This issue describes a UK housing market that is diverse and fragmented, where conflicting signals on activity and price growth confuse those who are trying to put together the jigsaw puzzle of house price forecasts. Download here.

In the past six months, speculation over whether there could be a recovery in the housing market has mutated into speculation as to whether we are on the cusp of a housing bubble.

Over the past year average UK house prices have risen by 5% according to the Nationwide monthly house price index; whilst mortgage approvals for house purchase have grown by over one quarter and transactions by 15%. Such statistics have fuelled the housing market hysteria over the prospect that Help to Buy will lure large numbers of new buyers into taking on unsustainable levels of debt in a scramble to get onto or move up the housing ladder.

It is difficult to find hard evidence of either a widespread housing boom or a bubble. True, in the run up to the launch of the mortgage guarantee element of Help to Buy, new buyer enquiries rose dramatically according to the RICS. But transaction levels and mortgage approvals respectively remain 40% below those in a normal market.

Cash dominant

Cash remains the dominant source of funding for house purchase. Only 38% of the sums spent on house purchase were funded by mortgage debt in the year to the end of June 2013. In this equity-driven, partially-functioning market those taking on a mortgage have tended to be more affluent; with a distinct division having opened up between the average UK household income and that of a reduced number of mortgaged home buyers since 2007-08.

Consequently, the areas that have seen both the strongest levels of transactions and the highest house price growth have generally been the more valuable markets with the deepest seam of existing housing wealth.

London, where a record of £9bn of equity was applied to house purchase in the second quarter of 2013, has seen the strongest price growth though even here there is a clear divide between the most and least valuable markets. This is not unusual at this stage in the housing market cycle, though there is evidence that the ripple of positive sentiment is beginning to flow into and, in some cases beyond, London’s hinterland.

1996 revisited?

If we were to benchmark the market by reference to previous housing market cycles and the regional pattern of current house price growth, we would be in 1996 when the last housing market recovery firmly took hold.

The affordability of mortgage payments has recovered in a similar fashion, albeit at much lower mortgage interest rates that are likely to increase over the period of our forecasts.

However, the average cost of a deposit is much higher relative to income than in 1996, a secondary factor that is likely to cap price growth and continue to restrict accessibility to homeownership among less affluent households and those on the lower rungs of the ladder, irrespective of government initiatives.

Against this context the biggest determinant of house prices will be mortgage interest rates. The current mortgage interest rate of 3.5% provides capacity for sentiment driven house price growth in the short-term.

Over the medium-term a five year price rise of 25% would see mortgage affordability fall but leave a sustainable household surplus to cover the basic costs of living should average mortgage interest rates reach 5% by the end of 2018. At this level of growth mortgage rates would have to rise to 7% for affordability to be as stretched as it was immediately prior to the 2008 downturn.

Stronger price rises in excess of 35% to 40% over that five years would also stretch affordability in a relatively benign interest rate environment and substantially affect the affordability of deposits, even if loan to value ratios returned to their pre-crunch levels.

This would leave the market exposed to further rate rises and act as a major constraint on transactions particularly on the lower rungs of the housing ladder.

Rational pricing

Much then depends on whether the market acts rationally or whether buyers rush to ride a wave of positive sentiment. Certainly, we know that the Bank of England is alive to the perils of an overheated housing market and will take steps to curtail recent government intervention or, if necessary, restrict the flow of mortgage finance in these instances. The problem that it faces is that this could widen the gap between the haves and have-nots in anything other than a credit-fuelled boom.

It seems to us unlikely that this will occur, earnings-led price growth remains the most likely outcome with a continued squeeze on mortgaged owner occupation that limits the recovery of transactions and results in continued growth in the levels of private renting among younger households.

Taken from
Residential Property Focus Q4 2013

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