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Housing troubles

House prices are too high. It will take a long time to correct this
April 30, 2019

The UK’s housing market is in a mess. The RICS is likely to report next week that demand and prices are both falling.

The fact they are doing so now unconfirms two popular theories about what causes prices to rise.

One theory blames high immigration. If this were the case, though, prices should still be rising. Official figures show that net long-term migration was 283,000 in the 12 months to September (the latest available date). That’s well above the levels we saw in 2011-14. That house price inflation has slowed as migration has risen suggests the link between the two is weak.

A second theory blames a lack of housebuilding. True, building has risen recently: there were just over 165,000 houses completed last year, a slight increase on the past few years. But building is still lower than it was before the 2008 crisis, when prices were rising strongly. If a lack of new supply were responsible for driving prices up, prices would still be rising. 

If migration and housebuilding are not the drivers of house prices, what are? To see the answer, remember that housing is an asset just like shares or gilts. And the price of assets depends upon people’s willingness to hold the stock of the asset. Just as share prices are not, fundamentally, determined by new issues or new cashflows, nor are house prices determined by flows of supply. New building last year was only 0.7 per cent of the stock of houses. That’s not big enough to materially move prices.

Instead, what matters are interest rates. There has been a massive negative correlation between the ratio of house prices to earnings and the 10-year index-linked gilt yield: of minus 0.83 since 1986. The main reason for rising house prices since the 1990s has been that interest rates have fallen. This isn’t simply because lower mortgage rates increase demand for housing. It’s also because a lower interest rate increases the present value of future rents and therefore increases the price of the houses that generate those rents; this is why long-term interest rates matter.

Now, for a long time rising prices caused increased mortgage lending to sustain those prices. As Josh Ryan-Collins at University College London shows in his book Why Can’t You Afford a Home?, there was a positive feedback cycle between mortgage credit and house prices.

That process, however, cannot go on forever. For one thing, as Princeton University’s Atif Mian and colleagues have shown, increased household debt eventually depresses growth and increases economic instability. For another, there eventually comes a point at which credit constraints do bite and housing becomes unaffordable for many. And for a third, it is possible that the housing market has priced in the good news of lower interest rates but not the bad – that they might well be a sign of lower future growth in real incomes.

This does not, however, mean that house prices will crash. The housing market doesn’t work like that. Instead, sellers are often reluctant to lower their asking prices in the face of weak demand, or even to put their property on the market: the RICS reports that new instructions to estate agents are also weak. This causes prices to be sticky, and housing transactions to fall – something which itself can depress consumer spending. It is only gradually that prices decline. And this suggests that we might be in for a long period of housing market weakness.