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Unsafe houses

There's a big chance that house prices will fall in coming years
March 8, 2019

Valuations matter. All equity investors know this. But in fact it is even more true of the housing market.

My chart, below, shows the point. It shows the annualised change in house prices (adjusted for the retail price index) for every period since March 1983. So, for example, since December 1996 prices have risen by 3.4 per cent a year in real terms, but since December 2006 they’ve fallen by 1.1 per cent a year. Against this line I’ve plotted the inverted house price to earnings ratio for first-time buyers, as calculated by the Nationwide.

 

It’s clear that from 1983 to 2010 the two lines are almost identical. If you had bought a typical house in the mid-1990s when the price-earnings ratio was low you would have made a nice profit. If you had bought in 1989 when the ratio was high you’d have made much less. And if you’d bought when the ratio was even higher in the mid-2000s you would have made a loss.

So strong is the link between the price/earnings ratio and subsequent long-term changes in prices that nothing else matters. Valuations are all important for longer-term returns on housing.

Yes, my chart shows that had you bought between 2011 and 2016 you’d have made more than housing valuations predicted. This doesn’t mean the relationship between valuations and subsequent price changes has broken down, however. It might merely tell us that over shorter periods factors other than valuations can also affect prices.

With the price/earnings ratio still near a record high, of 5.1, according to Nationwide data, this relationship points to house prices falling in real terms for years to come.

You might object here. Surely the house price/earnings ratio is high because interest rates are low, and low interest rates make big mortgages more affordable, which makes high house prices sustainable, doesn’t it?

I’m not so sure, and not just because interest rates could rise eventually. Long-term real interest rates are low because expectations for future economic growth are low – which is bad for house prices. Back in the 1980s and 1990s we could reasonably expect high debt burdens to be eroded by big rises in real and nominal incomes. Today, we cannot.

Let’s put this another way. Think of the housing premium – the return on housing relative to bonds – as analogous to the equity premium. Why should this premium be high when expected returns on bonds (their yield) is low? It’s not obvious. What is more likely is that low bond yields and low interest rates cause investors to buy other assets – houses, shares, commodities, and so on – which raises the prices of those assets to levels from which subsequent returns are poor. In fact, valuations suggest this has happened to a greater extent in the housing market than in the stock market: the house price/earnings ratio is far above its long-term average, whereas the share price to dividend ratio is below its long-term average.

In truth, we have another measure that predicts poor returns on housing. It’s simply the ratio of consumer spending to house prices. When this is high it points to rising real house prices, and when it is low it points to falling ones. Since 1983, the correlation between this ratio and the change in real house prices in the following five years has been a hefty 0.68.

There’s a simple reason for this: the wisdom of crowds. Spending is in part forward-looking: if we expect our income to rise we’ll spend more than if we expect it to fall. Averaged over millions of people, these expectations are often more or less correct: for everyone who is mistakenly over-optimistic somebody else is mistakenly pessimistic. A high level of consumer spending, relative to house prices, therefore predicts good economic times. And these are ones in which house prices rise.  

The ratio of spending to house prices is now slightly below its post-1983 average, which points to very weak rises in real house prices – of 0.2 per cent a year over the next five years if past relationships continue to hold. This, of course, is consistent with a significant chance of them falling over this period.

The message, then, seems clear: the medium-term outlook for house prices is poor.

What could change this? Interest rate cuts are not the answer: these are only likely if the economy does badly, in which case house prices will fall. Another possibility would be greater policy support for prices, such as an extension of Help to Buy. Or it could be that our incomes will rise by more than either consumers or economists expect. But how likely is that?