Andrew Moffat
Overall, data for the London residential market implies that the market is overpriced (and has been for some time), but behaviour in the market at a small scale makes calculating fair value very difficult and transactions continue at current prices nonetheless. Will it all collapse like a house of cards, or has some of the analysis been blinkered and wrong?
During a recent train journey, I was reading the current edition of Scientific American. It had a good article on the fact that despite Quantum Mechanics’ first formulation being made in the 1920’s and much experimental work showing its accuracy for elements at a very small sub-atomic scale, it remains a mystery as to how the theory converts at a larger scale to the ‘classical’ world we live and breathe in.
On reading this article I reflected on the comparison with the UK, and perhaps more particularly the London housing market and the research I am doing to define what should be fair value at an asset level, at an overall market level, and how do we join up these two market levels?
At the ‘real world’ scale we live in, whilst there are signs of house price rises slowing down, people continue buying houses and flats despite overall data on affordability suggesting that – on average – it should not be possible. Doing some ballpark sums current housing sales seem unaffordable.
So how do house prices continue to exist at levels of 15x average earnings in most boroughs of London? Surely this is massively overpriced, with future trouble brewing up a huge storm?
Or is it a new paradigm? (don’t we just love those!) How do we formulate a coherent argument to bring the two together?
Consistently low interest rates are often quoted as a reason why these new house price levels remain affordable in reality. Also, low levels of new supply are seen as providing a floor for house prices. New, affordable, housing is scarce. Competition between buyers leads to house price growth.
By my calculations the affordability argument stacks up, but only if we can keep a lid on interest rates and if the restricted supply argument is in general correct.
What is happening when one person wants to buy one house? (the quantum scale, if you will indulge my comparison.). How does this lead to these high overall price-to-income ratios?
It should be reasonable to assume that in the current climate it would be considered normal for a purchaser to buy with a 20% deposit (whether own money or the Bank-of-Mum-and-Dad) and perhaps a mortgage at 4 times household salary. Let’s do the sums: even if a household with double average local salaries were to buy, I still only get to an income that can afford to pay a maximum 10x earnings for a house compared to the current transaction prices at 15x salary.
What else explains the gap?
Take your pick of some favourite suggestions:
· Averages don’t tell the true story. It’s the averages that get quoted and but it’s probably not the averages that buy: perhaps the wealthier are over-represented purchasers? Possibly, but what happens if you crunch the data and do the maths?
· If earnings data reflects what is produced i.e. earned locally rather than the earnings of people living in that area, there would be a data inconsistency. Especially in London people do not live where they work. How big is this effect?
· People in central London have loads of equity and so an analysis times earnings is not relevant. But the ratio in all but one London borough is over 10 times income.
· In some boroughs investment stock is over 50% of private stock and investors appear to be prepared to accept yields that push investment value above owner-occupier values (*psst* don’t tell the valuers).
· Values are just theory, just a figure on a piece of paper, for those who don’t sell. However the ratios are calculated on transactions, and doesn’t apply to all necessarily.
If you have any other suggestions how we the high house prices appear to stay in existence – please let us know! I have formulated my conclusions on the topic and presented these to our core of investment contacts. However, feel free to join the debate. The only hard conclusion is that you can estimate the level of prices on a macro basis but you must do your research at a micro level.
Andrew Moffat is an institutional PRS investment & asset management specialist, with a solid basis in RE debt on top. Andrew also has experience in BTR. Andrew is one of the main trainers on the Institutional PRS course run by Property Overview. For more information visit https://www.propertyoverview.co.uk/prs-courses
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