Regional Housing Outlook - August 2001

Here are some charts of the current regional housing outlook.

In the last 30 years, booms in UK house prices have tended to be led by London and the South East, where house prices rose not only earlier but to a greater extent. East Anglia and the South West followed fairly closely, with the West and East Midlands some way, and the rest of the country - Wales, the North, Yorkshire and Humberside and Scotland furthest behind.

This is often called the 'ripple effect', as in a pond with London and its affluent commuter belt at its centre and generating waves (see map).

In the 1990s slump, falls in nominal prices were most pronounced in East Anglia, the South East outside London, the South West and Greater London, in that order. In the recovery-turning-into-boom since then, the biggest rises have been in Greater London, followed by the rest of the South East, the South West and recently East Anglia. This recovery has been led by the top end of the market, where foreign buyers have been particularly active since 1996, and therefore most visible in the most affluent areas.

Another important reason for top-end leadership lies in the fact that Council Tax, unlike the old Domestic Rates, is so little related to property values. For example, the marginal tax rate, in other words the extra tax payable on each extra £ worth of property value, is zero for properties worth £320,000 or more in 1991. Moreover, second or third homes attract only half the overall tax rate of the main home.

The regional picture disguises a great deal of local variation, which can be seen on the Nationwide, Halifax and HM Land Registry websites. However, understanding some of the underlying reasons for regional differences which lie in the industrial structure of employment, wealth ownership and indebtedness also helps to understand some of the local variations.

Figures 1 and 2 show house price to earning ratios of each region minus the same ratio for Great Britain. We use a log scale. To illustrate, the South East graph (indicated by SE) peaks at around 0.3 in 1987. This means that in 1987, the house price to earnings ratio was around 30 percent higher in the South East than in Great Britain, while in the North (NN), the North West (NW) and Scotland (SC) it was between 35 and 45 percent lower. This peak in the South East was caused, in part, by the rise of relative earnings in the South East in the 1980s.

Our research suggests that a one percent rise in relative earnings is followed by a two percent rise in relative house prices, holding constant things like interest rates, housing stocks, demography etc.

However, this is far from being the whole story, since an important role is also played by the portfolio investment motive, or, if you like 'speculation'. As noted in the Introduction, rates of return in housing have tended to be high in many of the last 40 years. People's experience of house price movements is one of considerable persistence in the rate of change so that, even without a particularly clear appreciation of the underlying forces, they tend to extrapolate recent rates of change. The upswing in house prices in the South East, outperforming the rest of the UK for as long as five years in a row, raised expectations of continuing gains. By gearing up with a mortgage, buyers could multiply the rate of return on their own cash many times.

So, seeing house prices rising, particularly when the rises began to exceed the transactions costs - estate agents' and solicitors' fees and stamp duty - the desire to buy increased, in turn helping to push prices up further.

Indeed, in the early 1970s and the late 1980s a speculative 'frenzy' resulted. Those active in the more affluent parts of the South East in the last 3 years will not deny that, at times, local conditions have been close to a state of 'frenzy': many buyers chasing the same house, houses being snapped up within a day of coming to market, and a psychological state among buyers to match.

One other factor, which has perhaps been even more important in the recent boom in the South East than in the 1980s, is the fact that UK financial assets are disproportionately owned by South East residents, given the importance of London as a financial centre. As Figure 3 illustrates, financial asset prices reached record highs relative to earnings in 2000, as measured by the FTSE100 relative to GB full-time earnings (note, the FT All Share index actually peaked in August 2000).

Furthermore, the spread of profit sharing and share option schemes have made incomes, particularly in the South East, more sensitive to profits and the stock-market than in earlier years. The figures from the New Earnings Survey, which refer to April of each year, and which under-represent earnings from these schemes, show an as yet only a small renewed widening in the late 1990s of the South East earnings premium compared with the average for Great Britain, see Figure 4. Indeed we have become concerned about the accuracy of the New Earnings Survey results for 2000 which show average earnings in London rising at only 1% comparing April 2000 with April 1999 while the Average Earnings Index for the country rose by 4.5%. Therefore, our charts rely on the New Earnings Survey only until 1999 and we assume that all regions experienced the same 4.5% rise in 2000. Similarly, we use the Average Earnings Index to project earnings forward to mid 2001.

The sharp divergence in house price to earnings ratios since 1996 between the South East and the rest of the country (less so for the South West and East Anglia, but very pronounced for the rest) has its roots, as noted above, partly in its regional outperformance in earnings, in financial asset prices and because of the regional preferences of foreign buyers. This has also been a period of low nominal interest rates and the higher debt to income ratio in the South East, therefore makes low interest rates act disproportionately on house prices in the South East. Note also that the phasing-out, now complete, of tax relief on mortgage interest with a £30,000 ceiling has had a larger negative effect on the lower priced regions. Finally, the fact that house prices in the South East fell to historical lows relative to earnings, gave more headroom to the upswing and more scope for upward momentum to build up.

If anything, the ripple effect has been less pronounced at this stage of the boom than in earlier episodes. Part of the reason lies in the overvaluation of Sterling: even after so much restructuring, it is still the case that regions outside the South East have higher fractions of employment in sectors such as the car industry, textiles and agriculture which are suffering so badly from international competition, especially from Europe, though strong economic growth, both in Europe and the US offered some compensation until this year.

As we noted in our paper on regional earnings and unemployment, written well before the Rover debacle, a 10 percent rise in Sterling eventually leads to around a 0.8 percent increase in the unemployment rate in the West Midlands relative to Great Britain, since the share of employment in manufacturing there is still 10 percent higher than in the country as a whole. The job losses at Longbridge and in West Midlands textile firms confirm our analysis.

Sterling is currently at around DM 3.15. In 1992 it was forced out of the ERM at a rate of around DM 2.80, after which Sterling traded for some years in a range between DM 2.25 and 2.50. Inflation since 1992 has been much the same, certainly not lower in the UK except very recently, than in core Europe. Many analysts believe that Sterling is currently 10-20 percent overvalued against the Euro and 10-15 percent overvalued on a 'trade-weighted basis',i.e. on the average against all our competitors. High oil prices have re-emerged as one of the factors behind the strength of Sterling.

The fact that the UK, led by its financial services sector and consumer demand, has been growing more rapidly than core Europe has helped to drive up Sterling. Foreign capital is attracted by the profits to be made in the UK and by higher short-term interest rates than prevail in Euroland . In turn, higher house prices are playing their role in fuelling consumer spending.

Consider the impact of April's Budget on regional housing markets. In June we argued that raising Stamp Duty from 3.5 to 4 percent on properties worth £0.5m or more and from 2.5 to 3 percent on properties priced between £250,000 and £0.5m would do little to curtail housing demand in the more expensive South East. Spectacular rates of return had been achieved in the South East, especially for mortgage borrowers who geared up and so invested relatively little of their own cash. For example, when prices in London rose by 25% last year, with an interest rate of 7%, someone borrowing 90% of the price of a house and spending, say, 6% in total transactions costs including Stamp Duty, would have made an 80% return in one year on the funds invested - and that leaves out the fact that home-owners pay no rent. An increase from 6% to 6.5% in transactions costs due to the rise in Stamp Duty would have made little difference to the attractiveness of these returns.

We argued in our UK Market Outlook that part of the temporary slowdown in house price rises since the 2000 Budget was due to buyers avoiding the expected rise in Stamp Duty by transacting in the pre-Budget period. Another factor is likely to have been the beginnings of problems in the high-technology sector of the stock market. If the publicized slowdown in the market in April to August lowered expectations of capital gains, Stamp Duty will have had stronger effects in slowing the market. Paradoxically, Stamp Duty has its biggest proportional effect when rates of return are low, that is, when house price rises are in the 2-5% range. The degree to which Stamp Duty impedes labour mobility would then also be at its greatest.

We thought earlier in 2000 that in the absence of a stock-market crash or a major rise in Eurozone interest rates, the house price boom in the South and other favoured locations had some way to run. In the event, the fall in share prices, particularly since August 2000, and the slowdown in the world and UK economies, has made us more pessimistic on the market, less for the UK than for London and the South East. However, the four cuts in interest rates by the MPC have supported the housing market and consumer confidence.

The overvaluation of Sterling and the global manufacturing recession lead us to expect rises in unemployment and more subdued rises in earnings in the West Midlands and other parts of the economy with a heavy weighting in manufacturing.

These are likely to be joined in the coming year by similar trends in London and the South East as a consequence of the falls in the stock market and continued problems in the high technology sectors. It is not obvious how regional unemployment differences will move as unemployment rises, but given the very high levels of house prices in London and the South East, it is clear that their relative prices will decline.

Finally, we must point out the negative implications for the economy of record house price to earnings differentials in London and the South East. Our research on regional migration shows the importance of these differentials for migration. Given that many employees in the public sector have found their earnings lagging behind the private sector (for example, since 1980, average earnings of academic staff in Universities have fallen 40% relatively to average non-manual earnings), the national recruitment problem in the public sector has become a disaster for recruitment in London and much of the South East. In the past, this would have been a recipe for sharp pay rises. The current Government's choice is to try to keep pay rises as localized as possible, think of special housing schemes to attract workers and probably in the end choose not to deliver the public services rather than endure the inflationary consequences of a pay explosion. These problems will not be immediately addressed by an arrest of house prices in London and the South East. Our research indicates that part of what keeps in-migration from other regions going and discourages out-migration, despite very expensive housing, is the prospect of further capital gains. As these evaporate - and now is just that moment- mobile and smart money moves out or refuses to come in. A school-teacher in a £500,000 house in Wimbledon relocating to Devon or Manchester with little loss of salary can purchase a similar house at half the price, look forward to an almost sure capital gain instead of the risk of a capital loss. Indeed, over a couple of years the potential benefits could be of the order of an annual salary or more. One hardly needs to mention the prospects facing the potential reverse migrant.

As we have argued over the past 4 years in our council tax reform proposals, these problems of what is now called 'the two-speed economy' could have been greatly reduced by sensible reforms, including a fairer tax and more regular revaluations. At the end of July, the local government minister Nick Raynsford announced that the next revaluation for council tax would be in 2005, with tax bills based on this revaluation to be sent out in 2007. He gave no hint that the unique regressiveness of the council tax bands would be redressed. Last autumn's rural green paper made no mention of the 50% property tax discount on second and third homes which worsens the problem of the rural population being priced out of their own localities. Along with the new Centre for Council Tax Reform , we continue to whistle in the wind.
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