How much should we worry about a house price crash?

One question that economists dread at parties is ‘what is going to happen to house prices?’. The sensible answer is ‘I don’t know and I can’t give you investment advice anyway’. But for what it is worth, here are my two hunches.

The first is that UK house prices are likely to fall further and more quickly in 2023 than most expect. The second, though, is that this will not harm the economy anywhere near as much as many fear.

Looking back, 2022 was the cliched ‘year of two halves’ for the housing market. The first half was buoyant. House prices rose sharply as the economy opened up again, many people reassessed their property needs (especially those now ‘working from home’), and borrowing remained cheap.

The market then began to slow in the second half of the year, as the cost-of-living crisis worsened, recession worries grew, and mortgage rates took off.

By the end of 2022, house prices were already falling (for four successive months on the Nationwide index), with some of the largest declines in areas (such as central London) which had dropped most out of favour during the pandemic. The latest RICS survey was pretty downbeat too.

The fallout from Kwasi Kwarteng’s infamous mini-Budget did not help either. It froze the market temporarily, as heightened uncertainty about the future path for official interest rates caused lenders to withdraw products, and deterred potential buyers.

That said, mortgage costs would have risen sharply anyway as the Bank of England finally returned official rates to more sustainable levels, and as the combination of higher interest rates and a weaker economy drove up mortgage spreads (the difference between mortgage rates and underlying interest rates).

The same thing has happened in the US, where mortgage spreads have jumped and long-term fixed rates have more than doubled, and to a lesser extent in the eurozone (where monetary policy is being tightened more slowly, partly due to the structural problems in the single currency area).

The consensus now is that the downward trend in UK house prices will continue through 2023, reflecting a combination of higher interest rates, lower real incomes, higher personal taxes, and a weakening jobs market.

These headwinds may be offset to some extent by the shortage of supply, as housebuilding has failed to keep up with population growth, but this tailwind is little new. Instead, the big change is that people can no longer afford to pay such high prices.

Consistent with this, the Halifax is predicting that house prices will drop by around 8 per cent next year. Others are forecasting a similar but more drawn out decline: the Office for Budget Responsibility (OBR) is expecting a fall of 9 per cent between the fourth quarter of 2022 and the third quarter of 2024, and Knight Frank is going for a decline of 10 per cent over the next two years. The Nationwide and Zoopla are hoping for a relatively soft landing, with prices only falling by 5 per cent in 2023.

If the housing specialists are wrong, I suspect it will be because house prices fall more quickly and further in the first half of 2023, before a limited recovery in the second.

In part this is because almost everyone now expects a significant decline in house prices. Even those predicting a smaller fall are warning of the downside risks. Given this, why would anyone want to pay the current asking price for a property that might be worth 10 per cent less by the end of the year?

Basic economics therefore suggests that any price fall will be brought forward. It may only be the relative lack of activity which is preventing this from being clearer in the data already.

Hopes that the fall will be less than 10 per cent also look optimistic. For a start, a drop of this size would reverse less than half of the sharp rises over the last few years.

The Halifax index, for example, increased by 23 per cent between March 2020 and August 2022, and has risen by 71 per cent over the last decade. According to the Nationwide, the average London house has increased in price by an astonishing 304 per cent since 2000.

Affordability is also increasingly stretched as house prices have continued to rise much faster than wages, with typical first-time buyer deposits in particular now at an all-time high relative to incomes.

This did not matter so much when interest rates were low, but this is clearly changing. According to the Bank of England, around 20% of owner-occupier mortgages (or 1.7 million households) are on variable rates linked directly to Bank Rate (which has already been increased from 0.1 to 3.5 per cent). Average two-year and five-year fixed rates have also jumped, from around 2 per cent to around 5.5 to 6.0 per cent.

On top of this, there are around two million buy-to-let mortgages, the vast majority of which are ‘interest only’. Landlords are likely to pass on higher interest costs as higher rents, or to sell properties (thus adding to the downward pressure on prices).

Stepping back a bit, most economists agree that the main factor driving up house prices since the mid-1980s has been the fall in the real rate of return on alternative assets. Previous Bank of England staff analysis has suggested that a sustained increase in the yield on inflation index-linked gilts of just one percentage point could lower the equilibrium level of real house prices by up to 20 per cent. That seems the right ballpark to me.

Nonetheless, the consensus may be wrong in another way too. A sharp fall in house prices – even 20 per cent – would not be a disaster for the economy and could even have some benefits.

It is usually assumed that ever-higher house prices are a ‘good thing’ because they increase the wealth of homeowners. Rising house prices can also encourage more housebuilding and boost tax revenues. Consistent with this, house price booms have traditionally gone hand-in-hand with a strong economy, and with buoyant consumer spending in particular.

The reality is more complicated. As every student of economics should know, ‘correlation does not necessarily prove causation’. Rather than rising house prices driving higher spending, both could reflect some other factor, such as a fall in interest rates or an increase in expected future income.

The ‘wealth effects’ from changes in house prices are often exaggerated as well. The key point is that houses are different from other financial assets, such as shares or bonds, because people also pay to live in them.

Some people will gain when house prices rise, typically older homeowners planning to downsize to a smaller property, or to withdraw some of the equity in their home. But many others will lose, including younger families hoping to trade up, or renters whose landlord needs to charge more to finance a more expensive asset. High house prices are also not good for spending if potential first-time buyers have to save even more for a deposit instead.

The upshot is that it makes more sense to view a rise or fall in house prices as something that redistributes wealth, rather than creates or destroys it. The bigger concern should be the factors that are causing house prices to fall, notably higher interest rates and lower disposable incomes (though the proportion of income spent on mortgage payments is still likely to be well below previous crisis levels).

As for any direct link between the housing market and other forms of consumer spending, including those associated with moving house, the level of activity is typically more important than the level of prices. Put another way, if prices are too high, the market will dry up, and a correction to a more realistic level would actually be healthy.

This is not, of course, to say that a sharp fall in house prices would have no costs. The negative headlines alone could further undermine consumer confidence, which has only just started to recover. However, a sizeable fall in house prices could do more good for first-time buyers than any number of gimmicky Treasury schemes.

In summary, my guess (not advice!) is that UK house prices will fall by between 10 and 20 per cent in 2023, compared to consensus forecasts of a decline of around 5 to 10 per cent. But this would be far from the disaster for the wider economy that many assume.

And yes, economists do go to parties. We are the ones arguing in the corner about how house prices should be treated in the official measures of inflation. But that is a debate for another day.

This is an extended version of a piece first published in the Daily Telegraph on 29th December 2022

One thought on “How much should we worry about a house price crash?

  1. Reblogged this on Calculus of Decay and commented:
    WORRY BIG-TIME. Not only is the aggregate global housing market subject to boom/bust cycles as a baked in feature…watch what happens when the property values tank and the ordinary people suddenly have upside down mortgage notes…adding to the purposely orchestrated destablization of everything we once knew as “material conditions of everyday life”..

    No loan modification without taking on wind/solar/dildo alternative energy renovations.

    No loan modification without clean Antisemitism score.

    No loan modification for a racism done ever.

    No loan modification if you ARE WHITE.

    Like

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