FOOL'S EYE VIEW
Why House Prices Might Fall And Does It Matter?

By David Kuo (TMFDragon)
June 27, 2002

We all know in our heart of hearts that house prices are getting a tad expensive and in some part of the country, houses are just downright expensive. The clever people at PricewaterhouseCoopers reckon that property in and around the London region is overvalued by approximately 31%. They arrived at their conclusion by comparing the affordability of houses with average historical levels. Affordability in this case was measured by looking at the ratio of house prices to personal incomes.

The situation however varies from region to region with some parts more overvalued than others. Those people living in the North of England and Scotland have seen much less severe price rises. In those areas property overvaluation is only estimated to be about 8%. No doubt there will be those living in some parts of Edinburgh or Harrogate in Yorkshire who will throw their hands up in horror complaining about the how expensive houses have become down their neck of the woods.

And therein lies the problem. Prices of apparently similar looking properties can vary not only from region to region but can differ markedly from just one side of a street to another. Nevertheless on a countrywide basis, average house prices have gone up by some 15% year-on-year. This rate of house price inflation is in the opinion of many experts unsustainable over the long-term. At some stage prices will have to slow down in order to allow average earnings to catch up. That slowdown could result in a period where prices remain largely unchanged or could even fall should the supply of housing exceed market demand.

House price inflation could also slow because a healthy housing market requires a crop of new entrants to take their first steps onto the housing ladder. However these so-called first time buyers are finding it increasingly difficult to find the money to pay a deposit on their first home. This is in contrast with the subsequent on-going mortgage payments, which have become more affordable as a result of very low interest rates. However mortgage lenders are unwilling to approve mortgages unless an adequate deposit, typically 10% to 15% of the value of the property, is paid.

The recent rise in house prices has also been fueled to some degree by existing homeowners trading up to bigger and more expensive homes. These are not faced with the same problem as the first time purchasers. Existing homeowners have benefited from house price inflation because the equity in their homes has also increased. Their position has been further enhanced by low interest rates that have in turn brought down the cost of servicing mortgages. However higher interest rates are now on the horizon. It is therefore unlikely that house price inflation brought about by this "trading up" effect will persist.

There is also the issue of some buy-to-let investors who are finding that rental yields on their property no longer look as attractive now as it once did. Those investors could start releasing their properties onto the market increasing the amount of housing available to prospective buyers.

So would a fall in prices affect us? Well of course it would! A significant proportion of our wealth is tied up in our homes and no one in their right mind wants to see their wealth decrease. This recent poll suggested that how wealthy we feel has an effect on the way that we behave as consumers. In other words we tend to spend more if we feel wealthier, and wealth here refers to our marketable and non-marketable assets.

Ultimately, however, houses are long-term investments and more growth now will probably just equal a little less growth in the future and vice versa. So by the time we come to sell up, it will all most likely have come out in the wash. Besides, we all have to live somewhere and as your house goes up in price, so does the cost of your housing. It's six of one and half a dozen of the other.

Those who owned property in the late 1980s will be able to speak at great length about the housing boom at that time. They might even relate some of the horror stories of plunging house prices and the numerous repossessions that occurred around that period. What that period taught us is that the secret to successful home ownership is to never overextend yourself. Always make sure that you allow enough leeway in your mortgage repayments for possible interest rate rises. And one final thing, look after your property, it is after all a significant part of your overall wealth.