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It may well be time to batten down the hatches and prepare for an oncoming housing storm. The Bank of England (BoE) recently released updated guidance suggesting that the UK economy is likely to experience a prolonged recession, with up to five consecutive quarters of negative growth.
Even more startling, the ‘transitory’ inflation that the BoE previously suggested would peak around 10 percent this year is now expected to peak at over 13 percent in October. This leaves landlords facing the prospect of stalling economic growth and annual inflation at its highest rate in over 20 years. It is only the UK’s robust employment market that is standing in the way of 1970s era stagflation.
What Does the Deteriorating Economic Picture Mean for House Prices in the UK?
Prices are a function of people’s willingness and ability to pay for housing. Homeowners and homebuyers alike are likely to see their disposable incomes squeezed more than any other point since the financial crash in 2008-09. Vladimir Putin’s invasion of Ukraine has caused food and energy prices to spiral across the globe, sparking a cost of living crisis. This is made worse by lingering supply constraints from the pandemic lockdowns, as freight rates remain high and key components such as semi-conductors remain in short supply. The likelihood of double digit inflation, at least over the coming 12 months, will tighten people’s disposable incomes and hinder their ability to afford current house prices.
Whilst the cost of living crisis is squeezing incomes, the Bank of England is taking steps to rein in inflation. The Monetary Policy Committee (MPC) recently voted to increase interest rates from 1.25 percent to 1.75 percent. Rates have risen 1.65 percent, from their historical lows of just 0.1 percent at the back end of last year.
This increase is quickly feeding through into the mortgage market, with mortgage rates rising as a result. Higher mortgage rates will inevitably reduce the affordability of mortgages for borrowers, with the latest rise likely to add at least £50 onto the average borrower’s monthly mortgage payments. From a more theoretical investment perspective, rising rates should also mean falling asset (house) prices. Higher rates mean that investors earn more at the risk-free rate – that is investing their money in safer, relatively risk-free investments such as bank accounts or government debt. To account for this, the yield on riskier investments, such as housing, will need to rise to maintain the added compensation for taking the risk. This means that either rents will need to rise, or because price is the inverse of yield, house prices should fall.
What is Happening in International Housing Markets?
There is already evidence of house prices collapsing in other anglosphere housing markets. House prices in Australia are falling on the back of aggressive central bank interest rate hikes. House prices in Sydney have fallen 4.7 percent since April, with many commentators predicting double digit declines over the next 24 months.
Similarly, in the United States, house prices are beginning to wobble. US new build prices have fallen at their fastest rate since the financial crash, as housebuilders struggle to cope with excess supply. During the pandemic, many US house builders accelerated their building cycles to take advantage of rising house prices. Consequently, the supply of new homes has increased dramatically, with inventories hitting 10-year highs.
In Canada, the cost of living crisis and rising interest rates have also had a dramatic effect on house prices. The Bank of Canada has increased rates from their pandemic lows of 0.25 percent to 2.5 percent, sending house prices into free fall since April of this year. Prices fell by 1.9 percent nationally in the past month. However, key regional housing markets such as Toronto have seen even more dramatic reductions of between 5-10 percent. Whilst there is still appetite to purchase properties amongst would-be house buyers, many are struggling to meet more stringent bank affordability metrics in light of higher interest rates.
In contrast, house prices in European nations have held up better than their anglosphere counterparts. The latest data suggests that French property prices are continuing to rise, with some areas witnessing double digit year-to-date returns. However, the European Central Bank has been far more conservative in its response to rising inflation, with interest rates remaining close to their all-time lows. As rates begin to rise, it is likely that European nations will begin to experience similar house price wobbles.
Worryingly, it is possible to draw a lot of similarities between the UK housing market and its anglosphere counterparts. The Bank of England has been less aggressive in raising rates than its Australian and Canadian counterparts. Although rates have increased to 1.75 percent, rates were 50 basis points (0.5 percent) lower as of a couple of weeks ago. As such, the impact of the recent increases is unlikely to have fed through into the latest house price data. By the same token, the undersupplied UK housing market also experience a significant uplift in new build developments in 2021. There were an estimated 166,860 new build dwellings started in the year to June 2021, a 32 percent increase compared to the previous year. All of this suggests that the UK housing market may be set to experience similar trends to those seen internationally.
Is It All Doom and Gloom for the UK Housing Market?
The odds do suggest that the UK housing market is about to go through a difficult period. However, nothing in life is certain and there are lights at the end of the tunnel for astute investors and landlords. Firstly, we should take the Bank of England’s predictions with a pinch of salt. The forecast of five consecutive quarters of recession assumes current market conditions. However, the UK is in the midst of a leadership contest, with both Liz Truss and Rishi Sunak both proposing expansionary fiscal policies. Changes to tax rates and increased government expenditure could go some way to offsetting an economic slowdown and mitigating the cost of living crisis. Equally, a reduction in tensions between Russia and Ukraine could help to alleviate inflationary pressures and prevent further interest rate hikes.
However, even in the upside scenario, inflation is likely to linger. Many expect annual inflation to continue at 4-6 percent over the coming few years as supply constraints and the repercussions of war attempt to resolve themselves. This poses a different problem for property investors, the concept of nominal versus real returns. If, for example, house prices were to remain stagnant at their current levels for the next 12 months, but inflation sits at 5 percent, the real value of your properties will have fallen, despite the nominal price (say £250,000) remaining the same. It is all well and good maintaining the nominal value of your investment and being able to sell your property for the same price. However, if the purchasing power of your £250,000 has fallen by 15 percent, it’s not been a particularly worthwhile investment. Should general inflation remain high, investors should keep an eye on how well wage inflation keeps up. If wages rise in line with inflation, then would-be homebuyers will be more able to support higher house prices, which stand more of a chance of keeping up with inflation.
The prospect of declining house prices may not be all doom and gloom. Falling house prices may well afford long-term investors and landlords a golden opportunity. Although the concept of ‘below-market-value’ (BMV) still exists, it has been increasingly difficult to acquire such properties in recent years. Falling house prices and more stringent affordability metrics will help to ease competition, making it more likely that astute investors can pick up properties below market value. There will be a significant opportunity for long-term investors to find and complete great deals, supporting returns into the future. At the same time, rents are unlikely to fall. The number of private rental sector properties has been in decline for years, forcing tenants to compete for a more limited number of available houses and propping up rents. If house prices were to fall, investors may be able to acquire properties with more favourable long-term yields, in excess of what has been available over the past 5 years.
What Does a Decline in House Prices Mean For Landlords?
The prospect of declining house prices is never ideal. However, prices are volatile and housing market dips are part and parcel of investing in property. Landlords who believe that prices are set to fall will want to use the current environment as an opportunity to sit on their cash. Even with rates significantly higher than 6 months ago, it may be wise to consider refinancing properties whilst rates remain low in a historical sense. The added benefit of doing this is that it may afford landlords the opportunity to lock in longer-term fixed rates and take equity out of their portfolio whilst prices remain high. Doing so may help to bolster a war chest for when prices bottom out and there are bargain properties available. The caveat being that investors should stress test their portfolios first and ensure that they have sufficient coverage for their mortgage rates.
Finally, it has to be noted that whilst prices may fall nationally, the UK is in fact made up of many distinct regional housing markets that can vary. Certain areas, such as the North East and Yorkshire where properties remain reasonably priced may be more insulated compared to the more popular pandemic locations such as Cornwall which have experienced more dramatic rises. The trend remains that well priced properties in sought after locations will continue to remain a good investment.
