The bull cycle in UK property prices

David Guthrie - Wed 14 Jul, 2004

...Two clear warnings convince me weve already hit the top of yet another bull cycle in UK property prices...

The bull cycle in UK property prices

Two clear warnings convince me we’ve already hit the top of yet another bull cycle in UK property prices.

Neither sign is what you would “rocket science”; both are grounded in common sense. Both also pointed to the start of the last major property slump - that began in autumn 1989...and lasted for another 7 years.

The first bell to toll on the UK’s housing bubble is the upwards turn in the interest-rate cycle. Back in 1988, rates bottomed at 7.5% after a long drift lower from the peak of 17% seen in 1979. By October 1989, they had doubled to 15%. Rates next bottomed in the middle of 2003 - this time at 3.5%, having again spent many years in a broad drift downwards from that 1989 peak.

Of course, we’re unlikely to see a return to rates in the teens; I am not even expecting them to double this time round. But when the property bulls adduce this as an argument that property investors and new homebuyers will get away unscathed, they’re wrong.

The bull cycle in UK property prices: In the past

Borrowers are now much more indebted than they were in the past. Record low UK interest rates have encouraged people to take on larger and larger mortgages, stretching themselves to the limit of affordability. A rise in rates of 1.5% to 2.0% may sound insignificant compared to the hike of 7.5% we witnessed in the late ‘80s. But it could mean an increase of 50% in monthly mortgage payments.

Roger Bootle of Capital Economics also points to today’s historically high ratio of average house prices to average income...now at over 5.5 times. The bulls riposte is that, if you compare average mortgage repayments to disposable incomes, this gauge remains well below the peaks of 1988-9, of around 70%. But this measure is rising. Every interest rate hike will send it higher.

The second clear sign that residential property prices in the UK are already turning down is that - as ever - London is leading the way. The Halifax’s data for the late ‘80s show a pattern very similar to what we have now. London prices led the swing higher, rising by 21.6% in 1986 and then by 25.7% in 1987. Meanwhile, the nation as a whole generally saw advances of only 11.0% and 15.4% respectively.

By 1988, London was still moving higher at 22.3%. But significantly, its inflation rate had been overtaken by the general UK’s rise of 23.3%.

But this was the bell that Britain’s over-geared property buyers refused to hear. By 1989, the Halifax data shows, London had slowed to 2.3%, while the UK was still surging at 20.8%. The rot set in nationwide the very next year, 1990. London prices slid by 5.8% and prices in the UK stayed flat. The ensuing slump lasted until 1996.

The four years leading up to today look very similar:

    London    All UK
2000    17.5%        9.8%
2001    14.7%        8.5%
2002    16.6%        17.4%
2003    12.8%        22.4%

So, we see the first crossover occurring in 2002; then, last year, the widening disparity emerged with London slowing to a 12.8% increase, while the nation as a whole raced ahead at 22.4%.

The bull cycle in UK property prices: Property isn't selling

In the first quarter of this year, the Halifax figures show London slipped to 9.1%, with the UK only slowing to 18.5%. And anecdotally, the evidence from estate agents in London is that the market has become very sticky since May: property is not selling, details are reappearing with prices marked lower, and prospective buyers are holding back - especially following the soothsaying of Mervyn King in June.

My guess is that the coming numbers will continue to show weakness. But the big question is whether we are witnessing a slowdown or a downturn. I suspect the latter.

There is clear statistical evidence that the rapid advances in house prices of the last few years represent a bubble. When you take general inflation into account, real average house prices stood still between 1973 and 1998 (1973 is the earliest date for which there are figures available from the Nationwide Building Society).

So in fact, property remained a remarkably good store of value through the rampant inflation of the '70s and ‘80s. In this current cycle, however, house prices have more than doubled since 1998 - while general price inflation has been very subdued. This smells of bubble, and is clearly what worries the Governor of the Bank of England. The Halifax produced a report in March showing that eight out of ten towns in the UK are now unaffordable for first-time buyers. There is also evidence of widespread earnings misrepresentation in mortgage applications from people desperate to get a foot in the market.

At the same time - and at all levels of the great property ladder, not just the bottom rungs - the massive increase in interest-only mortgages represents a desperate resort of buyers unable to afford traditional repayment mortgages. We also note that interest-only borrowers are also the most vulnerable to rate changes.

The bull cycle in UK property prices: The UK property bubble

Moreover, the UK property bubble of the early ‘00s became a vehicle for bubble mentality speculation...as evidenced by the mania for mortgage equity withdrawal. As a percentage of post-tax income, it has soared beyond the levels last seen at the height of the ‘80s boom.

Buy-to-let investment, meanwhile, accounted for 25% of all the new money coming into residential property in 2003. Back on 15 April, I emailed The Zurich Club’s managing editor, Frank Hemsley, to say: “The involvement here in the buy-to-let market is as epidemic a concern as the dotcom mania was five years back.” Everywhere I went at that time, people were talking about buy-to-let in exactly the same feverish manner as they had about tech stocks in 1999-2000. And these people were not professional or full-time investors. They were ‘ordinary joes’, fired with enthusiasm for the latest get rich quick idea.

ARLA, the Association of Residential Letting Agents, in their first quarter 2004 survey of buy-to-let landlords, reports that 57% have only one or two properties. This suggests that the majority of participants are amateurs, dangerously unprepared to cope with the vicissitudes of a bear market.

If you are invested in buy-to-let, we believe you should think carefully about realising some capital gains at this stage in the cycle. Tax implications, however, will be as important a consideration as the near term direction of the market for many. Consult your tax adviser before acting. But be sure to research your options.

Going forward, the probability of a flat market at best - and the strong possibility of a massive price slide combined with declining rental returns - categorically make now the wrong time to initiate any new investment in the buy-to-let market. The latest ARLA figures show average weighted returns on residential property falling from 5.4% to 5.1%. On flats, the return has dropped from 5.6% to 5.4%. But even these figures assume 52 weeks per annum of rental income and ignore running costs. Real yield figures, which can validly be compared with yields on shares, gilts or cash, are a whole lot lower.

If the only property you own is the house you live in, it shouldn’t matter whether its value goes up or down - as long as you have not stretched yourself to the limits of affordability. You should not speculate with your home.

But when all the costs of running a buy-to-let - plus void rental periods - are taken into account, the net picture looks much less rosy figure. Your money is better off in a building society than a building.


Regards,

David Guthrie
for the Daily Reckoning

P.S. No one can be certain of what will happen to UK house prices, this most unpredictable of markets. But the balance of probabilities suggests we will not simply suffer a flattening of prices, but real and sharp declines in value. Bubbles demand to be burst; this mania demands such a conclusion.

Yet the bulls claim that, because residential property will become eligible for inclusion in self-invested personal pensions next year, a declining market will be avoided. I am a SIPP holder myself, and I welcome this new investment option. But I’m hardly going to rush into a market I perceive as vastly overpriced. I can’t imagine others will either. And in any case, SIPP holders are not numerous enough to halt the inevitable bursting of the bubble.

More significantly, the Financial Services Authority will take over regulation of mortgages from the end of October this year. They have already indicated they will do so with a heavy hand. More rigorous oversight means lenders will no longer be able to accept earnings misrepresentation on the part of new mortgage applicants. Desperation at the bottom of the market will lose its power to effect price growth.

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