• Stuart Fowler

The housing ladder: what exactly pushes it out of reach?

Surely a silly question! Rising prices relative to income make house prices unaffordable. I’m not a property economist but if I apply my expertise in both financial asset pricing and personal financial planning, I think I gain further insights. I hope some property experts will take these further.

Ownership (relative to renting) satisfies several non-monetary desires but also a financial one. The latter is broken down into lifetime enjoyment and a ‘bequest’: the value we pass to our heirs. In periods of high inflation and high discount rates, the cost to a first-time buyer of the bequest portion was virtually nil. With lower discount rates, it is now significant, though much the smaller part. It is a form of over-investment and it is unaffordable. This anomaly may remain even after freehold prices fall from a valuation level in real terms which is about 50% above the sustainable rate (see my latest real house price update). These economics can be tested in the leasehold market. Long leases look like part of the solution to the problem that affordability varies massively through time but our need to satisfy lifetime enjoyment is pretty much fixed by our age.

Price still matters most My previous posts on house prices focus on the time-varying ratio of real prices to a sustainable trend of about 2% pa. I have argued that in a market defined by broadly static land supply, with no technology breakthroughs affecting construction costs, this is the naïve expected rate, approximately equal to trend growth in real incomes.

If the trend is about 2% and real prices can fluctuate slowly between extremes of, say, 50% above and 25% below (as the historical plots in my previous posts imply), then clearly affordability for first-time buyers will largely depend on the lottery of when they are born. The longer deviations can persist, the greater the chance that a 27-year old is still renting against their will (or living at home) when 32. These dynamics of course apply equally to people wanting to trade up but I assume not being on the ladder weighs more heavily with people than not being on a higher rung.

The most recent deviation does seem to have remained at an extreme level for longer than in past cycles, but periods of deviation greater than 20% do regularly last as long as five years.

This source of variance in affordability will always tend to dominate others. The effect is felt either as the frustrated desire to get on the ladder or as consequences of paying too high a price to get on it. Those consequences range from lost opportunities to meet other consumption goals or financial saving goals to foreclosure and a permanent loss of financial capacity (as well as loss of the home).

Over-investment not dependent on price In ‘normal’ conditions, when the expected growth in prices will be in line with real incomes and so hopefully in line also with the real cost of money, an affordability problem can still arise systematically if the value of homes includes a significant present value of the ownership enjoyment that exceeds the owner’s own life span. When discount rates are about 10% or more, there is virtually no present value to assign to the cash flows from selling the property in 60 years, which might roughly correspond to the life span of a first-time buyer. With a discount rate of about 5%, freehold purchasers and leaseholders with the typical 99-year lease are having to pay 10% more than they need. For much of the current bull market in house prices, the over-investment has been even greater than 10%..

Across the economy as a whole, I believe this excess investment is highly inefficient. One practical impact for those willing to pay the market price is that financial savings are reduced. In this case, any hoped-for bequest value is likely on average to be absorbed in making good under-provision for pensions.

Many people would argue that this actually rationalises the whole process, as home equity is a tax-efficient form of saving and flexible processes for turning it into an income stream are likely to get better in the future. I have some sympathy for this view but from an economic view it is still wasteful.

The over-investment at cost is likely to earn the real return of just 2% which is the real house price trend. However, it is a rate that faces downward pressure if you believe home-construction technology will lead to lower building costs, as has occurred in other periods of industrial history. Even 2% pa in only about in line with the index-linked gilt yield and is well below any real returns incorporating risk premiums available to investors in typical pension products. This gap arises partly because the economic rent on the excess portion of the property value is being given up – or more accurately ‘consumed’ as part of the ownership benefit. There is no reason to suppose this consumption is valued: it is just another aspect of the affordability problem.

Though not central to my argument, I have always thought that an intelligent approach to flat or flatter taxes, which requires a broader tax base, will lead to notional income such as the commercial rent foregone on owner-occupied property will at some point be taxed, consistent with the ‘true’ economics I have tried to set out here. This will increase the inefficiency of over-investment in home ownership.

Leasehold versus freehold The concept of excess investment, relative to the lifetime ownership that people actually value, appears similar to that of a lease, where the term of the lease is given by life expectancy (or whatever shorter period ownership benefits are valued). The excess value in a freehold then directly corresponds to the present value of the interest that reverts to the freeholder at the end of the lease.

Applying the logic to the problem of affordability linked to working lives, such as essential workers, the ownership value that needs financing is much less than the first-time buyer’s lifetime value. Using taxpayers’ money to meet the over-investment is both inefficient and unfair.

Although the length of many long leases is still beyond the life expectancy of a first-time buyer, or the working life of a location-bound employee, personal affordability could therefore be expressed as a lease length, beyond which any shortfall in lifetime enjoyment has to be satisfied by renting (which preferably will always be under an assured tenancy).

Temporarily high prices necessarily reduce the lease length (and vice versa) but if the market was more flexible lease lengths could at least vary to help clear demand.

There are many reasons why the actual legal and institutional frameworks may prevent this simple theoretical model working in practice. The challenge to others is to consider why this has to be the case.

Of course, the economic assumptions I have made may also be wrong. I would like to see comments that address both.

#economics #houseprices


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