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That house prices in London are high is not news. What we still find puzzling are two things: How can people afford these prices, and why do they continue paying them? Houses in the South-East of England seem to be the only asset where people still stretch to buy the biggest and most expensive house they can afford. This is in marked contrast to most other goods and services, where buyers seek out the cheapest. The explanation for this is perhaps not difficult to find. House prices rose 14% last year. That is almost as much as the equity market. But the big difference is that the availability of mortgage finance to house buyers, essentially buying houses on margin, means that the return on the invested capital in a house is much, much more than that.
With such attractive returns to be had from relatively small amounts of capital it is perhaps not surprising that people are devoting as much as they can to servicing the mortgage. That can mean both partners working and switching the mortgage to an interest-only one. Although that trick, as any student of compound interest will understand, substantially increases the total amount of the mortgage.
At some point the reality that most people have nothing like enough invested to provide for their old age, be it in ISAs, pensions or whatever, will start to impinge on the collective consciousness of the population. That will take some time, but I have no doubt whatsoever that it will occur. The Government has already taken the point on board by floating the idea that the minimum age of tax approved retirement should be raised from 50 to 55. The prospect of large numbers of impoverished pensioners is a frightening thought for our masters. And they are compounding the problem by allowing the state pension to wither on the vine of low inflation. Companies are making the problem worse by moving away from defined benefit pension schemes to defined contribution plans. That eliminates the dangers they faced of having to issue blank cheques to their pension funds to ensure that the benefits were maintained.
Why are house prices so high?
Leverage makes the difference
This game, of course, makes sense only for as long as house prices rise faster than the cost of funding. Last year a 14% return clearly beat a 6% mortgage. But simple logic tells us that cannot continue. If house prices only rise at 3% and you have a 50% mortgage then what you pay in interest will match the capital gain on the house. It is not difficult to play around with the numbers to come up with different scenarios in which the equation gives a negative return. At the moment it only works because it is like a vast pyramid scheme. New, leveraged money coming in keeps pushing prices up. But what happens if that flow of money is diverted to other uses?
But pensions need funding too
In the face of this withdrawal of future benefits the population as a whole will have to address the issue of how it is going to look after itself as its longevity increases. Without doubt they will have to redirect discretionary money away from housing, and mortgage service, into long-term savings and/or tax privileged pension funds. A reallocation of funds of that magnitude will obviously have enormous implications for asset prices, namely houses and equities. Shares are the natural home for most long-term savings; houses are just places that keep the rain off. The switch in asset allocation will certainly happen. It's just a question of when.
Related Links
• Fool's Guide to Homeowning
The Fool's Eye View is published four times a day, at 10am, 12 noon, 2.45pm and 5pm.
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