The case for London house prices to crash 20% by 2025
...just hear me out
As a bitter member of London’s generation rent, it is rare that a day goes where I don’t fantasise about a long overdue crash in property prices allowing me to finally get out from under the thumb of my presumably evil landlord. Perhaps that makes me biased, but nevertheless I found myself wondering where prices might go next, so I made it my mission to crunch the numbers.
House prices can be thought of in terms of a combination of price to earnings (i.e. wages) ratio, that is the level of prices that can be supported by a given amount of earnings, and the level of earnings itself. The former is largely impacted by the cost of financing, i.e. interest rates, as well as other demographic and market factors which I will caveat my analysis with later. The latter is primarily a function of economic strength and inflation as it applies to wages, but again there are various factors including demographics which impact this.
My analysis will look at both of these in turn before concluding.
Price to earnings ratio
Taking the price to earnings ratio first, we can see that it has steadily climbed over time, from as low as 4x in 1997 to a whopping 12.97x in 2021.
It is worth noting that in the face of tight credit lending criteria following the 2008 GFC, this increase in P/E ratio has not been accompanied by significantly reduced affordability, which has remained stable over this period. How is this possible? There are several factors at play:
Interest rates (in my opinion the most key factor and the subject of my analysis) - lower interest rates have meant that borrowers can borrow more without it impacting affordability.
Demand from rich foreign buyers - rich [insert nationality with vast natural resources here] have fuelled demand for property in the capital, increasing prices with little to no effect on the denominator in the equation. (Though I would argue that the use of the median price, as opposed to a mean average, should help nullify this distortion.)
Supply constrictions + demographics - London has a horrible issue with the supply of housing and population growth has forced upward pressure on house prices.
A rise in purchases by more than one individual.
For the purposes of my analysis I’m going to focus in on interest rates. It is common wisdom that higher interest rates mean lower asset prices in general, including house prices. At risk of reinventing the wheel: higher rates means higher repayments, which in turn reduces affordability for owner-occupiers. Similarly from a landlords point of view, rental yields necessarily must rise to compete with alternative financial assets, which in turn reduces the capitalised value of property.
My approach has been to use the BBA Mortgage rate (courtesy of Trading Economics) and to plot this against the price to earnings ratio over time. And there is a relationship here (R-squared 0.6039) which we would expect, but where we are right now is remarkably outside of the trend:
Of course, there is a delay in the impact of increased interest rates. In the UK mortgages are typically on 2, 5, or 10 year fixed periods before borrower remortgage. Note this is unlike the US market where mortgages are largely fixed for the entire term. As time goes on, more borrowers need to refinance at higher rates, can’t afford repayments, eventually leading to more properties on the market and lower prices.
The best relationship I could find using these 2 factors was by applying a 2 year delay to the PE ratio (R-squared 0.673):
If we then apply this regression against current (and forecast) BBA mortgage rates, which currently sit around 7% (again per Trading Economics), then this is what we would expect to see in terms of the PE ratio in the coming years.
Clearly there is a lot of noise around the P/E ratio given the other factors previously mentioned, and notably the current ratio is close to one standard deviation above where the regression would predict. Nevertheless this gives us a good range to look within and, without a rapid decline in rates or some radical government intervention, we can expect the PE ratio to fall to at least into the 8x - 10x range.
Earnings
The earnings part of the equation is probably the easier bit, it hasn’t moved around a great deal, stalling in the last couple of years:
The question is, how much will wages inflate over the next few years, and could this inflation offset the impact of a reduced PE ratio on house prices?
In 2022 earnings increased by approximately 6.4% in 2022, and with inflation close to 10% we can expect wages to grow similarly in the coming years.
For the purposes of my analysis, I’ve taken a relatively conservative view:
Clearly if a recession ensues earnings might not grow at all in which case the outlook for house prices may be even worse…
Pulling it all together
As of December 2022, the Median House Price in London was £543,100. If we take the earnings forecast and use what the last 25 years of house prices in London can tell us, it looks like pretty grim reading for the next few years once interest rates have baked in to prices.
What will unfold over time? I will be interested to revisit this and see what happens. In the meantime, I shall continue to window shop for unaffordable properties on Rightmove.
Eddie Lloyd