Housing Part 1

The housing market. The UK's favourite pastime. Until recently...

For the last 5-10 years it has been hard to find anyone over 25 who did not hold an opinion (or expertise) on housing. Even now, it's not uncommon to believe that rising house prices go hand in hand with a healthy economy. Like boom goes with bust?

For a subject matter that many people understand, the intricacies can be quite complicated. Things like:

• What is a 'fair' average price?
• Have trends changed in recent years?
• Do granite worktops in kitchens add more value to a house than having 10 bathrooms?
• Is it linked to the current financial crisis? (obvious question!)
• How did high house prices contribute to our problems?
• What should 'normal' lending criterion be?
• What is a sustainable level of lending for the economy?
• If prices are too high, how can we tell when they are good value again?
• etc etc - the list is endless.

Here's my take on the key question:

What is a fair average price and how can we tell if housing is overpriced or underpriced?

Traditionally, house prices have a good correlation with earnings, so a good measure is the average price:earnings ratio. Namely:
Average Price / Average Earnings

The trend for the last 25 years (plus my 'best guess' of the next 3 years) is shown on the graph below.
Before the mid-70's, this ratio had a trend between 3 and 3.5 but more recently it has moved up closer to 4. Since the 1980's another theme has been that the ratio has fluctuated more - indicating more extreme boom and busts.

For the ratio to go up, either house prices have to rise or average earnings has to fall.
For the ratio to go down, either house prices have to fall or average earnings rise (inflation???).

The current cycle is a biggie! Using the Halifax data, the ratio peaked around 5.8 in mid-2007. That was 30-40% over the trend value (i.e. 30-40% overpriced).
It's currently (Dec 08) around 4.4, so is still 10-20% overpriced.

But note that prices overshoot on the down slope as well as the up. So house prices could well fall further...

If we assume that house prices bottoming out is key to putting a floor under the current problems (bank losses, repossessions, etc) then either prices need to fall quickly (deflation?) or wages rise quickly (inflation?).

This brings us to another key concept to master: 'nominal' and 'real' house prices. Nominal is the face value of the house at any point (e.g. £200k now and £200k 2 years later are the same nominally) whilst real house prices take account of inflation (so with 2 years of 10% inflation, the above example would have lost almost 20% and only be worth about £162k in equivalent terms). A lot of people don't 'get' real house prices - and our politicians know that!

If the politicians get their way and run the printing presses at full speed, nominal house prices could rise sooner than we think. But they would not 'real'-ly be going up in value...