UK House Prices - Primary Reasons For a Sharp Fall

By: Nadeem_Walayat

The Market Oracle expectations are for the UK housing market to fall by 15% over the next two years. However this decline is not expected to be a gradual trend but rather periods of stagnation punctuated by sharp falls which could be of more than 5% in a single quarter! Therefore this article looks at the primary driving forces that could lead to sharp falls in the UK housing market.

1. Buy to Lets Mass Selling

Its a numbers game - The fundamental approach to buy to letting is for the rental income to cover the mortgage and all other costs associated with managing a property. Whilst 10 years ago, buy to let investments were a no brainier, i.e. a virtually cannot lose investment producing yields in many cases in excess of 10%, today's yields have by and large fallen below the costs of servicing buy to let loans. This is especially true for the most recent entrants that banks such as Northern Rock were more than happy to sign up right up to the first major blow out from the credit crunch in June 2007.

An estimated 1,000,000 buy to let mortgages have been taken out, up from barely 20,000 10 years ago. This illustrates the size of today's the buy to let market.

There are two main reasons why this million strong army of speculators could trigger a sharp drop in the UK housing market:

a. The Yields - As I have already mentioned the yield available today from rentals ranges anywhere from 3% to 5% of the value of the property. Add in costs of insurance and management / maintenance and the yield reduces by a further 1% to a range of 2% to 4%. Therefore whilst portfolios built up during the early years of the housing boom are more than manageable in payment terms, i.e. when houses prices where half their current price. The fact is that buy to letters can earn far more yield from high street high interest savings accounts of upwards of 6% without any of the associated time spent on managing properties. The only incentive to retain property portfolios is the expectation of capital gains. If this expectation evaporates then there would be no point to buy to let investments.

Off course recent buy to letters over the last 12 months that number more than an estimated 100,000, risk falling into negative equity. This associated with a rental income that does not covers costs, could trigger a wave of selling hitting the market so as to cut losses .A recent BBC report featured on "All About Money" demonstrated that many buy to let investors in the Flats market are already being hit by negative equity with associated rental yields not covering loans and therefore investors being forced to sell at losses of over £50,000 on properties originally valued at £200,000.

b. Government Tax Changes on Capital Gains - Gordon Browns Darling in all his wisdom has probably done more to set a date for a crash in UK house prices then any one could have imagined. Basically Alistair Darling has cut the capital gains tax on property investments from 40% to 18%, effective from 1st of April 2008. The effect of this would be that those sitting on fat profits built up over over recent years now have an incentive to sell to lock in profits whilst they can. Whereas in the past the incentive would have been to hold onto properties for many more years to benefit from taper relief which would reduce tax liability from 40% to 24% over 10 years.

Whilst many market commentators view this tax change as a boost for the Buy to Let market. What it effectively means is that there will be NO tax incentive to hold onto properties. This will to some degree support the market in the lead-up to April 08, with the expectation for a large number of buy to let properties coming to the market in April 08. More so if the housing market continues to weaken.

2. Foreclosures (Repossessions)

UK repossessions rose to 17,000 by the end of 2006, and are on target to to more than double this year to over 40,000. The expectations are that 2008 will see the rate of repossessions double again to 80,000 as declining housing market impacts on the economy. Eighty thousand repossessions in 2008, would be more than the peak number of 75,000 repossessions during the last housing bust in 1991. As a sign of how shocking these figures we only need to turn back to the Council of Mortgage Lenders own forecasts of January 2007, which forecast 19,000 repossessions for 2007 and 20,000 repossessions for 2008.

3. Home Owners Downsizing.

Many Home owners, especially the over 50's are looking to capitalize on the huge gains in the property market by selling up their large houses and down sizing to smaller UK properties or to retirement homes abroad. These are so far the only real winners of the UK housing boom, i.e. those that actually capitalize on their gains, with cash in the bank. A declining housing market is expected to hasten the decision to act and add to the momentum of falling prices, especially in London.

4. Credit Crunch

The credit crunch increasingly impacts all types of property buyers, and has already seen mortgage approvals hitting a 7 year low, as the US subprime contagion continues to spread. There is little sign that the worst is behind is, with US Adjustable rate mortgage resets unlikely to peak until March 2008 and stay at high levels of resets until September 2008.

The impact of the credit crunch is directly felt in the surge in mortgage interest rates which are in large part based on the LIBOR rate (the rate which banks are prepared to lend one other), that have surged in the wake of the credit crunch as a consequence of increased risks which was evident during September when Northern Rock Bank teetered on the brink of collapse. For more on the credit crunch see -Hedge Fund Subprime Credit Crunch to Impact Interest Rates

Added to this we have yet to experience the impact of the UK subprime mortgage credit crunch. As more UK banks will be faced with mortgage defaults and bad debts, so credit requirements will be raised thus both increasing the price of credit and decreasing the supply of loans. Which will put a break on the housing market for the duration of 2008.

5. Affordability

The Market Oracle affordability index accurately explained why house prices were historically cheap in affordability terms during 2001, which was contrary to widespread bearish market commentary at the time as illustrated by the BBC News headline "House prices: Is the crash coming?"

House prices remained affordable right into 2006. However, as house prices approached the upper end of the decade long range, having failed to slow and moderate as they had during 2005, instead surged higher beyond the comfort zone range, despite rising interest rates which has led to the current state of unaffordability not seen since 1992.

During 2008, a slowing housing market is expected to hit households hard as taxes rise to meet the gap between government spending and government revenues. As an example of the size of the deficit, the government's budget should be in balance at this time as per Gordon Browns original Golden Rule, instead of which the government is estimated to end 2007 with a deficit of £34 billions. The forecast for 2008-09 is for £30 billions, but this is based on much higher growth target of 2.5%, whereas the Market Oracle forecast is for economic growth that could be as low as 1.4%, which would result in a much larger deficit, and further tax rises that will squeeze household incomes and thus ability to service large mortgages, that have in large part been built up as a consequence of equity release for consumption.

The expected trend of the affordably index between an anticipated market peak to a trough confirms the expectations for at least a 15% price drop. The expectations are that the affordability index will decline to below the 2005 trough, and possibly even extending to the bottom of the range which would imply a house price decline of more than 20%, as markets have a tendency to overshoot both at market peaks and bottoms.

6. Lack of First Time Buyers

UK House prices at an average of more than £200,000 have never been more out of the reach of first time buyers. This is reflected in the fact that there are less first time buyers than 25 years ago, i.e. you would have to go back to 1982 prior to the dawn of Margaret Thatcher's right to buy Council houses scheme boom.

This is not surprising given that the average first time buyer now needs to borrow more than X6 earnings to get on the housing ladder. In areas such as London, even with the higher salaries, multiples of X10 earnings are not uncommon, many of which have been taken out with self certification mortgages, which are primed for major difficulties given the rise in interest rates and housing costs.

First time buyers are taking on huge risks of going into negative equity and rising mortgage rates leading to increased risk of mortgage defaults and thus likely to add to repossessions.

Conclusion

The UK housing market is trending towards at least 1 quarter of price action that could be termed as a crash. The most probable quarter is April to June 2008, i.e. inline with the change in capital gains tax rules. However I would not be surprised if this 'crashette' will be followed by several months of rising prices, which the estate agents / banks and media will jump upon as a signal for the end of the UK's housing slump. This is as much as was experienced during the last housing market bust of 1989 to 1992. After the corrective rally, the third and more protracted series of house price declines will begin.

By Nadeem Walayat
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Nadeem Walayat has over 20 years experience of analysing and trading the financial markets and is the Editor of The Market Oracle, a FREE Daily Financial Markets Analysis & Forecasting online publication. We present in-depth analysis from over 100 experienced analysts on a range of views of the probable direction of the financial markets. Thus enabling our readers to arrive at an informed opinion on future market direction. http://www.marketoracle.co.uk

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