One of the biggest misconceptions in economics is that it’s difficult to spot a bubble. On the contrary: spotting a bubble is actually pretty easy. The difficult thing is predicting when it’ll go pop.
So let’s not beat around the bush. London is facing a house price bubble. House prices in the capital are rising at unsustainable rates. On almost every reasonable measure of affordability (we’ll get to them in a second) London property prices are at or beyond what would normally be considered danger levels.
The sensible questions to ask now are: how long the bubble continue inflating, how will it come to an end (a pop or a long period of relative deflation) and whether it will cause systemic financial turmoil elsewhere. It’s these questions the Bank of England’s financial stability team are privately investigating as they watch the rise in regional UK house prices with a mild degree of horror.
Evidence of bubbly activity in London’s property is nothing new. We first reported on the growing gulf in house prices about a year and a half ago. About six months ago our update showed that the affordability levels in the capital were at unprecedented levels (of unaffordability).
Since then, things have only become even more pronounced. Let’s run through the evidence.
1. Prices are rising very fast
Today Nationwide reported that house prices in London are rising at a rate of more than 18% – the highest rate since 2003. According to the building society the gap between London and the rest is greater than it has ever been before (though it was at a historic level even before the latest iteration of its survey).
2. Prices rises are no longer just in “prime” areas
What’s particularly interesting about the numbers is that what previously looked a lot like a well-contained bubble in prime London property prices (eg the smart parts of town where overseas investors are particularly keen to buy) has spread out into other parts of the capital. Just look at the table below: the biggest increases were in Brent and Lambeth, rather than Westminster and Hammersmith & Fulham. Though Kensington & Chelsea prices are excluded from the Nationwide numbers, Land Registry data suggest house price growth has slowed there too.
However, rising prices are not, on their own, evidence of a bubble. Prices in Manchester were also rising by around 18% over the past year. What makes London different is the performance of house prices in comparison with peoples’ ability to afford them. Now, there are a few ways to judge whether house prices are at sustainable levels. One is to compare them to the rise in other prices around the economy – in other words working out the real level of house prices, adjusted for inflation.
3. Prices are still high in real terms
On this basis (see the above chart, which looks at real vs absolute prices in the London market since 1988), London house prices are still a touch below the levels they reached in late 2007. The recent rise looks far less pronounced. The important thing to note, however, is that remain considerably higher than they were in previous decades.
This is a useful yardstick, but a far better measure of affordability is to compare house prices with people’s earnings – after all, their capacity to afford a home will depend in large part on how much they earn. On this measure, the disparity between London and the rest (and, for that matter, history) is striking.
4. House prices vs earnings are at historic highs
According to this chart, house prices in London are now more unaffordable (compared to earnings) than ever before in recent statistical history. It’s often thought that the “safe” level for house prices vs earnings is about three times, and that once you get beyond four times you’re moving into difficult territory. These numbers show that for the first time, the average London house price is now eight times the average first-time buyer’s salary.
However, what this measure doesn’t show you is the impact lower interest rates have had on families’ mortgage payments. The Bank of England has cut Bank rate to 0.5%; mortgage costs have fallen sharply in the past year or so thanks in part to Funding for Lending. And as a result, even though the absolute level of house prices is higher than ever before, is higher than ever before vs salaries and the necessary mortgage amounts are greater than ever before, the monthly mortgage burden faced by most first-time buyers is not.
5. Mortgage burden hardly dropped in London
This chart shows you mortgage payments as a % of take-home pay by region. As you can see, mortgage payments still account for an average of more than half of first-time buyers’ salaries, but this is considerably lower than in 2007 or, for that matter, the late 1980s. It’s this chart that many people refer to when arguing that house prices at their current levels remain sustainable. The problem with this argument is it ignores the fact that whereas in most periods when the mortgage burden was 50% or more Bank rate was close to 5% (or double that in the early 1990s), it is currently at a 320-year low. The only way is up.
Moreover, what’s striking in this chart, and in most of the others above, is how different the London story is to the rest of the country. Housing affordability in the capital is at its worst level ever, on most metrics. Even on the mortgage burden metric it is far, far above most of the rest of the UK, and never fell as much as it did in previous corrections.
It was possible to argue, until relatively recently, that this was merely a “prime central London” phenomenon – money rolling in from overseas investors to pay for nice, sparkling new apartments in Battersea. Not any more: prices across the capital are rising at unsustainable levels – not just in prime areas. There is growing evidence that households in London are having to take on unprecedented levels of debt to stay afloat – almost a fifth of new mortgages being taken out in London are for more than 4.5 times the buyer’s salary.
In other words, this is already a systemic financial problem. The London bubble has been growing for some time (and, by the way, Help to Buy is likely only to have had a marginal effect on this phenomenon, though it certainly won’t help). Other prices of the UK may well face their own bubbles, but right now they are not in that kind of territory. So contrary to what some commentators claim, there is no nationwide bubble. London is another matter entirely.
House prices in the capital cannot keep rising at this rate. At some point, either buyers will be unable to afford property or investors will be unwilling to accept falling yields (they’re already coming down) and will realise capital appreciation can’t carry on forever (whatever currency you’re buying in). However, saying all of the above is no guide as to when the moment of capitulation will come. No-one knows. It could be months; it could be another few years. The path will depend in large part on which party wins next year’s election and whether the winner imposes a mansion tax. It will depend on when interest rates go up and how quickly.
Either way, it’s high time the Bank of England, and, for that matter, the Government, put a little bit more time into thinking whether they need more tools to try to deflate the capital’s bubble safely and smoothly, without making the rest of the UK’s regions suffer.