• Stuart Fowler

Common sense on house prices: write on, Sharlene

Standing in for the outgoing editor of the FT’s Money section, Sharlene Goff penned a very thoughtful Serious Money column this week end, raising some very logical questions about the implications of government policy for first-time house buyers. She makes three challenging propositions. How will raising supply from 1% pa to 1.5% make any significant difference to prices? Is the price effect not a function of localised imbalances in supply and demand that are not easily micro-managed by governments? Why will the big idea of shared-equity finance not simply transfer the problem up to the next rung on the ladder? Read more to see what I think the answers are – but hopefully Sharlene will be encouraged to stick with these issues and talk to people who know more than I do.

The supply fallacy It is a simple matter, usually overlooked by experts, that the trend in overall real UK house prices and the pattern of very high cyclical variance around it is not obviously consistent with a structural shortage in house construction. The trend since the immediate post-war building boom has been roughly in line with construction costs and also roughly in line with incomes. The evidence for this can be explored here by searching for ‘house prices’. Logically, this is what you would expect unless the availability of land for new construction was so great that house prices could permanently (or for many decades) fall relative to incomes or even relative to other prices.

In an earlier article comparing UK and US house prices, I suggested that prior to the most recent US house-price boom there was a difference in underlying trend that is consistent with the very obvious geographical differences in land availability between the US and the UK.

You could argue that this makes planning laws the real difference. Sure, but we should expect planning policy to reflect the difference in land mass and population density. Viewed like this, long-term growth in the UK relative to other prices of about 2% pa, with neither increase nor decrease in affordability relative to incomes growth, is what we should expect of a fairly constrained land market. The absence of any real growth in the US (prior to the recent boom) is what we should expect as long as the good fortune of land availability supports increasing affordability.

Sharlene’s intuitions about orders of magnitude, at the national level, are right. The numbers are not significant in explaining future absolute prices, prices relative to general prices or relative to household incomes.

As my post on this subject last week repeats, the most likely driver for cyclical deviations from an unsurprising trend has to be monetary: the availability of credit to support (or validate) popular expectations about future prices, rational or otherwise.

The unwillingness of Americans to view their extraordinary boom as just a symptom of undisciplined mortgage lending is finally coming to an end with the unravelling of the credit supply to the market, whether new sources of loans (such as hedge fund investors and specialist sub-prime lenders) or the mortgage business of main-stream commercial banks.

It is time we too started to focus on the role of monetary inflation in our own house price boom instead of making superficial assumptions about other causes.

Local markets versus centralised policy Because net supply is such a small proportion of the stock, Sharlene’s intuitive sense that it is all about localised conditions is also right. The problem with the Government’s supply policy is that it is not obviously responsive to local demand messages created by the market but looks far too much like a desire to impose prior judgements about demand on the market.

This follows in a Brownian tradition of micro-management and is not at all a break with the past. The most likely result is therefore that the Government’s actions will fail to deal with either localised conditions or national trends. To the extent people are encouraged by them to take on risks they should not, they will make matters worse. Fortunately, our mass popular delusions about property are likely to have been shattered, as is happening now in America, before too much damage is done.

Solutions based on how we finance property The third element of Sharlene’s questioning is quite novel but also deserves much more analysis by economists and finance professionals: the impacts of changes in the instruments used to finance house purchases.

In an earlier post I highlighted the inefficiency inherent in the need to finance an asset whose present market value reflects a longer duration than the owner’s real utility. What on earth does that mean?! It means that the freehold house buyer has to pay for something that has two elements of value: i) the right to occupy it throughout your expected lifetime (which is obviously longest for the first-time buyer) and ii) the ‘bequest’ value that is represented by any present value in excess of the amount accounted for by the lifetime occupation period. The buyer benefits fully from the first. The buyer’s heirs benefit from the second, although that may be something the buyer also values.

In the period of high inflation in which the post-war generation acquired their freeholds, the present value of the second element was non-existent, because high inflation leads to high discount rates which make far-off cash flows of little or no value. After the event, it is possible to see that there was a bequest value (hence all the fuss about IHT biting on middle-England estates). But this bequest value is mainly accounted for by the deviations from trend rather than the underlying trend (ie buying at or below trend and selling well above trend) and by low after-tax real interest rates. Whilst mortgage interest deductions against tax might have been assumed before the event, low real interest rates could not.

The idea of two different elements of value with different ‘utilities’ associated with each is not at all counter-intuitive. I suspect most young people would be pleased to be able to satisfy the first, with reasonable confidence, and leave any bequest element to Lady Luck. For those with no children or expectation of children, they may even assign a negative value to the bequest element: it represents a highly inefficient form of wealth, unless converted to income and spending.

In that article I speculated that the most efficient way to maximise young people’s utility was to buy a lease that matched their expected lifetime occupancy. With volatile real prices, demand and supply within the existing stock could be brought into better balance by variable lease lengths, so that a first-time buyer could acquire the longest lease he or she could afford.

In this idealised solution, the problem Sharlene alludes to of transferring the problem of affordability to the next rung of the ladder need not apply. Decisions about trading up or down could use flexible leases as one of the ways to maximise utility at different life stages, as the occupancy element of the value declines with age.

In the real world, flexible lease terms may not suit investors as the source of finance as much as loans that share the benefits of housing appreciation. However, the logic of my general argument suggests the preference for shared-equity finance is based on a fallacy about the sources of ‘equity’. Like house-buyers themselves, the implicit assumption by financiers is that the market is undervaluing the present value of the future wealth created by a leveraged home. Either both are right or both are wrong. This is not an efficient market solution.

If it is based on a fallacy it makes no difference if the provider of the shared-equity loan capital is effectively the government, as this is just a different way of committing household money.

These are very superficial ideas and, as I suggest earlier, we need experts in finance to take them on. The guiding principles should be to match supply and demand. But in this case what we are trying to match is opposing financial utilities, not buyer and seller of a property.

Considering the extraordinary creativity in financial engineering in corporate capital structures, driven largely by investors’ utilities, it is odd that so little innovation occurs in housing finance. About the only thing we have to show for the best brains in finance is securitised, leveraged sub-prime mortgages. I think we can do better than this. And we can do better than the Government too.



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