UK Housing Market Historical Background

A convenient summary of the history of the British owner-occupied housing market can be seen in Figure 1, which displays the ratio of average British house prices to average earnings, on a log scale.

As can be seen, in mid-2001, the ratio of average prices to average earnings is not far from the historical peak in 1989, though a similar chart for the Halifax house price index instead of our index from the Dept of Local Government, Transport and the Regions, would show the situation in 2001 in a more moderate light.

Many factors conspired to produce the house price boom of the late 1980s. Initial debt levels were low as were real house prices, giving scope for rises in both. Income growth after the early 1980s recession was strong, as were income growth expectations and house prices became more sensitive to expectations as a result of financial liberalization, though partly offset by greater sensitivity to real interest rates. Wealth to income ratios grew and the spendability of illiquid assets was enhanced by financial liberalization. Financial liberalization also permitted higher gearing, levels, as borrowers were able to obtain higher loans relative to housing values. Demographic trends were favourable with stronger population growth in the key house buying age group. The supply of houses grew more slowly, with construction of social housing falling to a small fraction of its level in the 1970s. Finally, in 1987-8 interest rates fell and the proposed abolition of property taxes in favour of the Poll Tax gave a further impetus to valuations. The very experience of housing appreciation reinforced expectations of further appreciation to come.

The bust in the early 1990s was the result of the reversal of most of these factors. Interest rates rose from 1988-90. Income growth and growth expectations weakened. Demographic trends reversed. The revolt against the Poll Tax resulted in the introduction of a new tax, the Council Tax, which had at least some relationship with property values. Debt levels and real house prices had reached very high levels, while wealth to income ratios then fell and recently experienced rates of return became negative and made households more cautious. Mortgage lenders tightened up their lending criteria, in a partial reversal of financial liberalization. Under these conditions, not even the major falls in nominal interest rates that took place in the early 1990s, while real interest rates remained high, were sufficient to revive UK house prices. Our results suggest an important degree of persistence in house price changes, which can contribute to over-shooting. Moreover, the market is prone to 'frenzy', which implies a further potential for volatility. There is a risk of 'frenzy' when prospective rates of appreciation exceed the hurdles imposed by transactions cost, inertia and fear.

Evidence for such volatility can be found in the years 1989 to 1995 when house price to income ratios have gone from the second highest peak in the post-war period to the lowest level, probably since before the War.

Three dampening forces are operating on the upturn: less favourable demographic trends, fairly high levels of debt relative to income and relatively high real after tax interest rates, boosted by the phasing-out of mortgage interest tax relief. To this one can add the greater awareness by mortgage lenders of default risk and, by the authorities, of the UK housing market as a potential factor in macroeconomic instability. This last helps to account for the phasing out of tax relief on mortgage interest, for rises in Stamp Duty for the second year, and for the relatively tough stance, until recently, of the Monetary Policy Committee despite being constrained by the strength of Sterling and the outcry over plant closures in manufacturing.

On the other hand, the lending and borrowing risks associated with high loan-to-value and high loan-to-income ratios in the mortgage market were forgotten in some quarters in the last two years, though the Financial Services Authority provided a timely warning in the Spring. Furthermore, effective financial wealth relative to income reached its high point of the last 35 years in early 2000 and economic growth until this year has been healthy with unemployment continuing to fall. Moreover, the closest thing the UK has to a property tax - Council Tax - is poorly related to market values, and therefore dampens house prices less than did Domestic Rates, abolished in 1989. The rate of house-building has fallen to the lowest levels since the 1940's and, with supply restricted, rising demand must raise prices. It is likely that higher levels of immigration and greater earnings inequality have also added to demand pressures. A long period of low interest rates, helped by confidence in the Monetary Policy Committee, has led to moderate debt- service ratios despite the new records being set for mortgage debt to income ratios and has given consumers the feeling that interest rates will remain low for some time to come. Finally, the overshooting on the downside of house prices relative to incomes in the early to mid 1990s has helped to give the rises since then a momentum which, in turn, increases the risk that current valuations, at least in some locations, may have overshot fundamentals.

While medium-run demographic trends may be less favourable, many people under 30 postponed entry into owner-occupation in the housing recession of the early 1990s and its aftermath, when buying a house with a heavy mortgage still had the reputation with many of being risky. As these people have discovered their caution to be mistaken and as some of those caught in the repossessions crisis have begun to return to owner-occupation, demand for housing has been boosted.

This is another reason why the overshooting on the downside of house prices relative to incomes in the early to mid 1990s has helped to give the rises since then a momentum which, in turn, increases the risk of overshooting at the next peak.

One other element which probably contributed to the rise in house prices in the late 1990s, particularly in the London area, has been the 'buy-to-let' boomlet supported by a change in the attitude of mortgage lenders towards landlords. Fortunately, this boomlet carries with it some self-correcting tendencies: there is some evidence of higher vacancy rates in rented accomodation and flat or falling rents in parts of London. This dampens further purchases by landlords and by offering more effective renting options to potential buyers dampens demand for owner-occupied housing at the very high prices now prevailing in London.
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