Strong house rebound in 2006 after 2005 slowdown

House prices continued to rise in the UK in 2006. After the slowdown of late 2005, 2006 saw a distinct pick-up in prices, accompanied by strong increases in rents.

According to Nationwide figures, UK house prices rose by 9.3% (3.3% in real terms) from December 2005 to 2006. This follows a moderate rise of 3.2% (0.07% in real terms) in 2005, and an impressive rise of 13.9% (14.75%) in 2004.

London house prices bounced back strongly in 2006 from the 2005 slowdown. Over the 12 months to December 2006, house prices had risen by 11.3% in London. This is higher than the 2.4% price rise in 2005. The average house price was around £269,327 in Dec 2006, more than 50% higher than the national average.

Among regions, average house prices in Northern Ireland increased the most, with an impressive 44% rise in 2006. Far behind in second place was Scotland, with 16% house price rises. House price changes in other regions were still impressive, ranging from 5.8% to 8.9%.

UK house prices have been continually on the rise since 1995. From Q4 1995 to 2006, average UK house prices have risen from £50,901 to £172,065. This is an overwhelming 237% increase in nominal terms (146% in real terms). Over the same period, average house prices in Northern Ireland rose by 330%, London by 263%, the South East by 245% and the South West by 244%. House price changes from Q4 1995 to 2006 in other regions were also substantial, ranging from 165% in Scotland to 241% in Outer Metropolitan.

Housing affordability concerns

First-time buyers are increasingly rare, due to higher house prices and higher interest rates. A research by Nationwide showed that higher house prices added £75 to typical first-time buyer monthly costs in 2006 compared to last year. With the recent increases in interest rates, the typical mortgage cost rises by almost £120.

First-time buyers in Northern Ireland are affected the most; typical monthly mortgage cost has increased by £285 due to the rapid house price changes. The increase was around £190 in Greater London.

Yet press and analysts have repeatedly got the UK’s house price situation wrong. Three years ago, David Pannell of Durlacher forecast that house prices would fall 30% nationally, with cities like Liverpool likely to be worst hit. John Calverley of American Express also expected 30% fall, while Ed Stansfield of Capital Economics forecast a 20% fall by end-2005. These forecasts have been wide of the mark.

UK unemployment is now at an all-time low, and CPI pressures are expected to increase. The Bank of England’s response has been to raise base rates. House prices are not an explicit Bank of England target, but a softening of house-prices would substantially impact consumer behaviour, so that any pronounced weakening of the housing market would likely be met with lower interest rates.

Overvalued?

Are UK houses overvalued? One useful measure of affordability is the ratio between house prices and earnings. House prices are now 7.8 times earnings in outer metropolitan London, 7.2 times in the South West, 6.7 times earnings in London, 6 times in the Midlands, 5.7 times in Yorkshire and Humber, 5.4 times in the North, and 4.5 times in Scotland.

In the fourth quarter of 2005, the national average of house prices stood at 5.9 times average earnings based on Nationwide figures. This suggests that UK house prices are more overvalued now than ever before in post-war history.

However, a less alarming conclusion can be drawn from using yields as a ‘valuation yardstick’. Yields in the UK have fallen over the past decade because of the rapid rise in house prices, combined with only a modest rise in rental levels.

Yet yields are not dramatically low. Gross rental yields in the UK now (Q1 2007) stand at 5.07%, according to the Association of Residential Letting Agents (ARLA). Prime London gross yields are at 4.97%, while ‘Rest of London’ gross yields are now at 5.05%.

Global Property Guide research produces similar results. Gross rental yields in London range from 4% to 5.4%. Mid-sized flats (100 – 150 sq. m.) in prime luxury areas in the centre of London have the highest rental yields, reaching up to 5.36%. Flats in other luxury areas in London have slightly lower yields, at 4.5% to 5.2%.

Housing shortage

UK house-building has largely failed to respond to booming house prices for the past decade, largely because of building regulations. Increases in population, immigration, and decreases in unemployment, have all added to the pressure, as have changes in household sizes.

The recent Barker Review (HM Treasury) concluded that to reduce the trend in real price inflation to 1.8%, the rate of new home building would have to increase by around 70,000 homes per annum, to around 195,000 per annum. Government figures show that homebuilding stagnated at 148,000 new units annually between 1989 and 2005. In 2006, 180,000 new homes were built, still low compared to 425,000 units in 1968.

Over the past five years planning policy has swung towards emphasizing the development of high-density housing on brownfield land. Over the past five years, apartment completions have grown from just 15% of annual completions to almost 45%. Most city centres have seen a rapid expansion in the supply of new apartments, many of which have been bought by investors.

Yet despite the high media profile of buy-to-lets, the private rentals sector is still quite small, and has remained stable over the last decade, at around 10% (16% in London).

“One possible explanation for this would be that private landlords have been taking share in the rental market from the corporate sector,” notes Kate Barker. And only around half of that stock is, actually, available of the open market, i.e., assured shorthold tenancies.

In conclusion, constraints on new supply (planning controls), and the current low interest rate environment, do seem to have increased the long-term equilibrium price of housing in the UK.

Yet it is hard to imagine further substantial capital gains from the UK housing market, which is surely vulnerable to interest rate rises. And in the context of an economy which has been growing above-trend since 1992, and which shows sign of capacity constraints, caution is in order.