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LO's Marson: The 'greater fool theory' is driving the housing market
by Paul Marson on Oct 07, 2013 at 09:44
The housing bubble of 1989 peaked at a house price to income ratio of 5.0, followed by a 13% fall in the average house price in the early 1990s. The previous bubble, in the early 1970s, precipitated the secondary banking crisis and the inception of the Banking Act.
The British know a thing or two about housing bubbles but still propagated a bubble in 2007 which peaked at 5.7 times income, with the subsequent crash once again exposing the weakness in the banking system.
Have we learned? It would appear not! The current price to income ratio is 4.6, just shy of the late 80s peak and a worrying starting point for the traditional UK housing-led economic recovery, fed this time by mis-timed government incentives in the form of “Help to Buy”.
Housing, as we have learned, is a risky and relatively illiquid asset and should, on that basis, provide a fair margin of safety, or risk premium, relative to its funding cost. The return on residential property can be thought of as the net rental yield [allowing for maintenance costs, void periods etc.] plus any growth in the rent plus any change in the capital value of the property.
Where do we stand today? Well, the 6.1% national average rental yield equates to a 5% net rental yield. Rents have grown approximately 2.5% annually over the last 10-15 years and, if we assume that the price to income ratio reverts steadily to its long run median level over the next 5 years we lose 3.8% annually in capital value.
Adding the three components we have 5% plus 2.5% less 3.8%, giving a return of just 3.7%. With the current 5 year 75% loan to value mortgage rate at 5.5%, the real cost of the mortgage after inflation becomes 2.5%. The margin of safety offered by UK housing is, therefore, only 1.3% - that is, 3.8% minus 2.5%.
Whilst not negative, as it was at the 1989 and 2007 market peaks, it is meagre compensation for risk. Moreover, prices do not have much further to rise before the market moves into negative risk premium territory – with the same implications as in previous bubbles. The situation in central London, where the price to income ratio is 6.5 versus a long-run average of 4.5, is even worse. With a 4.8% gross yield, the margin of safety on London property is already negative at minus 4.5%.
Aside from the fact that housing overvaluation effectively transfers wealth from the young to the property-owning old, when the obligation for government debt is going the other way, the housing market is being held aloft on the expectation that prices will rise indefinitely. It is an exemplary demonstration, as only the UK housing market knows, of the “greater fool theory” of asset pricing: someone will always give you more than you paid. Nothing changes…
Paul Marson is the chief investment officer of Lombard Odier.
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