House prices: a bubble in London? | KPMG | UK

House prices: a bubble in London?

House prices: a bubble in London?

In 2007, UK house prices crashed for only the second time since the Second World War. They then hit rock bottom in 2009, before trending sideways until 2013. Over the past three years, however, they have risen again sharply, especially in London.

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Former Chairman, Economics and Regulation

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Bill Robinson

In 2007, UK house prices crashed for only the second time since the Second World War. They then hit rock bottom in 2009, before trending sideways until 2013. Over the past three years however, they have risen again sharply, especially in London. So much so, in fact, that I am often asked whether we are now living through a new housing bubble  ̶  a boom that will end in a bust.

There are two key benchmarks against which house prices are usually judged:  the ratio of house prices to income and the share of income taken by mortgage payments. Confusingly, these two markers currently tell completely different stories. 

As Chart 1 shows, average UK house prices now stand at nearly 8.5 times average earnings. Indeed, the ratio is as high as at the peak of the previous boom. But, because interest rates have been at historic lows ever since the crash, UK houses have on average never been more affordable. Mortgage interest accounts for only 9.2 percent of income for first time buyers and total mortgage costs including repayments are 18 percent of income (see Chart 2).

As long as interest rates stay low, new borrowing could sustain the housing market for a while. The house-price-to-earnings ratio tends to rise over time and is at present well below the peak-to-peak trend. Working on that basis, there could be some way to go before prices stall.

On the other hand, the turn in the market could be triggered by a rise in interest rates – as the last one was. We now see this on the horizon because the post-Brexit fall in sterling will, according to the Bank of England, push inflation above target later this year. Higher interest rates will follow, which means house purchases will become less affordable. By how much and how soon, though, is anybody’s guess. 

House prices are driven by the choice between renting and buying. If expected mortgage interest costs are higher than the rent for a comparable property, it is worth buying a property only if you think the capital gain on the property will make up the difference. If house prices are expected to rise fast enough, buying seems a good option.

If, however, you expect house prices to stagnate or fall over the next year or two, there is no point in taking on a mortgage interest burden greater than the rent for a comparable property. Those considering buying in London rightly worry about the vertiginous 65 percent rise in London house prices since the first quarter of 2011 (Chart 3). Chart 4 tells an even more worrying story, which shows how sharply London house prices have risen relative to London rents.

The relationship between house prices and rents is perhaps the most interesting metric of all. It has only recently become measurable at the macro level, thanks to new ONS data on rents. Just as the fundamental value of a share lies in the expected stream of future earnings or dividends it provides, so the fundamental value of a house lies in the stream of rents it generates. One key characteristic of a stock market bubble is a sharp rise in PE ratios, when share prices become very high relative to earnings. In a bubble, people buy shares not for the income they provide, but in the hope of selling them on at a still higher price.

Chart 4 does provide some evidence of a housing bubble. It shows how rapidly the average value of London property has risen relative to rents since early 2013. Buying at these levels is not an economical way of securing somewhere to live. It only makes sense if you believe that prices will climb still higher. Or, to look at it another way, those who are desperate to own their own home will buy at today’s very high prices for fear that tomorrow they will be even higher.

Of course, they may be right. The fall in the exchange rate post-Brexit has made London property an attractive option for many foreign property buyers. That fact could boost demand and keep prices rising for a while.

Is there a bust on the way? The truth is that, although interest rates and property price-rent ratios suggest the London property market is overheated, no-one really knows. It’s always much easier to diagnose a bubble than to predict when it will burst.   

Bill Robinson is an independent consultant and is writing in a personal capacity  

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