Friday, 20 July 2012

Henderson release flawed PR

Henderson's economist Simon Ward is here to tell us all that UK housing is just 'a-ok' with a tasty piece explaining why house prices are roughly at fair value.

Simon starts by explaing how the typical measure of affordability; price/income is not representative of housing valuation. Lets give it a whirl;

"A national accounts version of this metric is the value of the housing stock divided by aggregate household disposable income. This stood at 4.31 at the end of 2010, 52% above the average of 2.84 since 1965.

The 'equilibrium' level of prices relative to earnings, however, has trended higher over time as rising demand – due to an expanding population, a fall in average household size and the tendency to spend more on accommodation as income increases – has clashed with inelastic supply."

Now to a certain extent the idea that the ratio has been driven higher over time is true in so far as demand has risen and no houses have been built. This UK national ratio also masks regional differences for instance in London house prices are more like 8x income. Bubbles anyone?

But there is another more important factor at play here and it is called leverage. As the only leveraged investment available to UK plebs housing also offers the ability to increase in value as borrowing costs fall. A structural 20 year reduction in interest rates since the early 1990's (incidentaly the last UK property crash point) has made borrowing ever increasing amounts of money more affordable. Today rates for some trackers are below 2% and with 4/10 mortages being interest only im hardly surprised property is still affordable for those with such existing products.

So on measure no.1 Ward totally ignores the real driver of this changing ratio and tries to explain why this ratio should not remain constant whilst then citing another ratio as a constant;

"A superior valuation metric is the ratio of prices to rents or its inverse, the rental yield. Rents already incorporate fundamental influences on housing demand and supply. People need to live somewhere – the choice is between buying your own home or renting, not between spending money on housing or retaining income for other purposes."

Now ward has a point here since the cost of renting vs buying should never deviate greatly being a relative measure. However why should it not also change over time with increased demand for flexibility or other structural factors. Alas this is not explored.

"A national accounts version of the rental yield is the sum of actual and owner-occupied imputed rents divided by the value of the housing stock. This finished 2010 at 3.56% – almost exactly in line with its average since 1965, of 3.57%.

The yield reached a low of 2.77% in September 2007, consistent with house prices being overvalued by 29% (the percentage deviation of 3.57 from 2.77). This excess, however, has been eliminated by a combination of a 5% fall in prices – according to the Department of Communities and Local Government index – and a 24% rise in rents."

Oh dear. You can argue that buying compared to renting will give a relative measure of the affordability of one versus the other since said ratio is not an absolute measure. Therefore just because rents have risen 24% it does not mean house buying is affordable given it has fallen only 5%. It simply means housing across the board has all become more unaffordable everywhere.

We may have discovered that rare breed; a one handed economist! The lack of joined up thinking here is palpable;

"The statement that housing is not expensive does not, of course, preclude a fall in prices to an undervalued level, for example if a shock to household income resulted in forced selling. Displaced owner-occupiers, however, would add to the demand for rented accommodation. Any downside for prices from current levels is likely to be temporary and limited as long as rents continue to increase solidly."

Here our one handed economist has missed the point. When those who cannot afford their homes have them repossesed a surplus appears in the market. This surplus drives down the value of the existing stock of homes. Those stuck renting see the purchasing power of their deposit rise and move out and buy the now more affordable homes just as those who suffer repossesion move into the rental market. Rents do not rise forever.

The only reason housing is not now affordable in the UK against say the US is that homes have not been repossed due to (a) more people retaining their jobs and hence income during the recession (b) more floating rate mortgages linked to the BoE base rate alongside prices remaining robust due to (c) a less fraudulent lending bubble and (d) lack of supply due to planning controls.

Until repossessions rise prices remain above the level at which the market clears and illiquidty reigns.

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