Why Lower Home Prices Are in Your Interest

“Gambling promises the poor what property performs for the rich – something for nothing.”
– George Bernard Shaw.

Where have shareholders in UK lenders and homebuilders been living for the past year – under a rock? When the Nationwide reported last week that British house prices had fallen at their greatest extent since the early 1990s – and homebuilder stocks subsequently incurred intra-day share price falls of between 5% and 8% – it should hardly have struck anyone, other perhaps than the Nationwide’s now wobbly permabull, Fionnuala Early, as a complete surprise. But as with stock markets, the housing market is only ever viewed by traditional investors as something that inexorably rises over time, like knife crime and inflation under New Labour.

As Pali International’s James Ferguson recently pointed out, last month’s RICS survey found that for every 20 surveyors asked, 19 responded that UK house prices were falling. Until now, the lowest score over the last 30 years was -64.8% in 1988 as the UK property market slipped into a 6-year downturn. “That followed a 6-7 year real price uptrend but this latest uptrend in real terms has lasted an unprecedented 12 years, so the downturn is highly unlikely to be short. The RICS survey suggests it is also unlikely to be shallow.” What, asks James, is the realistic downside?

This is difficult to say, as James points out, because the various estate agents and mortgage providers who provide the numbers constantly fiddle the figures in a naturally self-interested way. This is, of course, wholly different from Wall Street banks who happen to be major commodity traders issuing self-interested price “targets” to the markets and media at large.

The real figures are almost as distortedly unrealistic as the official inflation numbers. While house prices are variously quoted at the record level of over 6 times incomes, the average UK house price (excluding luxury properties) according to Land Registry data is over £230,000. As a multiple of ONS average wages, reckons James, houses are trading at well over 9 times salaries.

The metric of house prices to incomes is a moveable feast. Mortgage lenders use a measure of household income instead of the average salary (£24,800) because more and more home buyers are forced to combine two incomes to afford a property. Mortgage lenders then began to use the average of their customers’ incomes rather than the national average. As James points out, HBoS, the biggest mortgage lender in the UK, claims that an average first time buyer’s house bought through its company costs £146,882. It also claims that this is less than 3.5 times the first time buyer’s salary.

The upshot is that to be a first-time buyer in the UK, you now need to earn £42,000, or 70% more than the national average wage. The average age of a first time buyer was mid-20s until around 10 years ago; now it is mid-30s. “To price first time buyers back into the housing market is not going to be a 5%-10% move whatever anyone says. It will take a substantial drop.”

How much of a drop? James Ferguson suggests that mean reversion would see house price to salary income multiples return to 5 times, which implies an average house price of £150,000 (or a 35% fall) based on household incomes and trend multiples. But that price could end up being:

£125,000 (-46%) based on trend multiples and individual incomes; £105,00 (-54%) based on trough multiples but household incomes; or £87,500 (-62%) based on individual salaries and previous trough multiples. Since first time buyers are the lynchpin of a falling market, stepping in where others fear to tread, another way of looking at it is first time buyer house prices, which should fall to between £62,500 (-57%) and £50,000 (-66%) from today’s levels.

His conclusion, which by now should be obvious:

Real UK house prices will probably approximately halve and take several years to do it. This is the Big One.

But as with negative financial market commentary, this message will likely get tuned out or otherwise ignored by investors determined only to hear positive news and hanging grimly on in a state of wretched denial until they receive it.

And this state of denial is doubly unrealistic, because it ignores the fact that for consumers of financial assets (all investors of means other than those in full retirement with no alternative income), lower prices are actually in their interest. Or as Warren Buffett puts it:

If you plan to eat hamburgers throughout your life and are not a cattle producer, should you wish for higher or lower prices for beef? Likewise, if you are going to buy a car from time to time but are not an auto manufacturer, should you prefer higher or lower car prices? These questions, of course, answer themselves.

But, if you expect to be a net saver during the next five years, should you hope for a higher or lower stock market during that period ? Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall. In effect, they rejoice because prices have risen for the “hamburgers” they will soon be buying. This reaction makes no sense. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices.

But there is no use shrieking into the wind about our psychological deficiencies. Since our lizard brains are poorly adapted to taking the long view about investments, it is little surprise that we are lured by the siren song of apparently wondrous short term bull action and depressed by bear markets, even if those markets end up consolidating rather than dissipating our longer term savings.

The financial media are complicit in this trend toward collective impoverishment, in part because their “long term” consists of a succession of our daily or weekly purchases of their product, and, as discussed, we are easily lulled into backing that inappropriate short-term horse.

While lower house prices in the short term have little impact on settled homeowners and improve the lot of those trading up or of first time buyers, their impact is reported as akin to the effect of some dreadful type of plague. Lower stock prices, similarly, have little impact on investors comfortable with their overall asset allocations and again improve the lot of those entering the market for the first time. The equation of “lower” with “worse” is understandable, but lazy and in many cases wrong.

(Though James Ferguson is surely correct, as he suggested last Friday, with the view that falling UK house prices will cause a collapse in mortgage equity withdrawal, which will in turn soften retail sales, and probably trigger a recession. But the supposed good times never continue in perpetuity. On this note it was pleasing to read Jason Streets’ letter to the FT last week: “The chief lesson... from the Crewe and Nantwich by-election is that if you take credit for economic benefits beyond your control, the electorate will give you short shrift when you try to blame misfortune on extraneous circumstances.”)

And not all markets are necessarily even lower. It may come as a surprise to many, but the long-despised Japanese markets are now showing signs of rude health. The broad TOPIX Index is now up by over 20% from its March lows. And as Asian hedge fund specialists Stratton Street point out:

After ten years of stagflation, an economic recovery has begun to take hold, driven by regional growth, a consistently weak yen and significant structural reforms.. Japanese reflation is no longer a hope but a seeming certainty which should finally lift domestic demand and long term economic growth.

It would also appear that almost all of the long-only foreign managers have now abandoned the Japanese market in disgust. If anyone were looking for a secular ‘Buy’ signal, that would be it.

Comments

[bluesmoke]

Makes perfect sense to me. I empathize with those who choose to walk away from mortgages because the value of their home has dropped. But it's a risky move. Their credit is now ruined and they are back to renting. In the long run it would be wiser for them to keep their home, and try to get better terms on a mortgage. Over time, they will regain their paper losses. But many refuse to look past the end of their nose. That's where our educational system has failed them.

[WAKEUP]

A damn house is a curse. I bought into this "American Dream" crap when I was young, and knew no better. The only reason I am keeping my (finally) paid-for house is that I put up with the B.S. of home ownership (taxes, insurance, maintenance, ad nauseum) for so very long that I feel I am due at least some relief from either house payments or rent, now. If I were young, now, there is no way I would saddle myself with the debt and other entrapments that come with owning (on installments) a house. I would write the rent check, each month, and let somebody else worry about ALL the property details.

[johndough110]

Sounds like you're a shitty house hunter. I've owned 25 homes, and made a profit on 24 of 25. Currently own another one, and if you buy in the most desirable locations and tastefully renovate, you will make money, end of story. Your bad luck (and subsequent bad attitude) is your own doing, and just like stocks you can be good at it, or terrible.

Have a nice day.

[WAKEUP]

"johndough110&quo... is probably the life of every party, with his narcissistic lies, and outrageous boasts. Heck, why not claim you made money on 25 out of 25 houses; no one believes 24, any more than they would 25, so why not go whole-hog, Hog? And by the way, "johndough110,&qu... you're not fooling anyone. We know you are in the real estate business. Times are tough, now, aren't they? But don't worry; your sparkling personality and "tastefully renovated" face will see you through. But if not, buy two (2) houses, and call me in the morning.

[Johnc]

While I have made money in real estate, I tend to agree with Wakeup that the experience was less than pleasant with all the expenses that dangle from the investment. I am a happy expat now so the issue of home ownership has been deferred for a while.

The real issue I fear is that Americans are not psychologically prepared for the kinds of drops implied for the UK market. I have seen past real estate meltdowns in the UK and in Hong Kong. I am not sure that the US is really ready for what might come in the next 18 months. With an untested Democrat in the White House and a trigger happy (with my tax dollars) Congress, I fear the policy response could cause tremendously unpleasant unintended consequences.

[msaghirmd]

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