Inflation, Inflation, Inflation

The title may seem strange as this article is about residential property, but the reason will become apparent.

The value of residential property is close to our heart (and our wallet). One could argue we remain too obsessed about house prices, but whatever one’s viewpoint, it is helpful to try and get a broad perspective of the housing market.

According to the Nationwide house price survey the average house price as at end 2018 was £214,178. If you think this seems a lot, pity the poor first-time buyer. According to Nationwide’s affordability index for first-time buyers, the ratio of average earnings to price is 5.1x i.e. if you are a first-time buyer with earnings of £20,000 the average says you can buy a property worth just over £100,000. Not a great outcome compared to the average price of a house in the UK.

As with all statistics based around averages, the real story lies beneath the headlines. One of the major factors exerting an influence on affordability statistics in this country is prices in London. Would you be surprised if we told you that the affordability ratio in London is 9.2x average earnings? Perhaps, perhaps not. If you live in London we sense this will come as no surprise.

Looking at historic trends helps. It gives a better a sense of what is changing and the direction of travel.

London Affordability Ratio vs Rest of UK

Source: Nationwide Building Society, February 2019

The chart above tracks affordability for Londoners versus the rest of the UK. The average over time shows that property in London has always commanded a premium, averaging 1.5x compared to affordability elsewhere. However, we can see how it jumped to over 2x from late 2009. Recently, the trend has started to reverse and appears, emphatically so, to be heading down. The main point here though is that London prices have been distorted and continue to exert an influence on media commentary around prices.

A most significant factor to be considered when looking at house price growth is the effect from inflation i.e. what is termed real house price growth. This is where it gets interesting. The unsmoothed blue line in the chart below represents house prices adjusted for inflation whereas the pink smoothed line is a trend line showing constant growth in real house prices. There are a couple of points to note from the chart:

1. House prices are not keeping pace with their long-term trend real growth rate
2. Long periods exist when house prices have diverged both above and below the trend line in real terms.

In simple terms there is something going on.

Real House price changes v Trend

Source: Nationwide Building Society, February 2019

We must be upfront and say that there are many variables impacting residential property prices. Starting with a look at affordability and then lurching into real house price changes doesn’t tell the whole story. To get a full perspective you need to look at;

• Changes to supply from new builds and change of use

• Demand from household formation, which requires an in-depth study in its own right.

• Availability of mortgages and the cost of borrowing both having gone through marked changes over the last 20 years.

Certainly, taking the above into consideration, we have a complex pattern for examination later, but for now we attempt to put additional flesh on the bones of the real house prices chart.

If you refer to the chart you will see that in the 6 years from 1989 to 1995, a period including a recession in the UK, house prices fell by 37% in real terms. This is worse than the drop from the peak in 2007, before the financial crash. After the crash in real terms prices fell by 26% before recovering again.

We need to pay attention today to the fact that real houses remain substantially below their prior peak in 2007. When prices collapsed in 1989 it took almost twelve years to get back to their prior peak. We are now passing the eleventh year and house prices in the UK, on average, are 16% lower in real terms. Moreover, the slightly perplexing aspect is that the trend remains sloping downwards.

There is little doubt that UK property goes through long cycles. The cycle since the financial crash is probably more painful than many people realise. It only becomes fully apparent when you switch to look at property prices in real terms, after taking account of inflation. In case you are wondering, the average price level peak, without adjusting for inflation back in 2007, was £184,131 i.e. prices today in absolute terms have grown but they are lower in real terms because they have not kept pace with inflation