House of Cards

UK dinner party chatter may have moved on thanks to the well-publicised slowdown in house price growth, but the new consensus seems to be that the country has miraculously avoided a crash, and the more welcome 'soft landing' has occurred instead. As the quote at the top of this blog states very eloquently (the book from which it was taken was written in the mid-19th Century), when a view becomes entrenched particularly in the light of overwhelming evidence and theory to the contrary, it usually pays to challenge the consensus. The power of group thinking and irrational behaviour can lead to long periods when valuations of assets (or goods) are out of synch, but when sentiment turns the speed with which these misvaluations can reverse usually catches the uninformed by surprise.

I hope in this rather lengthy post to destroy, or at least challenge, several 'myths' about the UK housing market and property in general. Given the UK's well-known obsession with the asset class (thanks in no small part to ubiquitous media hyping), there are times when I feel like a modern version of those radicals who challenged the assumption that the world was flat.

The myths as I see them are as follows:

1. "You can't go wrong investing in property - house prices always rise."
2. "Renting is dead money"
3. "House prices can't fall - the Bank of England won't allow it"
4. "House prices will at worst flatten out - they won't fall in nominal terms"
5. "House prices won't fall in the absence of an increase in interest rates"
6. "Affordability is the key determinant of value, not multiples of income or rental yields"
7. "House prices will stay high because of demand and supply factors"
8. "House prices have already begun rising again - the Halifax and Nationwide say so."

I will tackle each in turn though some counter-arguments are relevant to more than one. However it is worthwhile focusing first upon what has occurred and why.

According to the Nationwide, the average house price in the UK began to rise in 1995, but very markedly from 1999 onwards reaching a peak 12-month inflation rate of 26.5% in Jan 2003, before dropping precipitously ever since. As a result, and according to the UK Land Registry, the average price of a home in the UK doubled between end-1999 and the present.

There are several good and understandable reasons why property prices began to rise slightly above trend from 1995-1999. Firstly, the prior property market correction had probably overshot and thus the initial increases represented a form of reversion to the mean. Second, there were (and still are) some demographic factors which help to justify a small secular increase in long-term house price rises eg. higher divorce rates, net immigration etc.. Third, the shift to an independent Bank of England in 1997 increased the credibility of inflation-fighting, and lowered the 'fear premium' imbedded in interest rates.

It is worth bearing in mind that house prices 'should' rise over time. All other things being equal, house prices should rise broadly in line with nominal income growth, plus some extra to account for general improvements in the housing stock. However most observers, myself included, were taken by surprise by the degree to which the initial justifiable momentum became a frenzy from 1999 onwards. The gradual reduction in interest rates from 7.5% in Sep 1998 certainly added fuel (ie. liquidity) to the fire, but then the natural herd mentality and behavioural biases of millions of homeowners and speculators really took over. It is never easy to sit idly by whilst peers make (or claim to make) multiples of their investments in a highly accessible asset class, and hence fear and greed ensured that the party would continue so long as there was a 'greater fool' ready to pay an even higher price further down the line.

As is inevitable in any bubble, those who stand to profit from a continuation of the status quo begin to build a rationale to justify what has occurred, hence my list of 'myths' which I will now challenge in turn.

1. "You can't go wrong investing in property - house prices always rise."

The fact that the above opinion is so widely-held is very surprising given the fact that the last property market crash occurred so recently. According to the flawed (see below) Halifax House Price Index, the average homebuyer who bought at the peak (July 1989) would have had to have waited until Feb 1998 before they could sell their home for more than they paid for it. A lot can happen in 8 1/2 years - it would have been enormously frustrating for anyone whose life circumstances required them to sell up and move. The peak-to-trough fall in nominal terms was only 14% or so, but given the higher inflation rates prevailing at the time, the fall in real terms was more like 40% (and far higher in the frothiest markets).

Speak to anybody from Japan (location of probably the most excessive house price bubble of all time), and you may get a strange look if you talk about something being as 'safe as houses.' Prices in Tokyo in the late-1980s were so egregious that they implied that the land on which the Emperor's Palace stood was worth more than the whole of California. As has been well-documented, the subsequent crash was monumental in terms of size (70-80% falls in nominal prices) - it was perhaps only the Japanese propensity to save which saved the economy from outright collapse.

Fortunately for many homeowners in the UK in the late-1980s, the high inflation at the time enabled a 40% overvaluation in real house prices to be corrected by just a 14% fall in nominal prices. In essence, painful as it was for many at the time, it was a crash which perhaps didn't really feel like a crash. Thanks paradoxically to the success the Bank of England has had in taming inflation, and thus wage growth, the current overvaluation of house prices (whether they be 25% overvalued, 40% overvalued or whatever) will require a far larger fall in nominal terms to return them to equilibrium or trend. Those that belong to the 'soft landing' school of thinking seem blissfully unaware of this important point.

2. "Renting is dead money."

This is a statement usually wheeled out by those of an older generation (parents particularly), to persuade their offspring to put the proverbial mortgage albatross around their necks. It is however a statement which needs to be placed in a certain context. Before one can assess whether renting is dead money, one needs to try to place some sort of objective value on the qualitative aspects of renting versus buying. If you are the type of person that finds the very idea of living essentially in someone else's home somewhat abhorrent, then it is not appropriate to view the decision in purely financial terms. Similarly, many renters place a high value on the flexibility which renting provides. Hence whilst adding this caveat about not assessing the decision whether to rent or buy in purely financial terms, it is vital to at least accept that these touchy-feely traits cannot be monetised ie. turned into real cash.

When viewed in a purely financial context, a rational homebuyer hopes that their purchase will a) have appreciated in value when they come to sell it (the 'investment' rationale), or b) over time they will have paid off their mortgage and thus own it (the 'saving' rationale). It is clear that in a flat or falling market, the 'investment' rationale for buying will not hold - this is straightforward. However the 'saving' rationale is more complex.

Since everyone is forced to either rent or own property (they cannot choose to consume zero accommodation) , the consensus view is that one may as well pay a mortgage because at least you will over time pay off some or all of the principal, which is a form of saving (since by reducing a liability, you increase your net worth). However in a flat market, the renter will save quicker than the mortgage-payer provided that their rent less return on home deposit saved, is lower than the sum of the interest portion of the homeowners payment, plus the maintenance cost of ownership. This is perhaps easier understood by comparing the position of someone with an interest-only mortgage (where essentially the property is rented from a bank, not a landlord), to a renter's as follows.

According to recent reports, the rental yield in the UK is on average 5.9% (and considerably lower in property hot spots like London). Hence a homebuyer who funds a £250,000 house with a £25,000 deposit, and a £225,000 interest-only 25 year mortgage initially fixed until 2012 at say 5.19% (currently available at Lloyds TSB) will pay £973 pm. It is generally accepted that ongoing maintenance/insurance for a typical home should be assumed to be 1% pa, which in this case works out at £208 pm, taking overall monthly payments to £1181. The renter meanwhile would pay £250,000 x 5.9% = £14750 pa or £1229 pm. However the renter does not have their £25,000 deposit tied up in the home - even if merely invested in the building society earning 4.5% interest, this would still generate additional gross monthly income of £94 taking the renters net monthly payment below that of the owner. In a falling market, the owner's net worth would fall far quicker than the renter's due to the inherent leverage embedded in a mortgage (in this example, 1% falls in house prices translate into a 10% fall in the value of their equity).

The above example probably overstates the actual rental yields experienced by many renters in the UK today. Speaking personally, the last property I rented in the UK cost me £900 pm. When we moved out, the landlord tried (unsuccessfully) to sell the property, asking for £269,000 implying a rental yield of just 4.0%.

Today's renters, if one believes prices are no longer rising, are infact not throwing money down the drain, but saving money quicker than homebuyers, which can then be put to good use to buy either the same property (but for less) or a better property for more (thanks to the increased deposit they will have built up).

3. "House prices can't fall - the Bank of England won't allow it."

Thanks to one of the smarter economic moves by the current Labour government, the Bank of England has been given an independent mandate to control monetary policy. Part of their rationale stemmed from the experience of the late 1980s recession, the depth of which was probably exacerbated by the politically-inspired decision by the then Tory goverment to inflate the economy prior to the 1987 election.

The mandate is fairly simple: The Bank’s monetary policy objective is to deliver price stability – low inflation – and, subject to that, to support the Government’s economic objectives including those for growth and employment. Price stability is defined by the Government’s inflation target of 2%.

The Governor of the Bank of England is required to write an open letter to the Chancellor should the annual rate of inflation be 1% higher or lower than 2%, including his proposals to return to target. The central bank does not thus have any mandate to protect homeowners from their own misguided actions. Indeed, their mandate clearly states that they are only required to support the Government's economic objectives for growth and employment, subject to delivering price stability. In short, price stability is their sole priority.

Clearly the Bank's role is not only to concern itself with current factors affecting inflation, or indeed the current inflation rate (provided it is between 1% and 3%), but to make forecasts about the future. Economic history has proved that once inflation expectations become well-entrenched, it can swiftly become a self-fulfiling prophecy, feeding through as it does into wage demands. Similarly, deflationary expectations are just as damaging as the Japanese example proved - despite zero interest rates for several years, the Bank of Japan was unable to lift the inflation rate back into positive territory.

It is at this point that I will make a fairly controversial statement. In short, rather than concerning itself with ensuring the housing bubble doesn't pop, in my view the Bank of England wants to ensure it does pop (ideally in a controlled fashion) and will thus maintain interest rates at levels which guarantee this outcome. Let me explain. If house prices were to continue rising at recent rates of 10% pa or more, the outcome would almost certainly be inflationary (thanks to the extra consumption brought on by refinancing, equity withdrawal etc..). Similarly, if house prices were to continue rising at recent rates but then crash, then the outcome would almost certainly be deflationary as the Japanese experience showed. In short, the housing bubble has to be stopped before it can do further damage (the only question is whether a 'soft landing' results or a crash).

Whilst the Bank of England (and also the Fed in the US) may dress up its hawkishness over interest rates in the language of 'oil-related inflation fears', in truth it is, I believe, focused solely on popping the housing bubble.

Finally, it has been suggested that homebuyers could circumvent higher short-term interest-rates by opting for fixed rate mortgages (more common in the US than the UK) since these are priced from long-term interest rates, which notably have fallen in recent months. Falling long-term bond yields usually imply either disinflation or deflation (lenders demand higher yields for taking on inflation risk) and/or concerns about growth (in a low growth environment, any positive return is a good return). The 'yield curve' plots these interest rates in a continuous form across different maturities from the present to the long-term (usually 30 years or more). In recent months, the UK yield curve has 'inverted' (long-term rates are below short-term rates) implying that lenders would find interest expense higher than interest income (since they typically 'borrow short, lend long'), thus reducing or removing the viability of lending at these rates.

4. "House prices will at worst flatten out - they won't fall in nominal terms."

I have already addressed in myth no.1 the theory that nominal falls will need to be greater to return to equilibrium because of the existence of low inflation. Equilbirium in this case might be defined as a return to historical norms in terms of price/income multiples, rental yields and housing debt/GDP.

However, the 'soft landing' supporters have a reasonable point - it is indeed possible (though in my view unlikely) that the return to equilibrium will occur via several years of zero house price growth, a period during which wage growth and rents could rise back to normal levels in relation to house prices. Whilst this is clearly the preferred 'solution' for most homeowners, in truth a 'short sharp shock' may actually be more optimal, since a flat housing market essentially serves to bring the entire market to a grinding halt, with homeowners unable to increase equity and move up the ladder.

However in order to explain why outright falls in house prices are likely, I need to draw upon historical analogies and focus on what have been the key drivers of the current bubble. Historically, bubbles in asset classes do not end in such a benign fashion, particularly when they are funded in large part by debt. Bubbles were documented as early as the 1600s when the Dutch traded tulips up to astronomical valuations. The most recent bubble was probably the technology bubble in US stocks which peaked in March 2000.

The excellent Philip Coggan, writing recently in the Financial Times, argued that for bubbles (or asset price depressions) to break, there needs to be an element of irrational buying (or forced selling), there needs to be a story or narrative that convinces investors they are right and there need to be signs of unusually high or low valuations. The UK housing market would seem to have all three elements in abundance today.

The process by which bubbles end tends to be common to all such occurrences - firstly, prices need to reach levels at which essentially the marginal buyer becomes 'exhausted' and unable or unwilling to pay the asking prices any longer. This stage is often preceded by an exogenous event, such as a rise in interest rates. The next stage is typically denial with participants unwilling to accept that the party is over - it is during this stage that one often observes short-term bounces in valuations as 'believers' cling forlornly to dying hopes. For example, the Nasdaq index had no less than six monthly bounces of 10% or greater as it made its precipitous decline from 5,048 to 1,139. There then follows fear and then typically outright panic, the existence of which tends to explain why bubbles tend to pop and overshoot on the downside.

The key 'unknown' however is always the exact timing of a market turn. Alan Greenspan (Chairman of the US Federal Reserve) famously gave a speech on 5 Dec 1996 suggesting that the US equity market exhibited elements of "irrational exuberance", well over three years before the market actually peaked. Several investors lost their shirts (and their jobs) calling a premature top for the market during the intervening period.

In my view, the UK housing market is now at the 'denial' stage with homeowners and vested interests proclaiming that a soft landing has taken place, whilst all around them evidence (not least horrendous retail sales) piles up to contradict them.

Now, admittedly certain aspects of property as an asset class likely prevent the type of swift sharp declines regularly seen in say the stock market. Most importantly, as mentioned already, people cannot consume zero accommodation and hence many non-forced sellers can opt to take their property off the market rather than sell at lower prices. Moreover heterogeneity of property (no two properties are alike) implies a lack of transparency about pricing, whilst I would also draw attention to the illiquidity of the market (it takes a long time to undertake a property transaction). Finally an oft-observed behavioural 'bias' known as anchoring leads homebuyers to rely too heavily on an 'anchor' or a single piece of information when making decisions, in this case the seller's asking price. This causes buyers to conclude they have acquired a bargain if they complete a purchase at below the asking price, even if the asking price was highly inflated in the first place.

However many homeowners who are not forced sellers and thus perhaps feel insulated from the effects of a crash, however need to recall that it is only those properties which are changing hands which determine market values, not the stock of housing which isn't for sale. Hence if your next door neighbour is a forced seller then the value of your house will fall with it, whether you like it or not.

The focus thus needs to be upon which parts of the market may contain forced sellers since it is their actions which will determine the extent and speed of any falls in prices. Much of the late momentum in the market came from the amateur buy-to-let landlords who, having previously shown little interest in property, saw the asset class as a mini 'get rich quick' scheme often drawing equity out of their the homes they lived in to invest in rental properties. As was seen in myth no.2, the maths simply doesn't add up in a flat or falling market - a combination of negative monthly cashflow and no capital growth is simply unsustainable. Whilst so-called professional landlords always understood the cyclical nature of the business, and the importance of diversification and careful property selection, the amateurs have focused upon the new-build sector committing the cardinal error of buying properties in developments with a preponderance of other hopeful landlords. Hence across the country, and not least in my part of the world (North London) there is a glut of modern 2-bedroom modern apartments, and not enough tenants.

5. "House prices won't fall in the absence of an increase in interest rates."

It seems that those people who espouse myth no.1 regarding property prices never falling, seem to get their collective memories back in time to espouse myth no.5. Their thinking is as follows: because the catalyst for the last bust was a rise in interest rates, ergo property cannot crash without a rise in rates. If only economics were this staightforward.

One important point to make at this juncture, is to point out the relevance of today's lower inflation rates, and the 'money illusion' suffered by many homeowners. Money illusion is a behavioural bias, and describes the propensity for people to think in 'nominal' terms and not inflation-adjusted 'real' terms. For example, most workers would more gladly accept a 2% rise in salary in an environment of 4% inflation, rather than a 2% cut in salary in a zero-inflation environment, despite the situations being broadly equivalent.

Similarly, there is a tendency to view an interest rate of 5% as inherently being 'cheaper' than one of 10% without any focus being placed on real interest rates (ie. the nominal rate less inflation). However it is the real interest rate which matters because the inflation rate drives wage growth, and wage growth drives the period during which a particular monthly mortgage payment is 'painful' for the homeowner. Our parents' generation understand this perfectly well - if one bought a house in the 1970s when inflation and thus interest rates were high, the first few years of the mortgage were hugely painful with very large proportions of incomes being paid to the mortgage company (far higher than today). However unlike today, the high inflation was the perfect backdrop for successful wage demands which ensured that within just a few years, the monthly mortgage payment was no longer painful at all, and they could easily 'over-pay' and shorten the mortgage if they wished. In short, inflation had eaten away the real value of the debt - nominal interest rates were high, but real interest rates were not. Today, nominal interest rates are low, but real interest rates are not especially so.

Reference again to the Japanese experience is useful at this juncture - because the inflation rate turned negative, the Bank of Japan was unable to get real interest rates negative (in the hope of stimulating the economy), even with nominal interest rates at zero.

The prevailing interest rate also needs to be understood in the context of its relationship to desired returns on investment (any investment, not just housing). In simple terms, the interest rate at which capital is borrowed represents the minimum return which the borrower should tolerate on whatever investment they are planning to make. When homebuyers expected house price growth of say 15% pa, there was essentially no realistic interest rate which the Bank of England could put in place which would prevent homebuyers from believing property would be a profitable investment. However, turn this theory on its head, and with numerous surveys suggesting homeowners expect zero house price growth for the timebeing, there is now essentially not an interest rate low enough to persuade people to buy property (in the hope at least of making a positive investment return). Hence the 0.25% drop in interest rates during the summer failed to have any impact on the market, and nor will any further cuts in rates in this bearish environment.

6. "Affordability is the key determinant of value, not multiples of income or rental yields."

This myth takes me back to the heady days of the tech bubble in the late-1990s. Back then, the tech geeks told us "this time it's different" - stocks should no longer be valued based upon old-fashioned metrics like cashflows or earnings, but 'eyeballs' and 'click-throughs.' Of course, there were some winners from that period (Google, Ebay, Amazon etc..) but these companies ended up doing boring old things like making money and generating cashflows. Property has no 'intrinsic value' aside from the value of the bricks and mortar which comprise it - it's value is derived from the cashflows (or opportunity cost of cashflows foregone) it can generate.

Investors should always be concerned when vested interests begin to justify valuations based on a 'new paradigm.' Although the housing bubble has lasted longer than most bears anticipated, we aren't yet ready to throw out hundreds of years' worth of economics textbooks. The focus on affordability focuses upon the idea that so long as homeowners can afford their monthly mortgage payment, the frothy valuations are justified. It doesn't matter whether they are tied into short-term discounted fixed mortgages shortly to become floating, or interest-only mortgages or mortgages which suggest such levels of leverage that a mere 5% drop in the market would wipe out their net worth. So long as that monthly bill can get paid, none of it matters.

Two things particularly concern me here. Firstly, the so-called 'affordability' has occurred thanks to historically low nominal interest rates (which, as I have already concluded, are misunderstood). When interest rates are low, then all other things being equal, one might expect the proportion of incomes spent on mortgages to be low also. After all, if homeowners are spending a growing and high percentage of incomes on their mortgages when interest rates are low, they are not leaving any buffer for the possibility of unexpected rate rises. Infact, this percentage rose as interest rates were falling, implying (as we all knew all along) that homeowners were leveraging themselves up to scary levels. This is confirmed by the fact that the multiple of average house prices to average incomes is now at around 5x nationally, and closer to 8-10x in the frothiest markets.

The second issue concerns the way that consumers treat housing in an entirely different way to any other good. If one was to ask the typical family with say £45,000 in joint income whether they can afford a £250,000 house, their answer might well be "yes, our monthly repayment mortgage payment is just within our budget." The same family would probably however baulk at purchasing a flashy new Porsche for example. But if one bought a new Porsche Boxter for £30,000, and funded it via a 10-year loan at 10%, you would pay £396.45 pm - well within the budget of most families earning £45,000 pa (even with the above mortgage). For some reason in the above case, even financially-illiterate consumers can work out that a £30k loan is a £30k loan and a 'real debt', however you pay it back, but lose the same logic when applied to a house.

Whilst asset valuations can go through temporary periods of euphoria and panic, ultimately the value of any asset is based solely upon the cashflow it generates (or, in the case of owner-occupied property, the rental equivalent), and a suitable multiple thereof (based upon prevailing interest rates). This multiple (similar to the Price/Earnings multiple used when valuing equities) is not fixed but dependent (especially) on interest rates, expectations for earnings growth and a 'risk premium' (since the best-laid plans can go wrong).

All other things being equal, lower interest rates, higher cashflow growth and a lower risk premium would lead to a higher multiple being applied to the underlying cashflows (in this case, rent). The risk premium is the trickiest factor to estimate, but at least acknowledging its mere existence is helpful. Interest rates are known and can be fixed; rental growth is typically linked to wage growth. With the UK 10-year gilt yielding 4.33%, the typical multiple one might willingly pay of annual rent might be say, 16x (based upon a 6.25% satisfactory rental yield - ie. 100/16). There would be no large additional growth premium applied to the multiple as rents have recently been falling, not rising and are likely anyhow only to grow with (low) wage growth.

Hence the £250,000 property would need to generate net rental income of £15,625 pa/£1302 pm (or save an owner-occupier this amount in rent) to justify the valuation. If you can find me a property on today's market where the owner would accept £250,000 to purchase it, but would generate £1302 pm in net rent (after costs), then you are a better property-finder than me.

An argument against the above would be, "..growth in rents may be flat but I have the chance of capital growth, hence I'm willing to 'overpay'." However I would argue that capital growth has to be linked in the long-run to the growth of rents, and hence this possibility is already factored in.

The basis for believing that the vast majority of families are quite easily meeting their debt obligations is challenged on at least two fronts. Firstly, total personal bankruptcies in the UK have risen for seven quarters in a row suggesting things are not as benign as they seem. Second, the retail sector has fallen off the proverbial cliff in recent months with many retailers expecting the worst Xmas sales since the last recession and year-on-year sales volume approaching zero following rises in the 6-8% range for most of 2004. In short, if homeowners are comfortably meeting their debt obligations, they are certainly not spending the excess in the shops.

7. "House prices will remain high because of demand and supply factors."

As discussed in my summary of what has occurred in the housing market, there are some demographic factors which would justify a small secular increase in long-term house price growth. On the demand side, according to the Office of the Deputy Prime Minister (John Prescott to you and me) the no. of households in the UK is projected to increase from 23.3m in 1995 (when the current bubble really began) to 25.2m in 2006, an increase of 8.2% in just over a decade. Meanwhile on the supply side, the no. of new dwellings completed fell from 198,000 in 1995/6 to a low of 175,000 in 2001/2, before beginning to creep up again thanks to voracious developers and some relaxation of planning laws. Clearly these demand/supply dynamics will have an upward effect on equilibrium prices.

However two important factors need to be noted. Firstly, these trends are not new phenomena which suddenly became apparent in 1995. The increase in total UK households in the decade prior to 1995 was actually 10.9%, higher than the 8.2% increase seen thereafter. Second, if there geniunely was excess demand for housing overall, then one would expect this to be reflected not only in higher prices but also in higher rents (since total demand for housing represents both buyers and renters). Instead as has been well-documented, rents never kept up with house prices and in many hot areas actually fell over the period.

It is likely that the trends which drove the increase in total households will continue, and there is no reason to expect the NIMBY ('not-in-my-backyard') mentality to suddenly dissipate thus allowing a material pick-up in supply. However none of these trends is large enough (nor new enough) to explain the explosion in house price growth, nor protect against the inevitable crash. Moreover, even if these demographic trends did justify the house price rises we've observed, one would expect consumer behaviour to adapt as they would in any other market that saw price rises, thus neutralising the original effects. Examples would include a greater propensity to house-share, lower immigration (many would be priced out), staying with parents for longer etc.. When energy prices rose in the 1970s, the collective move towards greater conservation and lower consumption assisted in bringing prices back to trend. In my view, housing is no different.

An important demographic trend likely to work against the housing market relates to the imminent retirement of the baby-boomer generation (born 1946-1964). With an average retirement age of say 60-years-old, this trend will peak around 2015 but be a key sociological and economic phenomenon for the next twenty years or so. The pension problem which this trend will cause is well-documented and highly topical, and moreover is relevant for any discussion about house prices. It is notable that the rapid rises in house prices from 1999 onward roughly coincided with the peak in the FTSE 100 share index in December of the same year. As investor portfolios (and their pension funds) were decimated by the subsequent declines in equities, a new fashionable asset class emerged in the form of property, the returns on which were enhanced by judicious use of leverage. Baby-boomers concerned about funding their retirements had found their panacea in the upward price appreciation of their homes, and to a lesser degree in buy-to-let. Unfortunately, for the most part, these gains are unrealised and the inevitable flood of supply from baby-boomers keen to realise their retirement dream will likely hang over the market for the next couple of decades, with buyers increasingly unwilling to provide the necessary capital to realise those gains. If you believe that demand/supply dynamics can explain the recent price increases, then it is hard to see how a secular increase in supply can be anything other than negative for the market.

A final point on this issue relates to the estimated 700,000 empty homes currently standing derelict or otherwise uninabited in England alone. If there was genuinely an excess demand for housing, then surely some bright entreprenueur would have found a way to develop some of these properties and returned them to market.

8. "House prices have already begun rising again - the Halifax and Nationwide says so."

This is probably the most contentious 'myth' and the one which makes me the most vulnerable to accusations of systematically manipulating the facts to suit my point of view. However, given the constant media battle which us 'bears' are forced to fight against those vested interests masquerading as independent commentators, perhaps I should be permitted a little leeway.

Most data and commentary on the state of the housing market, or at least that part of it which finds it way into the mainstream media, is presented by entities with a clear vested interest in rising prices. The most egregious examples are of course the price surveys by Nationwide and Halifax (two of the largest lenders), the Rightmove price survey (owned by Countrywide Plc, one of the largest estate agencies), the Hometrack survey (data provided by 3,500 estate agents) and the RICS survey (Royal Institute of Chartered Surveyors!).

Admittedly, there are independent surveys produced by the Land Registry and the Office of the Deputy Prime Minister, but these are less timely and based upon simple averages with no attempt made to adjust for the mix of properties sold. However they are at least based on actual completion prices which is the only price that matters - hence they will likely be seen as a lagging indicator of the true state of the market.

Whilst I am prepared to accept (under duress) that the vested interests report their numbers in good faith, the basis of calculation is inherently flawed. If indices are based upon (initial) asking prices (as in the case of Rightmove) then this says nothing about the prices at which houses are actually selling. However, they do give a reasonable view on general sentiment, and hence might be seen as a leading indicator of the true state of the market. For the record, the Rightmove survey showed three consecutive declines from July to September 2005, before a 0.5% increase in Oct. Time will tell how bullish sellers remain as we approach the quiet Xmas period.

Conversely, those indices based broadly upon mortgage approvals (eg. Nationwide, Halifax) will have an upward bias, most notably when volumes begin to dry up (see below). This is because during a slowdown, it is usually only the highest-quality properties which continue to have no trouble being sold (the old adage, "location, location, location") - these are also the properties with the highest relative prices. The Nationwide/Halifax will never pick up the fall in the value of that house overlooking the motorway, because it will never get sold. Also by being based upon approvals and not completions, the scope for sampling errors are substantial (many approved mortgages never proceed to a purchase).

The importance of sales volumes cannot be understated in this assessment. In a context of rising volumes, asking prices become a much better proxy for sales prices since properties are actually changing hands, at prices which (one can assume) are close to the prices asked for. When the bubble was in full swing, sellers demanded inflated prices and buyers shared their optimism, agreeing to pay them. In such an environment, references to 'intrinsic value' or 'rental yields' fall on deaf ears, as everyone just enjoys the party.

When volumes are falling however (particularly if one holds onto the 'excess demand' view) then it suggests a degree of market failure - ie. buyers and sellers are in disagreement about valuation. More specifically, first-time buyer volumes (in conjunction with buy-to-let volumes) are a useful proxy for the overall health of the market since they have historically provided the floor which enables buyers to move up the ladder. If the market begins to turn rapidly downward, it will be expected to be led by the bottom rung with everything else priced from it. In recent years the buy-to-let landlord has replaced the first-time buyers on that bottom rung, but if my calculations above are accurate, this is unsustainable, and moreover buy-to-let activity has already slowed.

According to the ODPM, the total number of property transactions peaked in the first quarter of 2004 at 469,000 and fell by 23.4% to 359,000 during the quarter-ended 30 Jun 05. Not surprisingly, according to the Bank of England, the total value of mortgages approved by banks also peaked in the first quarter of 2004 (£11.2bn in Mar 04) and has averaged £8.4bn per month in 2005. More specifically, the woes of first-time buyers (who used to constitute >50% of volumes) are well-known and are increasingly squeezed out by the multiples of income required to purchase a home, and their own understandable reluctance to pay current prices.

Fortunately for those seeking factual evidence about the state of the market, the London Stock Exchange requires all listed companies to report any information material to their businesses to the exchange. Since most major banks and homebuilders are listed companies, and since there is at least one major estate agency listed too (Countrywide Plc), as well as several companies who generate their profits from housing-related activity, there is thankfully one place one can go for impartial information. Here is a not entirely balanced selection of recent comments:

Travis Perkins (11 Nov 05): "...we have seen a slowdown in activity from mid-October, and our monthly customer confidence surveys have recorded a marked deterioration in anticipated workloads and order books."

MFI Furniture Group Plc (8 Sep 05): "...since the commencement of the second half, we have experienced a deteriorating market place..."

Wimpey (George) Plc (6 Sep 05): "...customers have remained cautious with continuing weakness in the second hand market making it difficult for them to commit and contract quickly."

Redrow Plc (5 Jan 06): "...overall transaction levels in the total housing market for 2005 are now anticipated to be at their lowest level for thirty years..."

In my view, the housing market today resembles a stand-off. Sellers believe it is their 'right' to sell their property at the inflated asking price; buyers are increasingly unwilling (or more likely unable) to buy it. The stand-off is thus evidenced by reduced volumes, and the impasse will only be broken by lower prices. As this link shows quite nicely, there is no 'shortage' of property only a shortage of property correctly priced (£275k anyone?)

Conclusion

If you've managed to read this far, congratulations. The housing market is a fascinating subject for anyone interested in finance, economics and consumer behaviour because it encompasses theory taken from all three disciplines. If the highly desirable correction in house prices does not occur, one can safely throw out hundreds of years of economic theory and begin a new paradigm. The process may be fast or it may be slow, (or it may not happen at all.) But one has to place probabilities on various outcomes based upon the best facts one can find, and it is hard to see how the market can avoid a correction.

One would imagine based upon the type of headlines that one observes in the Daily Mail et al, that the house price bubble has somehow been good for the UK. Certainly the economy was boosted in the short-term by the extra consumption which it enabled, but much of this was funded by debt in the form of equity withdrawal and the like. However the rise in property values in itself constitutes merely a redistribution of wealth, not an underlying increase in wealth. Relative to the value of an average house, homeowners are no better off than they were a decade ago. Most ominously, the structure of the economy which has resulted from the bubble is dangerously leveraged and vulnerable to either an exogenous shock, or just the simple correction of the underlying imbalances.

The rapid slowdown in the retail sector has taken most pundits by surprise. A slowdown of this magnitude simply could not have occurred without implying some serious cashflow problems at the consumer level, which must by definition eventually be reflected in sentiment towards housing. In my view, the speed with which sentiment will change and flow through to prices will also cause surprise (and consternation) as the myths addressed above begin to fall under the weight of their own misguided assumptions, revealing the housing market in its true form....a house of cards.

Disclosure note: the author does not own a home!