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House price doom-mongering: cheer-up chat

The Centre for Economic and Business Research has today published it's weekly briefing and discuses why it thinks house prices would bounce back even if they did fall in 2004/5. This is what the CEBR said:

There seems to be a competition on to frighten people into thinking that their houses will decline in value. One of our commercial rivals is warning of price declines of 'up to thirty per cent' - technically a fall of only 1 per cent would be consistent with this but the language used is clearly designed to create a more scary impression. The Financial Times devoted the entire front page of one of its weekend supplements to house price doom-mongering recently.

The argument seems to be that because the ratio of house prices to average earnings has moved outside its past range it must inevitably fall back. I find it hard to take seriously any analysis of a market for a product that does not start by looking at supply and demand. In fact CEBR does some rather detailed analysis of the housing market which has been presented by us and our predecessors James Morrell Associates in a report called Housing Futures released annually for more than 20 years.

This analysis is broken down by region and by type of property. Looking at demand, the combination of immigration and declining household size mean that there will be a demand for an increased number of properties - we forecast an additional 4.2 million households in the UK in 2020 compared with 2000, mainly in London and the South East. Looking at the supply, at least in 2002 there has been some recovery in housebuilding.

In 2001 the number of properties built was only 176 thousand, the lowest since the 1920s. The figures for London and the South East show that new build is providing only about half the number of new properties that the market would like to purchase without excessive house prices.

We expect an increase in housebuilding of 13% in 2002/3 but even so the level built will be well below what the market demands.

Because planning rules continue to be restrictive and because the government is able to demand that developers build a proportion of so-called social housing (in effect an unlegislated-for special development tax on housebuilders) developers will only be tempted to build a sufficient supply of housing if prices continue to rise. If they do not, development will slow down, aggravating the shortage.

Supply and demand (which is also influenced by incomes) should determine how much people are prepared to pay for housing. How this translates into house prices depends on the rate of interest and of course on expectations about how house prices will move. Those whose models of the housing market are based only on a ratio to earnings are implicitly assuming that this will be in the same range in the coming years - when interest rates are likely to hover around 5% or below - as in the 1980s when they averaged 12%.

Because anyone buying a house has to take future house prices into account, it is possible that the current gloom mongering could prove a self-fulfilling prophecy - for a while. But in the long term supply and demand are key. And if house prices do start to fall in the near future consumer demand will weaken and interest rates will go even lower than they are today.

Our own latest forecast (to be released after Christmas) shows the price of an average house in the UK rising by 6.4% during 2003 and falling back by 5.4% in 2004 before levelling out with a rise of 0.5% in 2005. Obviously some (eg owners of houses worth more than £2 million in London) will do much worse than this. But they are atypical - normally the housing market works from the bottom up, not from the top down.

House prices cannot continue to rise at the present 20%+ rates. But over the longer term they will have to adjust further to take full account of the move to low interest rates and of demographic changes - our prediction to 2020 is that they will rise by 1.3% a year faster than average earnings.