It’s nice to know that the IMF (International Monetary Fund) and I agree on key aspects of the property market. But when it says that it expects ‘house prices to decline relative to income by roughly 10-15 percent over the medium term’, the casual reader could easily get the wrong impression. Previous experience suggests that that means incomes catching up with prices, not lower prices.
The IMF issued its latest review of the UK economy last week. It’s a 107 page document written in ‘officialese’, so not exactly riveting reading. But there are two pages which relate to the residential housing market and, once translated, they make some interesting points. You can find the full document here. Look for pages 23 and 24.
Very broadly, the IMF says that house prices have risen above their historical average (relative to income) over the last 20 years and haven’t fallen by as much as expected in the recession because of a) low interest rates and b) low levels of house building.
That sounds about right. It’s exactly the point of a post here on 25th April on this issue. Helpfully, the IMF provides a graph (see above right) illustrating how house prices in the last four years have remained relatively high compared to income, but affordability (mortgage interest payments relative to income) has vastly improved. It provides yet more evidence that it is the cost of borrowing rather than the total amount borrowed that is the principal determinant of house prices.
The IMF points out that the house price-to-income ratio remains roughly 30 per cent above its historical average and comments that ‘such elevated ratios do not persist’ and that the ratio of income to house prices will return to its normal level ‘in the medium term’.
They are probably right, but they don’t say how long this process will take or how it will happen.
Firstly, the conditions that have allowed prices to rise above the average house price-to-income ratio have been in place for nearly 15 years. Interest rates have been low by historical standards since 1999, shortly after the government transferred the power to set interest rates to the Bank of England. Moreover, it looks likely that they will remain low by historical standards for some time. So any return to levels closer to the historical average could take many years. In the meatime, low interest rates are likely to support house prices as they have done almost since the onset of the recession.
Secondly, previous experience in the UK suggests that the ratio is corrected by a sustained period of stable house prices while real incomes rise, rather than a substantial fall in selling prices. As long as incomes rise faster than house prices, the ratio will steadily get closer to its historical level.
That is exactly what happened during the last property market recession in the early 1990s. After a short, sharp fall in prices, average values trod water for several years while incomes caught up. The low point for prices in Scotland was 1990/1991. Thereafter, prices hardly changed until 1997, giving five or six years during which rising incomes made property affordable once again.
The chances are that this is how the market will correct itself this time too. So, when the IMF says it expects ‘‘house prices to decline relative to income’, it is not forecasting a fall in prices. It is merely pointing out that, at some point, possibly over many years, the normal ratio between house prices and income will re-establish itself. My guess is that that is more likely to happen through rising incomes than through falling prices.