House prices surge toward a 'tipping point'

Posted by Jaimie Kanwar on Tuesday, November 14, 2006

This week's viewpoint comes by way of a press release. Doug Shephard, director of Home.co.uk laments that just as the scene was set for affordability to be improved for first-time buyers a wave of market confidence has turned the tide again. This time though, suggests the cautionary tale, we may be on the verge of a nasty surprise...

Asking prices for UK homes took a 1.3% leap in November, according to the latest Asking Price Index report from Home.co.uk. This means that nationally, average house prices have increased for three, successive months and is a sure sign that sellers' confidence is growing.

A rally in asking prices signals an up-lift in market sentiment and a new upward trend, but the timing could not be worse.

These asking price rises come in the wake of September's interest rate hike by the Bank of England suggesting this initial inflation fighting measure was 'too little too late' to tame the inflationary pressures faced by the economy. This month, the UK central bank issued a further dose.

Will this second hike have the desired gentle braking effect on the run-away train that is the UK property market or will it stop dead in its tracks?

The combination of rising asking prices and interest rates is taking the UK property market into dangerous territory. In Q1 2005, high asking prices caused the number of monthly transactions to plummet. The market wobbled before transaction levels recovered through cuts in asking prices and the Bank of England base rate.

The market looks set to wobble again. Increases in the cost of borrowing coupled with rising asking prices are likely to slash transaction volumes and drive the market toward a 'tipping point'.

If the housing market retains some fluidity, the short-term outlook for first time buyers is bleak.

“Since 2004 we had observed a slow, downward trend in house prices - it looked as though the affordability gap for first-time buyers was closing as the 'froth' melted away. Over the last six months, the opposite trend has emerged. With sellers' confidence in the market on the rise and increasing interest rates, the affordability gap for first-time buyers is rapidly widening,” lamented Doug Shephard, director of Home.co.uk.

Caught between a rock and hard place, the Monetary Policy Committee (MPC) has no choice but to try bringing inflation under control. However cautious the approach, their actions could trigger a severe downturn in the UK housing market. The risk of reaching the 'tipping point' is real, similarly inflated property markets in Australia and the US have already tumbled, because of inflation fighting, interest rate hikes.

The need for caution on the part of the MPC is reinforced by recent reports stating that US house price deflation is the fastest since 1970. The US, mid-term, election results may illustrate to Gordon Brown just how unpopular such a correction could be. Too much caution, will mean that instead of preserving the value of capital, the Bank is simply 'fiddling while Rome burns'.

So Australia and the US have already lanced their asset price boils, surrendering their house prices to the altar of capital value. Will the UK have to make the same painful sacrifice? The Bank of England's published projections suggest they prefer the idea of slowing house price inflation but not raising interest rates past the 'tipping point' that would induce nominal falls in the value of UK property. An attractive idea but is it realistic?

As the precise location of the 'tipping point' is only known once it is transgressed, the potential for error in this stratagem, and therefore the risk, is large. Hyper-inflated markets do not like even the smallest whiff of such uncertainty and can self-destruct. This raises the questions: 'Why even try such a difficult blind balancing act? Why not bite the bullet and burst the bubble with a sharper rise in interest rates?'

Political suicide perhaps for the incumbent Labour party as the ensuing financial pain would be felt throughout the economy. However, we were told that the MPC was designed to make decisions without being influenced by politics and would be judged purely on what is best for the economy? If this New Labour creation exercises the independent power it is purported to have, Labour may be hoist on their own petard. Inflation must be controlled and economic fallout of a property bust may not be pretty.

If we want to understand the economic misery that can ensue when a property bubble is left to grow unfettered by the central bank, we should study Japan.

Japan suffered one of the biggest, and best documented, property market collapses of modern time. At the market's peak in 1991 all the land in Japan was worth about £10 trillion, almost four times the value of all US property at that time. The property crash came after the Japanese central bank finally moved to raise interest rates. House prices plunged into a fourteen year slump, from which they have only recently started to recover.

In 2005, Japanese property was worth less than half its 1991 peak. Meanwhile un-mortgaged UK property has more than tripled in value, reaching a total of around £3.6 trillion and debt secured on UK property has risen to around £1 trillion. These are both all time highs. Private homeowners were amongst the hardest hit. In Japan's six largest cities, residential prices dropped 64% between 1991 and 2004. By most estimates, millions of homebuyers suffered substantial losses on the single largest purchase of their lives.

Their experience contains clear warnings for UK homebuyers. One is to avoid the classic temptations of over-heated property markets; particularly the use of risky or exotic loans to borrow beyond one's means (e.g. Extended lending multiples, Interest Only and 125% mortgages). Another is to avoid property that may be hard to sell when the market cools.

Like their UK counterparts today, too many Japanese homebuyers overextended their borrowing to buy property that cost more than they could sensibly afford, wrongly assuming that house prices could only rise. When Japan's house prices plummeted, many buyers were financially ruined or caught in the negative equity trap. Unfortunately, a similar tale is now unfolding in the US.

Japan's story of post-crash woe also contains obvious lessons for UK policy makers. Firstly, MPC members should be mindful of the failure of Japan's central bank to attenuate the growth of the country's property bubble, although this lesson may have been learned too late. Secondly, policy makers should be aware of the Bank of Japan's failure to soften the fall and help reduce the pain.

Our policy makers need a crash plan. Only recently did Japan manage to reinvigorate their property market using deregulation to encourage new development. Most of all, Japan's experience teaches the need to be aware of the fabrication behind all asset bubbles - that prices will keep rising forever.

"The biggest lesson from Japan is not to fall into the same state of denial that existed here," said Yukio Noguchi, Finance Professor at Waseda University in Tokyo and a leading authority on the Japanese bubble (Martin Fackler, The New York Times).

"During a bubble, people don't believe that prices will fall," he said. "This has been proven wrong so many times in the past. But there's something in human nature that makes us unable to learn from history."

The Home.co.uk Asking Price Index reports may be viewed at http://www.home.co.uk/asking_price_index/

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House prices surge toward a 'tipping point'

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