Since a major source of leverage is the amount of debt employed, then the relationship between debt and equity is a key factor in assessing any commercial project. That's why we quantify the relationship between debt and equity in our company results and tips coverage.
A rule of thumb is that when the debt-to-equity ratio rises above 100 per cent then it's worth checking to see what's happening. Because the amount of equity in a group's balance sheet is much influenced by accounting rules, it follows that the ratio of debt to this often-theoretical figure can mean little. Yet sometimes the ratio throws out a warning that a company simply has too much leverage. And the higher the ratio, the more likely the warning should be heeded.
So how should we feel when we see a sector where debt-to-equity ratios are consistently over 400 per cent? If it were a corporate sector we might well be concerned. Should we feel the same if the sector in question is for residential mortgages, where the leverage ratio is the amount of a homebuyer's mortgage compared with the amount of equity contributed to the purchase price?
Probably, partly because homeowners - as opposed to businesses - can't deduct their interest costs against taxes. That said, when discussing debt in the personal sector, it's usual to compare it with households' disposable income net of direct taxes. On that basis, the UK's average is 155 per cent, which puts its debt-to-income ratio towards the top end of rich countries. Yet national averages mask great pools of debt building up in the UK's residential property market and the potential that brings for leverage to wreak its havoc. In its severest - and most worrying - manifestation this infects London's housing market, though in weaker form it applies nationwide.
Take Hammersmith & Fulham, a borough in central-west London that chiefly comprises Victorian housing stock of no great merit, where the template is a three-bedroom terraced house with a pokey garden. Despite these limitations, home buyers so love this part of London that average asking prices crossed £1m last year and, according to the latest data from Rightmove, continue to rise at a decent pace - almost 4 per cent in the year to April 2016.
Remarkably, this makes Hammersmith & Fulham London's most expensive borough, if we judge in terms of housing affordability. Here 'affordability' is measured by the Land Registry's ratio of house prices to median earnings in the district and I have excluded the boroughs of Westminster and Kensington & Chelsea - where the ratios are higher - on the grounds that, in effect, they have been transported offshore. That leaves Hammersmith & Fulham top of the pile, with a price/earnings ratio of 21 times; up from 13 times in 2011 and nine times in 2003.
Scariest are the implications of this ratio,
. Recall that the threat is leverage – the effect of fixed costs on a project. If the fixed costs of buying a house - interest payments - rise, then buyers are threatened.In Hammersmith & Fulham, these boys and girls are on the edge. That's the realistic conclusion from an average price of £1m and a price/earnings ratio of over 20. Assume a typical 80:20 mix of debt and equity in a house purchase; assume also median earnings in the borough of about £48,000, which is extracted from that house-price/earnings ratio. Trouble is, that's not enough to fund an £800,000 mortgage. So let's assume a double-income household, then it's do-able while mortgage rates are at their introductory level - typically 1.5 per cent. After two to three years, however, these rates leap to about 4.5 per cent. That's when payments really start to hurt. In our model, the Fulham 'dinkies' are then paying 58 per cent of net income to fund their debt, and that's before any spending on other necessities. If interest rates were to rise, the system would go into meltdown - a mortgage rate of 6 per cent would suck up 78 per cent of net income.
The picture in other London boroughs is almost as bad. In Haringey, where house prices have started falling, the average double-income household would be paying 52 per cent of net income with rates at 6 per cent. South-east England as a whole is also pretty stretched, where the fraction is 34 per cent.
Readers may object that the figures don't add up - maybe there should be more equity in the mix; maybe we should assume higher levels of income (though the assumption of double incomes throughout is already generous). But, actually, that's the point - the figures don't add up. House prices don't add up.
The signs of that are already present. Compared with the rest of the UK, Londoners are becoming poorer as housing costs absorb more of their net income, says the Centre for London think-tank. Simultaneously, the number of 20-somethings living in the capital is falling, reversing a 30-year trend. Somewhere, some day, something has to give. When it does, it will be painful - for house prices, for equity prices (they'll be correlated) and for the nation's wealth.
