Why House Prices Boom and Crash
Why can’t UK House Prices Remain Steady?
If you look at the historical trend of UK house prices, one thing stands out - Volatility. House prices seem to be either rising by 20% a year or falling by 10-15%. Why can’t house prices remain steady, like say the price of cars? Why are house prices so volatile?
Speculation
Although people talk of housing speculation, the majority of homeowners do actually buy a house to live in. A house is not like stocks and shares which can be easily bought and sold. It is true there are investors who are influenced by the prospect of rising and falling prices, but, this small (if growing segment) cannot explain the housing volatility by themselves.
Falling Prices Makes Lenders Cautious.
When prices are rising lenders are more willing to lend ‘risky’ mortgages. If house prices are rising by 20% a year. A 100% mortgage will soon become a standard 90% mortgage. In a period of rapidly rising prices lenders require a smaller deposit. They are more willing to lend to people with bad credit. Even if people default, it doesn’t matter because the bank will have made capital gains.
When prices fall, the opposite happens. Banks are concerned with negative equity. With house prices falling, repossession becomes a real liability. Not only does the bank suffer costs of repossession but also the equity loss. This is why banks are currently penalising homeowners with small deposits. It means the goal posts have been moved for first time buyers. A couple of years ago, only a small deposit was needed. In today’s climate a much bigger deposit is needed. This is leading to a fall in the number able to get a mortgage.
Price changes and confidence.
With prices in seeming freefall, there are very good reasons for delaying any purchase. Even if prices are falling by 5%, it makes sense to wait 12 months, as this could save you £10,000. The problem is that this, common sense attitude, exacerbates any price falls. As soon as prices fall by a small amount - nobody wants to buy and this magnifies the price fall. It becomes a vicious cycle, with prices falling no one wants to buy. With no one wanting to buy, prices keep falling. It is because of this that house prices can overshoot in either direction. With house prices falling at the moment, I anticipate price falls will overshoot and fall too much. Then we will go back to a period of rising prices. It’s rather like a bouncing ball which can’t stop moving from side to side.
Mortgages
The ratio of house prices to earnings did rise significantly in the 2000-2006 boom suggesting house prices were becoming unaffordable to first time buyers. But, this decrease in affordability was magnified by changing conditions in the mortgage sector. The credit crunch has magnified the variation of house prices because banks have changed their criteria for lending.
Time Lag in Supply
When prices are rising, homebuilders often find it difficult to build enough houses to meet growing demand. The planning process is long and difficult. Even when permission has been granted it can take several months to complete the house build. Because demand rises faster than supply, prices increase. On the other hand, when prices start to fall, there is a lag of new houses coming onto the market. Then in the midst of a housing price fall, nobody wants to build. This makes good sense in the short term. However, for the long term, the fall in building supply, means long term shortages of supply will continue. When the housing market recovers in the UK, we may again face supply shortages which squeeze prices higher.
Housing Market and Economy.
When house prices are rising it helps boost economic growth (people feel more confident and can remortgage). When house prices are falling, it results in lower economic growth, and rising unemployment. This results in less people being able to buy. Falling house prices reduce demand and therefore exacerbate the fall
Cost of living.
The current downturn in the housing market has coincided with another economic shock - rising oil prices. Homeonwers are being squeezed in two directions. The last housing crash coincided with high interest rates to try and defeat inflation.