A key factor driving house prices upwards is that demand for new homes outstrips supply. Some 50,000 fewer new-build houses come to market each year now than in the 1980s. Economic analysis by Hilber and Vermeulen (2016) suggests regulatory constraints on house-building were responsible for a 100% increase in inflation-adjusted house prices between 1974 and 2008.
Green belt restrictions are an essential consideration here. Imposed in the mid-twentieth century to prevent the urban sprawl that had seen the footprint of towns and cities swell during the 1930s, green belts essentially limit the expansion of many of our urban areas, including London. Approving more land for housing is, however, unlikely to solve the supply shortage on its own. This has already become apparent in recent years as a substantial increase in planning consents has not resulted in a comparable increase in house building. The discrepancy between the number of homes approved and the number of homes built has become particularly pronounced since the introduction of the National Planning Policy Framework in 2012, which was designed to free up the planning system and bring forward more land for development.
A lot of land that is approved for development is not even in the hands of a house builder. The landowners’ choice is between striking the best deal today and waiting for a better deal at a later date; based on the expectation of increasing land prices, they are holding off sales. This has not always been the case; when Britain’s post-war house building boom began, it was based on cheap land. The 1947 Town and Country Planning Act under Clement Attlee’s government allowed local authorities to acquire land for development at “existing use value”.
The New Towns Act 1946 was similar, giving public corporations powers to compulsorily purchase land at current-use value. This meant land for new homes could be acquired at or close to its much lower agricultural or industrial use values. What happened? Landowners rebelled, and Harold Macmillan’s Conservative government introduced the 1961 Land Compensation Act. Henceforth, landowners were to be paid the value of the land, including any “hope value”, when developed.
The housing market has stabilised at much higher valuations than were previously reckoned possible. A common measure of affordability is the ratio of average house prices to average earnings, since income must ultimately pay for the acquisition of a property financed with a loan. Homes are nearly as overvalued as they were at their peak before the great financial crisis. In London, affordability metrics appear to be defying gravity. But comparing prices to average incomes is less relevant here because large swathes of central London are owned by foreign investors.
Much the same message emerges from another valuation method, which measures the relationship of house prices to rents, and essentially shows the relative affordability of buying versus renting a property. It is worked out by looking at the average cost of ownership divided by the received rental income if buying to let, or the estimated rent if buying to live there.
House prices have risen faster than rents, in part because of growing demand for property from buy-to-let investors, who in turn increase the supply of places to rent. The buy-to-let phenomenon got going in 1996, with the introduction of mortgages which no longer required the borrower to live in the house. Now, however, there are signs that regulatory changes have begun to send the buy-to-let boom into reverse. In 2016 the government introduced a 3% stamp duty surcharge on top of normal stamp duty rates for those buying second homes. It abolished a generous wear and tear allowance for those letting furnished properties, and began tightening the rules on how landlords write off interest costs against income tax. These changes are enough to turn healthy annual profits into losses, especially for investors in higher tax brackets and with large mortgages.
It is the challenge for policymakers to ensure that more homes are built, to address inadequate supply. Politically, the main parties have already been looking in this direction: the latest Conservative manifesto pledged to ‘reform Compulsory Purchase Orders to make them easier and less expensive for councils to use and to make it easier to determine the true market value of sites’. Labour promised to increase local authority powers including ‘enabling compulsory purchase at a price closer to existing value’.
On the demand side, higher valuations deter purchases, and aforementioned tax and regulatory changes have already made buy-to-let less attractive. And when homebuyers work out whether a property is affordable or not, the cost of servicing a new mortgage as a chunk of take-home pay is now what matters. On this basis, valuations are also stretched, albeit considerably more affordable than they were at the end of the 1980s. The decline in borrowing costs over the past decade goes a long way to explaining why house prices have proven so irrepressible so far in this economic cycle. However, it is probably just a matter of time until we see durably higher interest rates again.
All of this suggests that in the medium term, the chances are that real house prices will revert to their trend of being flat over time, or increasing at most 1% a year. After accounting for fees, tax, and the advantage of living rent-free, this makes the benefits of owning and occupying a house comparable to the expected return of a moderate risk financial portfolio – albeit without the robustness, conferred by carefully judged diversification across industries, countries, and asset types, and liquidity of a balanced portfolio of capital markets assets.
These are our current opinions but the future, as ever, is uncertain and past performance of investments is not a reliable indicator of future performance. The value of investments can fall as well as rise and you could get back less than you invest. If you’re not sure about investing, seek independent advice.