Will an interest rate rise crash the property market?

For today’s blog post I will be looking at some UK related property market data to try to make some sense of what is going on at the moment and to plan intelligently going forward. This is a simplistic summary of a longer analysis that I will be doing this Saturday with the Tycoon Genius Partnership group.

Let’s start with the key factors that affect residential property prices:

  1. Supply of properties, existing stock as well as new.
  2. Demand, from existing population and those from outside the UK.
  3. Availability of finance and the cost of finance.
  4. Affordability, i.e. sufficient income to be able to afford finance payments or rent.
  5. Confidence among builders, lenders, home buyers, investors etc.

    1. Supply

In the UK, the supply of new build housing is largely controlled by a few large private developers (see chart below), unlike the system in Europe where most new residential housing is supplied by individuals building for themselves (more information here). The sharp drop off in local authority contribution to new housing is quite striking:

Local authority contribution to housing

Demand changes much more quickly than supply can adjust. For example, as the property market recovered from the 2008 crash, many builders struggled to scale up to meet demand. This was reflected in increased prices for materials, especially bricks which have a long production lead time and similarly, the availability of skilled labour was strained and remains so. Developers are also constrained by the planning system and the availability of finance. Having said that, developers are interested in maximising profit so they balance building just enough to maximise profit margins whilst avoiding cannibalising each other’s developments since building more properties than markets can absorb will depress prices. What developers really struggle with is planning permission, especially for green field land.

Thinking about supply in these terms helps me understand why more far fewer properties than we apparently need are getting built out.

2. Demand

According to a government study, the number of households is projected to grow by over 200,000 per year (this is the demand that soaks up the new mentioned in the last section) and interestingly from a landlord’s perspective, one person households are projected to equate to ⅔ of the increase in households. Population growth accounts for ¾ of the growth in households:

United kingdom population

Source:tradingeconomics.com

In nominal terms (i.e. without adjusting for inflation), UK house prices have risen 4x in just 22 years. That is almost twice the rate of increase that Spain and the USA experienced over the same period. Clearly, it has been a remarkable period in which to own real property in the UK:

House price index

Source: Economist.com

Help to buy has made it easier for people to buy newly built homes by reducing the level of capital input from the buyer. The important thing is that help to buy stimulated demand to help get the construction industry moving. This is crucial for confidence because so many people are employed in construction related industries which leads to knock on confidence effects (mentioned later) that stimulate the housing market further.

3. Availability and cost of finance

It seems plausible that if borrowing becomes cheaper, more people will borrow money and compete for a limited stock of assets. Asset prices should then rise in response, given that supply cannot be scaled up easily to meet demand and this is pretty much what we see happening:

Real house price vs interest rates

The chart shows there is some correlation between borrowing costs and property prices. It is hard to predict what will happen when rates rise because there hasn’t been an equivalent period in the recent past where interest rates have remained so low for so long, but going on what has happened before, it would seem likely to have a dampening effect should rates rise sufficiently.

Finance is loosening up as shown in the chart below. It is interesting to split this into finance for BTL investors and non investors and see just how much buy to let lending has risen since the crash (I’ll talk more about this on Saturday):

United Kingdom mortgage approvals

Source:tradingeconomics.com

4. Affordability

Mortgage payments as a percentage of take home pay is low at the moment because it is cheap to borrow:

Mortgage payments as percentage of income

Increases in borrowing costs as a result of an increase in interest rates will not affect everyone. Those with little debt will hardly notice. Some will worry how far they may rise in the future and for others with too much leverage it will hurt. If rates rise quickly, over leveraged property owners could panic and this is why the Bank of England has spent several years softening up the public about a future rate rise.

Were rates to shoot up as they did in the late 70’s, and early 90’s, this could spell disaster for many owner occupiers and landlords whose incomes may not stretch to meet all their commitments.

A small rise in interest rates won’t hurt many landlords, but it will naturally make them realise they can’t stay low forever. Most investors I meet have simply gotten used to them being low and this is very dangerous in my opinion. The removal of mortgage interest relief will further hurt those with significant debt to service.


After inflation, property in Britain has risen 2.5x since the early 90’s:

House prices in real terms

Source: Economist.com

However wages have risen much less:

Real wage growth in UK

Source goldmadesimplenews.com

According to the ft, the lack of wage growth is due to dismal productivity, which, it could be argued is a result of low wages but that’s for another discussion…

This huge rise in prices and meagre income growth help to explain why as a multiple of average income, property prices in the UK are now nearly 7x from a low of 2.5x during the early 90’s crash (100 on the chart below represents the long term average of about 4x). Against average income, property prices in Britain are way above the long term average, and are close to the levels seen at the height of the last boom:

Price against average income

Source: Economist.com

This is why young people cannot afford to buy a house on their own. They either share the burden with their partner who also needs to work, rent, or move in with parents.

5. Confidence

We do not read much in the papers about how ‘confidence’ affects asset prices because confidence cannot be easily measured, but just because you can’t easily measure something doesn’t mean it matters less than the things we can measure. I would argue that confidence matters a great deal.

People are more confident about property when prices have been going up in the recent past (e.g. 2006) than periods when prices have recently been falling (e.g. 2010). Exceptionally low interest rates have forced many investors to seek a home for their money, and many millions of pounds has flowed into residential property as a result. This creates a feedback loop: rising asset prices attract more investors who compete with each other for limited stock which causes asset prices to increase and so on..

We all feel more confident when we have a stable income. This matters because loans on property require stable long term streams of cashflow. Therefore, when people feel they have the ability to take on mortgages, they naturally compete for property and prices go up:

Unemployment vs property prices

Also notice the positive correlation between unemployment rates and property transactions:

Unemployment vs number of property transactions

People generally feel confident about the market at the moment, and judging by some of the behaviour I have observed in auction rooms, there is some overconfidence. As Warren Buffett famously says ‘Be Fearful When Others Are Greedy and Greedy When Others Are Fearful’.

Conclusion

So will an interest rate rise crash the market? Pundits will insist they know the answer, but I’m always suspicious when someone is convinced they have the right answer but he has not bet any money on it. You might look at the evidence in this blog post and decide (as I have) that UK property seems expensive.

The best we can do as investors is plan for the future. Should homeowners and investors lose confidence in the market, or there is some major shock to the system then prices could fall. This could present a buying opportunity for the prepared.

If you are coming along to our next Tycoon Genius Partnership meeting this Saturday I will be presenting my detailed findings and discuss further with the group.

Parmdeep Vadesha

P.S. I have not had the chance to list all my data sources, but if you want to know where I got any of the data from just drop me a line.

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