‘Since Londoners cannot seem to stop asking, “Is there a bubble?”, I’ve been trying to figure out the answer’
I predicted the UK house price slump of 2007. I was even planning to devote an episode of my BBC2 series to the subject back in 2006, until my producers demanded a different topic. They argued that house prices would assuredly keep rising, so I would seem silly. The replacement theme was “It’s hard to predict the future”; prices duly fell by 15 per cent in real terms.
This triumph should be set in context: I had been forecasting a slump in 2002, 2003, 2004 and 2005. Nevertheless, since Londoners cannot seem to stop discussing the question, “Is there a house price bubble?”, I’ve been trying to figure out the answer, both for Londoners and others.
This isn’t an easy question for economists to answer – bubbles are a matter of psychology, and psychology is not our strong suit. But we can attempt a diagnosis by looking at economic fundamentals. The price of any investment asset should be related to the future income you can derive from that asset, whether it’s the rent you can earn as a landlord, the dividends from corporate shares, or the interest payments on a bond.
A good working definition of a bubble is that the price of an asset has become detached from fundamentals, which means the only way to make money in a bubble is to find a bigger fool to take the thing off your hands.
What are fundamentals telling us? The most straightforward comparison here is of the price of buying a house versus the price of renting one. In the UK, both prices and rents are at high levels relative to income. This is no surprise: everyone knows that the UK has been building too few houses for many years.
But have prices outpaced rents, suggesting a bubble? It seems so. US house prices are at historical norms relative to rents, and German and Japanese prices are unusually cheap to buy rather than rent. Yet in the UK, house prices are one-third above their long-term value relative to rents. And in London, gross rental yields are lower than in other UK regions at a slim 5-ish per cent. Such returns look low, given the costs of being a landlord. Logically, either rents should soar or prices should fall.
Yet London prices have lost touch with London earnings and with the price of houses in London’s commuter belt, and they continue to rise quickly. All this seems unsustainable, and when interest rates finally rise, surely the distressed sales will begin?
But there are three counter-arguments. The first is that housing is different. The second is that London itself is different. The third is that this time around is different.
Let’s dispense with the argument that housing is somehow bubble-proof. Bricks and mortar seem reassuring but there is no law of economics that says money is safe in housing. Real Japanese house prices have almost halved since 1992. Real house prices in the US have soared and slumped and are now cheaper than they were in the late 1970s.
But what if London itself has a housing market that never falls? We only need to go back 25 years to see that this isn’t true. According to Nationwide, a UK mortgage lender, the average London home was selling for just under £98,000 in the summer of 1989. Prices then fell by one-third and didn’t top £100,000 for nine years. Cumulative inflation over the same period was well over 50 per cent. London housing in the late 1980s was a disastrous investment.
All we have left, then, is the argument that there is something different about London’s housing market this time around, because London has become an investment hotspot for wealthy foreigners seeking a safe haven for their cash.
Surprisingly, there is truth in this story. Research by Cristian Badarinza and Tarun Ramadorai, economists at the University of Oxford, finds that trouble spots across the world are correlated with hotspots in local London property markets. When the Greek economy imploded, for example, areas of London with a higher proportion of Greek residents saw a measurable pick-up in demand. The thinking here is that if a Greek wants to get his money out of Greece and into London, he’ll pick a place where he already knows people who can scout out property and where he might someday want to live himself.
Yet the laws of supply and demand have a habit of reasserting themselves eventually. Londoners might want to glance at New York – another ludicrously expensive city, and another magnet for money and people from across the world. House prices in New York have fallen by about one-third since 2006 and are at about the same level as in the mid-1980s relative to rents, income or inflation. In the long run, why should London be any different?
The final counter-argument is the most depressing. It’s that returns on all assets will be low in future because the world has entered a secular slump. That means that house prices should be expensive because other assets are expensive too. As Oxford economist Simon Wren-Lewis points out, the secular slump theory should apply globally if it is true. And while some housing markets, including those in Australia, Canada, France and Sweden, also look expensive, others do not.
If the secular slump tale is true, London housing is sensibly priced and property in many other parts of the world has yet to catch up. Heaven help us.
Also published at ft.com.