: Prices are now 30% above their long term average in relation to earnings*. So I would predict a fall of over 23% in real terms over 5 years.
Bull: Don’t you mean 30%?
Bear: You need to get your calculator out! A fall of 23% would mean values would drop to 100-23= 77% of current price. And 77% x (130% of average price) = average price!
Bull: Er. Yes. I think. So when will it happen?
Bear: Ah, that’s the million dollar question. I follow the news closely, but nobody has ever worked out a formula for predicting the timing of the end of a bubble.
Bull: Well, Bear, what you’ve said is very interesting but still.. At the end of the day I just don’t believe all these abstract financial considerations come into the very human business of buying and selling houses. Thank you but I’m going to buy that cupboard after all.
Bear: All right. It’s your choice. I’ll buy you a nice picture to hang on the wall.
Bull: Um. There’s no room for pictures actually, Bear. But thanks for thought.
Bear: You’re welcome, Bull.
* See Guardian reference as above.
* Personal communication to the author, 11/12/06
* See Paragon reference above.
* See Paragon reference above.
*http://www.scottish.parliament.uk/business/research/briefings-06/SB06-76.pdf* , graph p.6
* See Scottish Parliament, as above
* See Guardian reference as above