The illogical pricing of property

The illogical pricing of property

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The dream of property ownership has been fostered by Government in the UK for a very long time. Perhaps not as long as in the US, where FDR's New Deal in the 1930s promoted the goal of every American owning their own home: but certainly for over 50 years. Owning a house has become the principal icon of membership of the middle class. 

Yet owning a house is becoming ever more difficult as house price rises outstrip wages. In the US, this tendency was interrupted by the 2007/8 crash, though house prices are now rising again. But in the UK, house prices have risen to the point where in much of the country only the very well-paid can afford property on a single income, and in parts of London and the South East even well-paid couples struggle to afford a family home:


The age at which people buy their first house is rising well beyond the age at which they have their first child, and an increasing number of young people are opting either to live with parents or rent instead of buying. The dream that everyone can own their own home is fast dissolving into the reality of unaffordable and unsustainable house prices. 

In both the US and the UK, people expect property to appreciate. A rise in house prices is greeted with relief, while falling house prices are a cause of worry. But actually this is pretty illogical. Leaving aside the question of the price of land (to which I shall return shortly), there is absolutely no fundamental reason why house prices should rise, either short-term or long term. 

Left to itself, property decays. A house that has been left empty does not remain in the condition that it was when its occupants left: gradually, over time, ivy comes through the walls, rain comes through the roof, and even if vandals don't trash it rats do. If it is neglected for long enough, rot sets in, and eventually it becomes a ruin. The natural course of property value, therefore, is downwards. The effect of people living in property is to arrest that downward trend, because people maintain the houses they live in - which costs money. Maintaining a house at its original value requires additional money to be spent on it. 

 If we assume that the majority of people maintain their houses at the standard at which they bought them, a minority allow them to deteriorate and another minority actually improve them, the housing market should be flat over time. If we further assume, as we do with cars and computers, that new builds have technological improvements such as greater energy efficiency that older houses don't have, we would expect the value of even well-maintained houses to fall over time. But this doesn't happen. Instead of declining in value gradually as they age, houses tend to INCREASE in value. 

This can be indicative of only one thing - a shortage of supply relative to demand. Demand for housing is deliberately increased by Governments promoting the dream of home ownership, encouraging people at ever lower income levels to buy houses and introducing all manner of schemes to help people buy houses they can't really afford, from mortgage guarantees to tax breaks and even outright subsidies. The result, as we might expect, is a tendency to demand-pull inflation in house prices. But for some reason we have come to believe that inflation in house prices is a good thing.  I shall discuss shortly what that reason might be. 

The valuation of land is slightly different. Land is a scarce asset: you can't create more of it except by doing expensive reclamation projects or going to war with your neighbours. The latter is not recommended, but in the not too distant past it was the preferred way for nations to obtain more "living room" (yes, I chose that phrase deliberately). And unlike property, land is not a depreciating asset. It is actually neutral: it is possible to "improve" land, which increases its value, but if you do nothing with land it doesn't deteriorate. The value of unimproved land, therefore, should remain constant. So as with housing, appreciation in the price of land is a consequence of demand exceeding supply. It is, once again, inflation. 

Assuming that we aren't going to waste a lot of lives and even more money trying to capture a few more square miles of land, land scarcity is a brake on housing development. Though not much of one, really - even in the UK, which is often considered "crowded", only about 9% of the land surface is actually built upon. A much bigger obstacle to development of land for housing is planning restrictions, usually put in place by well-meaning governments concerned about the effect on the value of EXISTING housing if lots of new houses are built in nice places. They may also be concerned about the effect on the environment, but that's a lesser consideration really: it's amazing how ways can be found round environmental objections, but not round the objections of existing residents. I suppose that is understandable: there are far more homeowners than environmentalists, and votes matter. But it does mean that trying to get approval to build houses anywhere near a pretty village full of Conservative voters is a minefield.  Farming, too, can seriously restrict the land available for development - though plenty of farmers, suffering from poor returns in farming and attracted by the high price of development land, have circumvented planning restrictions that prevent their land being used for development and sold extensive plots for ribbon development. 

So on an asset that has constant value - land - we build assets that naturally depreciate. Yet we expect both the land and the property built on it to appreciate in value, and we deliberately restrict supply and talk up demand to ensure that prices do indeed rise. Why?

A friend of mine has a beautiful house in the little village of Hartlip, near Sittingbourne. I have no idea how much that house is worth, but it is probably seven figures. Anyway, when I visited him recently I complimented him on his lovely house. And in three words, he explained the reason for the illogical pricing of property. "It's my pension", he said.

That, in a nutshell, is the reason why house prices must always increase. We have come to see houses not as a home to live in, but as an investment - a safe haven for our savings. And the investment is long-term. Most people buy houses with mortgages that are 25 years or more, and during the period of the mortgage the mortgage owner has a claim on part of the value of the house. But when they pay off the mortgage, they have a valuable asset. Now, if that asset had depreciated as it should, they would receive a negative return on 25 years' worth of savings. Oh dear. We can't have that, can we? 

The need to ensure that people don't save diligently for 25 years and end up with an asset worth less than the (principal) amount they paid for it is a sufficient explanation for all manner of apparently illogical and even dangerous behaviour on the part of governments, homeowners, housebuilders, lenders and real estate valuers. Housebuilders, for example, will hoard land, restricting its supply, in order to drive up the price. Some property owners do the same with property, leaving it empty in the expectation that the value will increase even if the property itself deteriorates. Governments prop up overvalued housing markets and pressurise lenders into higher-risk lending. And lenders relax credit criteria, lending more and more to people at higher and higher risk, in the expectation that the rising value of property will always compensate them even if borrowers default. Does this sound familiar? Yes, it's exactly what happened in the run-up to the 2007/8 financial crisis. There is no doubt that expectation of ever-rising house prices encourages excessive risk-taking in mortgage lending, leading to periodic property market collapses and financial crises: Charles Goodhart observed that of four banking crises in his lifetime, three were caused by property market collapses. 

If inflation in house prices is to be not only tolerated but encouraged, it must be countered by stricter regulation of lending standards to avoid unacceptable risks to financial stability. Politically, though, this is not popular. Enforcing lending standards that make it even more difficult for people to buy into an overvalued property market is a certain vote loser. No wonder Governments come up with all sorts of dodges to make it possible for people to buy houses they can't really afford. 

The latest crackpot scheme for helping people to buy ridiculously overvalued property is the UK Government's Help to Buy scheme. The first version of this scheme was effectively a subsidy to housebuilders, since it guaranteed part of the mortgage on new build houses only. Not surprisingly, housebuilders loved it and almost everyone else hated it. It was panned by the Chancellor's own department, and the IMF and the OECD both expressed concern about its possible effect on an already overblown housing market. So of course the Government is now extending it - to buyers of existing houses and remortgages. 

This looks like complete madness. But actually, there is a sort of warped logic to it. Let's start from the premise that the primary purpose of house purchase is not to provide a home to live in, but to acquire an appreciating asset. There is actually a desperate shortage of safe assets for ordinary people to invest in: savings banks disappeared long ago, the Cyprus disaster showed that lending banks and building societies are not safe places for large amounts of money, and the Government is trying to reduce issuance of gilts ("We have to get the deficit under control"). I don't know if Reinhart & Rogoff realise what damage they did when they invented their 90% threshold for government debt becoming "unsafe", but by creating the myth that a high level of government debt is always a drag on growth they made it virtually impossible for governments to provide safe savings vehicles for ordinary citizens. No wonder government has started to rely on property as a substitute safe asset for ordinary people. No wonder it is hell-bent on persuading as many people as possible to buy houses. No wonder it is determined not to allow property prices to fall, as they naturally should. And no wonder it is resorting to mortgage guarantees (Help to Buy) and outright subsidies (the Right to Buy is a subsidy) to tempt people to buy. The only other choice it has is to issue far more government debt, and hope that future growth will be sufficient to keep returns above inflation - or, of course, invest the proceeds of that debt issuance productively to generate that future growth.

Not all Western countries use property as a savings vehicle. Germany, for example, does not. In Germany people save with savings banks (Sparkassen) which invest those savings in businesses. There are hundreds of these savings banks, most of them are publicly owned and all are in effect backed by Government. It's all a question of where you put your Government guarantees - do you guarantee property investment, or do you guarantee business investment? There have been calls for the UK to develop a similar network of small savings banks, but I fear this is a non-starter. For the UK to release the savings needed to fund such a network, it must end its love affair with property. And I don't think that is likely to happen any time soon.

What bothers me the most about the UK's property addiction, though, is the effect on growth. Ever since the war, the UK's economic performance has been less than spectacular. And I think it is the property addiction that is largely the cause of the UK's tendency to stagnation. Consider this: if people see buying a house as their top priority, they will cut other spending in order to pay the mortgage. Property prices have risen enormously in the last 15 years, far faster than wages:


If property prices continually rise faster than wages, then the amount of spending that is taken out of the economy and diverted into payments to lenders constitutes a serious reduction in demand. Admittedly, in the 2000s we compensated for that demand drop by ramping up consumer credit, but that gave us a mammoth hangover from which we have not yet recovered. And of course our obliging Chinese friends have produced goods at much lower prices for us to buy, so we haven't noticed the reduction in our spending power quite so much - but we have noticed a fall in manufacturing and the growth of a considerable trade deficit. We have also, in the last five years, had very low interest rates, which at least makes mortgages vaguely affordable (mortgage payments at over 50% of income, as they were in 2007, is not remotely sustainable): 


Does anyone REALLY think interest rates will return to the levels of the past while house prices are so high? 

It is a fallacy to suggest, as some do, that lenders recycle mortgage interest payments back into the economy in the form of productive investment. They are much more likely to "recycle" them into more mortgages, other economically unproductive investments, shareholder dividends and bonus payments to executives. Indeed, if the effect of house price rises outstripping wages is to depress consumer demand, I would expect that over the longer-term, a rising property market would correlate with poor business investment. When they can't see future sales, businesses won't invest....

If I am right, then the use of mortgaged property as a form of long-term saving is toxic for the economy if it results in ever-rising house prices. But there is one other factor that is even more damaging - and that is the political power of retired, debt-free homeowners. These people own valuable assets that continue to appreciate. I don't see any sign of elderly homeowners selling their assets and living on the proceeds, as we might expect if - like my friend - they really viewed their houses as their pensions. No, they don't. They expect to keep their assets and be supported by the State. And they lobby politicians to ensure that, for example, the cost of their care when they are too frail to care for themselves is largely borne by taxpayers. If politicians agree to this - and because of the size of the grey lobby, failing to do so looks like electoral suicide - the result must be yet more depression of demand in the economy, as younger working people pay ever more for houses while also supporting asset-rich elderly people through their taxes. I can't see how this is remotely sustainable. At some point, there must be a reckoning: either the elderly must sell their assets, causing a significant fall in property prices, or they will have to be taxed on those assets to subsidise younger people's purchase of property that is priced out of their reach. 

It's not difficult to see which direction we are heading in at  the moment. Help to Buy is the start of Government subsidy of house purchase; the so-called "mansion tax" (currently shelved) would be the start of asset taxation. But I'm not convinced this is the right direction.

Either houses are homes to live in, or they are investments. If the latter, then house prices must continue to rise - in which case we will inevitably have to support house purchase with Government guarantees, tax breaks and subsidies, so that demand doesn't fall through the floor due to people spending ever more of their income on houses. This does make some sort of sense: people need to save for their old age, and since Government has tied itself into a straitjacket that prevents it using public debt for its real purpose - to provide safe savings vehicles for citizens - property is a reasonable substitute. But don't then provide pensions, health care and social care to the asset-rich elderly from the taxes of the young who are also trying to buy houses at far higher prices than the elderly ever paid. Let the elderly sell their assets and live on the proceeds. After all, that's what savings are for. 

But we don't have to do this. We can restore housing to its real purpose, which is to be homes for people to live in. We can build or renovate enough properties to ensure that supply matches demand, so that house prices are not constantly driven upwards by supply shortages. We can tax away unearned profits on unimproved land, and we can tax away profits from speculative investment in property. We can allow government debt to become the preferred savings vehicle for ordinary people, issuing as much of it as people want to buy and using the proceeds to upgrade our national infrastructure and support domestic enterprise. And we can stop draining our economy to support a bloated property market.  

Related reading:

UK Housing Market Stats and Graphs - Economics Help

The illusory housing recovery - Coppola Comment

Government debt isn't what you think it is - Coppola Comment


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