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London housing inflation to slow

London prices could go down through the gears, but the shortage of housing stock, economic prosperity and continued demand should provide a measure of support
October 16, 2015

It could be said that London has two housing markets. There is the so-called prime central market (PCL), which is the two boroughs of Westminster and Kensington & Chelsea, and the rest of London. It could also be said that properties within the PCL are bought more as an investment than as somewhere the owners can live. London is a useful parking lot for overseas investors looking for somewhere to put their money that is both relatively safe and that offers a better rate of return than can be achieved in the more traditional low-risk fixed-rate environment.

The flow of funds bears a direct correlation to economic prosperity and localised instability. Rich people in countries with political instability will always have an eye on protecting their wealth, on top of those successful business people looking for a better return. The recent downturn in the Chinese economy may affect the inflow of funds from there, but there is always somewhere else to take its place.

Suffice to say that PCL residential property values are little short of bonkers. Take Kensington; average prices for a two-bedroom flat run at £1.4m, and this creeps up to £3m for a house with extra bedrooms. However, these numbers start to make a little more sense when factoring in the rent, which can run from £950 to £6,000… per week. It seems little short of surreal to people throughout the rest of the country, but London prices are obviously subject to more external stimuli.

 

Back to single-figure growth

However, housing market activity has started to slow, as has price inflation. PCL price rises were limited to just 3.1 per cent in the year to July (the latest data available); that's down from 17.3 per cent a year earlier, and is now below the London average for the first time since 2010. Crucially, the Royal Institute of Chartered Surveyors revealed that 60 per cent of surveyors polled in London felt that the market was overpriced in their area.

 

Moving out to the 11 inner London boroughs, sales volumes have continued to decline. The beginning of the year was affected by worries over a possible mansion tax, but higher stamp duty on properties worth over £1m also took its toll. In the less expensive outer London boroughs, where London workers aspire to live, price growth has also been moderating, slowing from 13.1 per cent year on year to 9.8 per cent in the third quarter. Capital Economics expects this decline to continue to around 5 per cent by the end of this year, followed by flat prices next year and 1 per cent growth in 2017.

 

Affordability and supply imbalance

The moderation here can be explained by factors that affect potential buyers who plan to live in the property they buy. The first and most obvious influence is that potential buyers are simply not prepared to bid up for property. This can be seen from the volume of transactions recorded, which fell by 10 per cent in the first half of the year, compared with just 1 per cent across the UK as a whole. Since then, however, new buyer enquiries - and it's important to remember that these are just that and not sales - have started to accelerate once more.

Prices are underpinned to some extent by the lack of properties coming on to the market, with unsold stocks per surveyor in London at a record low. However, the affordability factor will act as a restraint. Average earnings have failed to keep pace with house price inflation, and while mortgages are cheaper than they have ever been, the lending criteria for potential mortgagees have been tightened up in order to ensure that borrowers are financially fit to maintain payments when economic conditions are less buoyant.

At the heart of all this remains the chronic imbalance between supply and demand. There are two contributory factors; building out and upwards. High rise has always had social issues attached, but building out has become more pronounced as communication links improve. According to property analyst Dataloft, homes within half a mile of a station running the night tube (if it ever comes) are expected to rise in price by as much as 10 per cent more than baseline growth. This will appeal to students and young adults who will be tempted to spend more of their leisure time in central London.

 

Population density for selected European cities

 

Targeting density

There is also a case for increasing housing density. This is already happening in previously unfashionable areas such as Stratford and Shoreditch, but leaving out green space and water leaves plenty of potential. According to a report from London First and Savills, housing density in London is lower than other major European cities such as Paris and Barcelona. If those areas with good transport links - but low housing density - were developed to match higher density areas, the report suggests that this could equate to 1.4m new homes. Areas identified as potential targets include Old Oak Common, Tottenham and the Lee Valley. Bringing all of the requirements together, including planning, infrastructure and the actual building capability would be a big ask, though.

With housing so tight, it's small wonder that demand for rented properties has grown. Inevitably, so have rents, as landlords attempt to sustain rental yields in the face of rising property values. Rents were up 3.2 per cent in the year to March, but this accelerated to 3.8 per cent in the second quarter, also reflecting the fact that the number of prospective tenants is growing more quickly than homes to let are coming on to the market.

 

FAVOURITES
Housebuilders with a big presence in central London include Telford Homes (TEF) and Berkeley Group (BKG). Telford has made extraordinary progress since the recession, and has a development pipeline stretching out eight years and worth over £1bn.

More recently it bought the regeneration business of United House Developments for £23m. This comprises four significant investment opportunities that could add a further £500m to the development pipeline. At 412p, the shares are up from our longstanding buy tip (101p, 22 April 2010), but with such a strong order book and good earnings visibility, we're still buyers. Berkeley Group has a big development pipeline, and is due over £3bn of cash on forward sales over the next three years. Trading on 2.9 times net tangible assets, the shares might look expensive, but with big dividend payouts pencilled in for the next six years, the shares are worth holding on to.

OUTSIDERS
For estate agents, the first half of this year was badly affected by pre-election jitters, although business since then has started to pick up. Even so, full-year numbers are likely to be relatively subdued when compared with some pretty tough comparatives. Operators such as Foxtons (FOXT) and Countrywide (CWD) benefit from having a diverse revenue stream that covers lettings, surveying and mortgage broking. However, both look unlikely to produce a significant increase in profits this year, and both trade on expensive multiples.

 

The broker's view:

London's housing market has cooled notably over the past year. According to Land Registry figures, average house prices rose by 6.6 per cent in the year to August, compared with a rise of over 20 per cent in the same period a year earlier. And it seems likely that this slowdown in the capital has further to run.

After all, taking London as a whole prices are now more than 40 per cent higher than they were in the weeks leading up to the credit crunch and the gap between house prices in the capital and the rest of the country is at an all-time high. As a result, London is the only region where the monthly cost of servicing a mortgage is higher than a 35-year average. That means that the supportive effect of record low mortgage rates has now been fully offset by the scale of house price gains.

To be fair, it is not unusual for house prices in London to run ahead of those in the rest of the country. Indeed, this has been the pattern following each previous housing market downturn. However, experience suggests that such outperformance is always followed by a sharp slowdown in London while prices elsewhere catch up. For example, between the start of 1997 and mid-2003, prices across England and Wales rose by 50 per cent, but prices in London jumped by 150 per cent. Over the next three years, however, London prices underperformed so that the relative price of homes in London fell by 15 per cent.

The recent moderation in the London market may well be a sign that something similar is now beginning to play out, with prices simply having reached their limit. And if the market were to suffer a major economic or credit market shock over the next year or so, I suspect that London would initially bear the brunt of any house price correction. Yet if the economy continues to grow and interest rates stay below 2 per cent for the foreseeable future, the next year or two should be characterised by a period in which London prices mark time.

Ed Stansfield, chief property economist, Capital Economics