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Calculating house prices, the Coutts way

publication date: Aug 25, 2011
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House prices are going nowhere. With the exception of the London market, lenders aren’t lending and buyers aren’t buying to any comforting level. Why? Interest rates are low, house prices are low, many people still have good jobs, lenders have been told to lend by the Government, so why isn’t the housing market recovering?

A major factor is a lack of confidence in the next 5-10 years, in the fortunes of the UK and the wider world. And a very real feeling that although house prices may be low, the cost of everything else is rising, so affordability is a worry.

A recent report by Coutts says that the two conventional methods of working out whether house prices are too high – the ratio of (a) prices to income and (b) mortgage payments to average income – are sending conflicting messages. Obviously they can’t both be right. The problem with looking at mortgage costs as a measure of affordability is that it does not take into account the full economic cost of owning a home.

Now, Coutts & Co has developed a new method of calculating affordability that shows the full economic cost of owning a home. Coutts predicts that house prices are likely to come under further downward pressure as interest rates are increased over the coming year at the same time as real incomes are still contracting.

UK house prices are at historically high levels relative to incomes, while interest rates are at a record low, keeping mortgage payments below average. The full economic cost, according to Coutts analysis, is somewhere in between, being close to its long-term average. But this is not comforting, they say, as that average is well above the levels that prevailed following the bursting of the late-80s housing bubble.

income ratio and deposits

The average house price is currently close to four times median incomes, at the top end of the historical range and well above the average multiple of 2.8 times. The previous 30 years had seen the house prices/income average around 2.5 times and never hit 3.5 times. Post-2003, the average ratio is closer to four times and has not fallen below 3.5 times (see chart).

The main factor is the advent of low interest rates, which hit 3.5 per cent in 2003, at the time, the lowest level for decades. Easy availability of credit fuelled the subsequent rise in prices and the Bank of England reacted to the subsequent house bust, coincident with the global financial crisis, by cutting interest rates to their lowest level ever. The sharp rise in house prices did not raise mortgage costs significantly above average levels.

These costs have now fallen back to very low levels, so by this methodology UK house prices currently look inexpensive. But to obtain a mortgage the borrower must put down a deposit. Currently, for first time buyers, the average deposit is over £26,000, some four-fifths of the average gross salary. As a consequence of the time required to save for a deposit, theaverage age of an unaided first-time buyer is currently 37 years. First-time buyers accounted for only 37 per cent of the market in the first quarter of 2011, the long-term average is 45 per cent.

Carl AstorriAccording to Carl Astorri (left), Head of Economics & Asset Strategy at Coutts & Co, “To take the cost of the deposit into account, Coutts has augmented the calculations of interest cost by assuming that the money has been borrowed as an unsecured loan. This can be justified on a practical level, as buyers lacking capital seek alterative sources of unsecured borrowings to provide the deposit for a mortgage. On a more theoretical level, it can be seen as placing a more appropriate price on the capital used for a deposit. That deposit is not cost-free, as is only too obvious to those that lack such means, and involves an ‘opportunity cost’ if it is invested this way rather than in other assets.”

Coutts’ estimate of the full cost of asset ownership for a first-time buyer shows that costs have fallen back from very high levels, as both house prices and interest rates have fallen. However, the decline is only to the historical average and the total cost of ownership remains well above the levels prevailing in previous post-recessionary periods.

An equivalent calculation for all house-buyers suggests that the total cost of ownership, including the implicit opportunity cost of capital tied up, is down from recent highs and below the long-term average. But it is still well above the levels prevailing in the mid-late 1990s at the start of the last housing boom. By including the cost of the deposit, we have a measure that more accurately conveys the full costs for home-buyers and allows us to assess the relative attractiveness of residential property compared with previous periods.

This explains why mortgage applications have remained low and house prices have fallen back after an initial recovery.

The mortgage issue
The lack of recovery in mortgage applications points to falling house prices, Carl Astorri adds, “Against this backdrop, ANALYSIS we expect house prices to decline further over the coming year, although at a modest pace. Average household income will come under pressure from sub-inflation pay rises, given the very weak pace of economic recovery and high rate of unemployment. Increased taxes will weigh further on incomes, as the Government reduces its deficit. Credit availability remains poor as banks continue rebuilding capital after the financial crisis and lending will be constrained by new regulations designed to reduce risk and leverage on bank balance sheets. High levels of indebtedness by the UK consumer will also reduce appetite for new credit.

“However the low cost of sustaining existing mortgages means that there are few forced sellers in the market, provided there is no ‘double-dip’ back into recession, while the market is also supported by an overall shortage of housing supply. This should keep further house price falls to a modest level, as the UK economy continues its slow recovery.”