Part 3: Why are prices so high and will building more bring them down?
The first of these three blogs established that the best available evidence shows that there appears to be a growing surplus of dwellings over households in the UK. The second established that the cost of housing — in either the PRS or owner occupied sectors — appears to be significantly lower than it was a decade ago, in real terms. So neither quantities nor prices suggest that the UK faces a shortage of places to live.
What it undeniably faces, however, is very high house prices. UK house prices are now over 150% higher in real terms than they were 20 years ago. How can such an escalation of prices have occurred if there isn’t a shortage of places to live? The answer lies in the fact that housing has a dual function: it’s a place to live but it’s also an asset that pays a return in the form of the owner occupier not having to pay rent.
Rent levels are set by the balance between the number of dwellings and the number of households, as well as the incomes of the latter. And rents, as we’ve seen, are relatively stable compared to prices.
But the price of an asset (house) that pays a stream of income (stable rent) depends on the cost of owning it (the mortgage rate, opportunity cost, taxes and depreciation). If the cost of owning were to fall substantially below the cost of renting — say because mortgage rates and global interest rates were falling — we would expect people to invest more in housing since the returns exceed the cost. That, in turn, would bid up prices until the net rental income as a proportion of the house price is brought back into line with the return available on other comparable assets.
This means that as global interest rates fall, house prices will inevitably rise. Indeed if the real cost of ownership were to halve, we’d expect prices to double, which, as it happens, is broadly where we are vis a vis 20 years ago.
Most econometric studies on the UK housing market in recent years, such as this from the OEDC and Oxford Economics’ study for the Redfern Review in November, attribute a lot of the price rise to growing incomes in the run-up to the financial crisis. But the evidence also suggests that falling interest rates have been a big factor. No doubt when we’re able to unpick the drivers of the 20% rise in prices since early 2013, rock-bottom mortgage rates will be key.
Whatever the precise distribution of responsibility for rising house prices between growing incomes and falling interest rates, what’s clear from both of those studies is that a lack of supply didn’t contribute to the boom in house prices in the decade to 2007. So when we hear of house price growth running at 10%, there are much more likely culprits than supply.
So putting it all together we have:
- no firm indication that there are too few dwellings for the number of households in the UK relative to 20 years ago;
- evidence that the cost of housing in either tenure has fallen over the past decade, and is broadly comparable with 20 years ago in real terms;
- a steady fall in mortgage, and more generally global, interest rates that we would expect to lead to a substantial price response regardless of the adequacy of the housing stock.
Should we worry about house prices when the cost and availability of houses to live in appear to be under control? I’ll end with a few observations on that question.
First, whichever way one looks at it, the cost of housing is an issue of primary importance to policymakers while the price of houses surely cannot be. Everyone needs a place to live. Nobody has to invest in property. A real ‘cost of housing' crisis should be on page 1 of the paper, a house price ‘crisis’ should make pages 4 or 5.
Second, to the extent that we do see high house prices as a policy priority in and of themselves (e.g. for wealth distributional reasons), this is not a problem that will be solved by any plausible amount of new supply. Many econometric studies in the UK (see page 43 here for a comparison of results) have concluded that a 1 percent increase in the housing stock per household will only cut prices by at most 2 percent. Consequently, even if we were to add 300k new houses per year (about 150k in excess of household formation, approaching 0.5 percent of current stock), this would only lower prices by about 1 percent per year. This is peanuts in the context of price rises over the past 20 years.
Third, if we wanted to build 300k per year, that might curb prices a bit at the margin. But building many more houses that people want to live in is a dangerous route to go down, as Spain and Ireland can attest. For comparison, Ireland had an estimated surplus of dwellings over households of around 14 percent on the eve of the financial crisis (which among other things proves that households don’t just form because there are vacant houses). This building mania was something like the equivalent, relative to stock, of the UK adding 1 million new dwellings per year from 2002–11. But even this didn’t do anything noticeable to rein in Ireland’s property market during the boom, with prices rising by a fair amount more than the UK’s. A similar story can be told in Spain.
As the OECD paper cited above notes:
“As the increase in demand largely proved unsustainable [in Ireland, Spain and some regions of the USA], there is now a large excess stock of houses [...] These examples highlight the fact that when excessive demand for housing is allowed to develop, higher responsiveness of supply might lead to a greater misallocation of resources.”
If we’re worried about house price volatility, focusing on supply is a red herring. We would be better off working out how to insulate the housing market from the vicissitudes of global financial conditions.