Readers Question: Critically evaluate the argument for and against the likelihood of an imminent house price correction in UK ?
House prices in the UK have risen much faster than inflation; in the past 6 years average house prices in the UK have more than doubled. This has caused many to speculate that house prices are overvalued and are likely to fall, in the near future, to more realistic levels.
These are the arguments in favour of house prices falls.
House prices have risen faster than average incomes.
This has made it more difficult for first time buyers, especially the younger generation to get on the property ladder. With falling demand for new houses, it is only a matter of time before this is reflected in lower prices.
Rising Interest Rates.
Interest rates have increased 5 times in the past 18 months. This rise in interest rates increases the cost of mortgage payments. Therefore, more people will struggle to make mortgage payments and therefore make renting more attracting than buying. It is also worth noting interest rates have a delayed effect; this means it takes upto 18 months for interest rate increases to have an effect on the economy. Therefore, even if interest rates don’t increase anymore, there will be more people affected by interest rate rises (e.g. those negotiating new fixed rate deals, will see a big increase in cost)
If house price rises have been caused by the fundamentals of supply and demand, there is unlikely to be any correction. However, some experts believe the booming housing market has created a ‘bubble effect’; this means that speculators and foreign investors have been buying houses to try and make capital gains. If the market turns, then these speculators will seek to leave the market and cash in their capital gains. This could make a small correction much bigger. – Falling house prices lead to a fall in confidence and discourage many others from buying.
UK investors may also be alarmed by the experience of the US housing market which has already gone from boom to bust.
Evidence suggests that house prices are already starting to fall in some parts of the country. Demand is falling from many areas of the economy. Bovis, the new house builder predicted prices would fall by 3% this year. link – Times
A study by PwC suggested house prices are overvalued by 10% - link BBC. This follows reports from the International monetary Fund IMF, which also states UK house prices are fundamentally overvalued.
However, it is notoriously difficult to decide whether house prices are overvalued or not. For example, back in 2003, many commentators argued house prices were already overvalued. The UK housing market has often defied Market predictions
The run on Northern Rock, was due to problems in global credit markets. These problems will have an increasing effect on the UK Housing Market. Basically, US mortgage lenders were too willing to lend risky amounts to sub prime lenders. When the housing market faltered there was a rise in mortgage defaults as people couldn’t pay back their repayments. Therefore, many US mortgage companies went bankrupt. This has made other financial institutions much more wary of offering support for mortgage lending. To summarise it is increasingly difficult to get mortgages, especially risky unconventional mortgages. Therefore, this will make it more difficult for first time buyers to get a mortgage; demand will fall further.
However, UK mortgage lending is generally much stricter than US. At the moment, there is not a significant problem of mortgage defaults. With interest rates unlikely to rise in 2008, affordability is unlikely to deteriorate.
Arguments against falling house prices
1. Shortage of supply.
Supply has failed to meet the rising demand. Thus the house prices are based on market fundamentals. There is no likelyhood of the supply shortage being fixed in the short term. Councils are reluctant to build houses in the UK.
2. Rising Population.
Immigration has helped to boost the UK Population, especially in the south east. This is creating additional demand
the rise in the population is being exacerbated by demographic factors which have been increasing the number of households. Basically, the average size of households has been falling. For example, increased divorce rates means that there are more single people living alone.
4. Strong Economy
Unemployment is low, inflation is close to government’s target and economic growth is strong and sustainable. With low inflationary pressures (CPI is currently 1.8%) there is scope for lower interest rates in 2008. This will help the housing market
5. Strong desire to buy
We cannot underestimate the strength of feeling that housing generates in the UK. Despite higher prices, people are still keen to get on the property market. Therefore, there are willing to borrow from different sources such as their parents. This means that the rise in the ratio of house prices / income could actually be more sustainable than people think.
However, there is no guarantee this desire for buying a house will continue forever. A fall in house prices would soon change people’s attitude to buying.
House prices are slightly overvalued and there is a significant element of speculation (such as buy to let). However, it would be a mistake to feel that the housing market is similar to a stock market bubble. There is a strong economic justification behind the rise in prices (simple supply and demand factors). Whilst these factors remain in place, house prices are likely to remain high, although it is likely that they will start to stagnate or grow very slowly.
Unfortunately, for those unable to afford their first mortgage, the situation is unlikely to change in the near future.