Concerns for Conservative Homeowners in Britain and the Implications for the Property Market

Location: London
Author: Shahin Shojai
Date: Monday, April 20, 2009
 

In recent weeks a number of reports have suggested that may be the worst might be over for the U.K. property market and that there are signs of a potential recovery. How are these signs of recovery detected? Is it that the number of transactions has increased or could it be that the prices paid for the homes have risen, or even what they have been offered at on agent websites? It is genuinely very hard to determine house prices since no one really knows what they were worth a year ago to make comparisons. In order to determine the true state of the market it is necessary to know what price the property was sold for in the previous year(s) and what it is selling for now. Given that people don’t exactly change their homes every year it is a difficult thing to do.

Consequently, prices are determined by what an average home in a given market is either being sold for or placed on the market. No comparisons with previous prices of the same property are possible. It is one of those highly unscientific methods for pricing an asset. Let’s just say that stock prices, despite their own enormous problems, are significantly more accurate. Fortunately I had the opportunity to ask about how property prices are compiled by attending a presentation by the former chief economist of Halifax and attending a number of presentations of the methodology that is currently being used in the U.S., as developed by Yale’s Robert Shiller. I should say that a lot more thought, at least from a scientific basis, has gone into the model developed by Shiller, though I am not sure if it is any more accurate.

It is the totally unscientific nature of these reports that makes them pretty much useless when the markets are booming and when they are collapsing. They are probably underestimating the explosive increases in property prices in central London by a margin and 30 to 40%. Perhaps because those compiling the report could not believe their own eyes when they saw how a 3 bedroom flat in central London went from around £30,000 in the mid-1980s to over £1.25 million by 2006.

These same reports are now underestimating the falls in property prices, especially since unlike during the boom times the number of transactions has fallen. It is usually very hard to determine house prices during a correction, but it is extremely hard in the current environment. The reason is that with the requirement of a minimum 25% deposit, though some banks do accept 10%, most people have no way of financing a move; hence it is close to impossible to determine what the property would actually sell for. If you consider how much the property prices have fallen you can appreciate that even the most conservative homeowners are stuck where they are.

Just imagine a very conservative homeowner who has bought a house a year prior to the market peaking at £500,000. He/she was a conservative owner and had paid 30% of the original house price as a deposit. At the peak, the property was probably close to £570,000, so they had an unrealized gain of £70,000 at the peak. However, if the price has fallen to around £450,000, which is significantly less than the amount of the correction we are observing, he/she would still have £100,000 of his/her own money in the property. If he/she wants to purchase a new house they will have to buy a house which is only £400,000, excluding the costs of the transaction, since their £100,000 equates to 25% of a £400,000 house. You can imagine that with a fall to around £325,000, which is much closer to the actual market correction, they have lost all of their deposit and are in fact in a negative equity situation. And, this is the situation of a very conservative homeowner, not someone who was buying homes with 120% mortgages.

The question is, what can this homeowner do? His/her only option is to remain in their current house and thank to the cut in interest rates make lower monthly mortgage payments. As long as they are employed they do not need to sell, and even if they are made redundant they can pay the mortgage for a few months until they find a new job.

What this example illustrates is that while the cut in rates allows them to stay at their homes for longer it does not mean that it will help revive the property market. All that is happening is that those who invested in their future in a highly conservative manner are stuck in their current homes, providing a floor for the current prices. However, those who remain unemployed for longer than 6 months combined with those who took out large mortgages are pushing the prices in the market significantly lower than what is picked up in aggregate figures issued by Halifax or Nationwide. The reason that actual figures are much lower than the aggregate figures is that those who are stuck at their current homes are providing a floor by not selling their homes, and at least artificially keeping the average prices higher.

Unless banks lower the threshold for the amount of deposit they need the market will remain as is, assuming of course that unemployment does not pick up as aggressively as I feel it will. And, should the banks lower that threshold we will have another boom in activity not from the conservative investors but those who live off the mortgage itself, namely borrowing on a house and keeping the difference between its price and the amount of mortgage taken out. I don’t believe, however, that banks will ease the amounts of deposits they need anytime soon, since many are going back to the levels required during the period when banks were also conservative. Given that the securitization market has shrunk, banks are forced to keep mortgages on their own books, meaning that they will take much more care in issuing mortgages than they did when they could afford to ignore due diligence because they simply passed on the risks to those investors who bought these loans in packages known as Mortgage-Backed Securities or Collateralized Debt Obligations.

What this means for the first time buyers is that most will find it impossible to get on the ladder. A combination of bad job prospects and the need to pay the equivalent of around 6 years of their gross, not net, salaries means that most will be forced into the suburbs of big cities, and reliant on the exceptional service of the British rail system. This is, of course, assuming that they do have a job.

It is for the aforementioned reasons that I believe house prices will remain reasonably constant with not much activity in the market for a few months till those who have been made unemployed are forced into foreclosures. It is at this stage when the full impact of the property crisis and the economic slowdown it helped create will be felt.

This briefing is provided as general information, and does not constitute definitive advice or recommendations. Any views expressed in the above articles are those of the author concerned and do not necessarily reflect the views of Capco or any other party. Capco has not independently verified any facts relied upon in any of the comments made in any of the articles referred to. Please send any comments or queries to Shahin Shojai (shahin.shojai@capco.com). Shahin Shojai is the Editor of The Capco Institute journal (www.capco.com).

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