House Prices Fell 2.3% in January - What Does this Mean?

princeofpounds

No-one has a crystal ball. You can only have an informed guess based on various investment fundamentals, the interpretation of which are themselves usually informed by history and reasoning.

Real estate prices depend on a number of factors, but like any financial asset it boils down to three in the end.

The first is the cashflow the asset generates - either rent, or the benefit of avoiding paying rent if you plan to live in it. This is a net cashflow, after costs.

The second is the growth of that cashflow.

The third is the discount rate. This is essentially a concept that tries to measure how much a recurring cashflow is worth. It can be conceptualised in a number of different ways, but it is best to think of it of an opportunity cost. For example, if the only other investment possible was a 5% risk-free bank account then £1 now would have the same value as a cashflow of £1.05 in one year's time, so you need to discount the future cashflows to arrive at an estimate of their value at the present time.

How does this apply to houses? The first two factors are influenced mainly by economic factors affecting how much people are willing to spend on housing. This can change over the years due to supply of housing, changing demographics, wage inflation, change in the reputation of areas, shifts in unemployment and the workforce etc.

The last factor is the most complicated. It is affected by a multitude of factors, but mostly the availability and cost of debt. Because we have had low interest rates and reckless lending for years, the discount rate was low an and asset prices high. This is no longer the case. Do not confuse interest rates with the cost of debt, although it is the main factor the availability of credit is very hard right now and inflation is the other contributor as the *real* cost of debt is inflation-adjusted.

The discount factor is also heavily influenced by psychology, greed and fear. People tend to be more wary of buying when prices are falling, and more keen when prices are rising, but it also has to encapsulate everything they feel about their jobs, government policy, the economy and so on. This is the 'it's only worth what someone will pay' factor, the herd mentality too!

People without a financial education tend to attribute the change in house prices to the first two factors, and indeed over the long term they influence the overall trend line. But almost all the cyclicality which accounts for the booms and crashes around this line is due to a varying discount rate. Rents are only a little different to last year, same with physical supply, but house prices are very different becuase of restricted availability of debt compared to the ridiculous availability before that.

There is good news and bad news. The bad news is that modelling all these factors explicitly and being right is nigh-on impossible (unless you have that crystal ball I mention). Experts can make some estimations to get by. But the good news is that you do not need to. As long as you understand the concepts there are quite a few economic relationships that tend to reassert themselves over time, and you can base judgments on your interpretation of them. I can only skim these now...

Look at the long-term trend for real house prices, and how the market moves cyclically around it. Note that has been almost suspiciously cyclical over recent decades - that is not a defined pattern which will continue perfectly, but it would have been very obvious from 2005 that things were abnormally expensive.

Look at the relationships between incomes and house prices. Lending used to be 2.5x one man's salary, recently it could be 6x double incomes! Long-term affordability tends to revert to a historical average range, although societal factors like more women working and structural improvements in the financial markets can adjust where the 'average' is over time. Interest rates obviously affect affordability too. There are affordability indexes out there that try to capture all this, but affordability is a necessary condition for a recovery, not a driver all by itself. You can lead a horse to water but you cannot make it buy a house!

Finally, as has been pointed out, housing tends to be a momentum market. If you follow the indices you will not see a sustainable turnaround until you have at least a few months stabilisation and reversal. Right now things are falling at just a steep a rate as they have been, so you need to have decelerating falls for a long time before you even think about stabilisation.

Be careful which house price index you look at. None are perfect. Rightmove is fast but rubbish as it reflect's seller's wishes in asking prices! Nationwide and Halifax are fairly rapid and give you some idea of what prices are agreed, but many sales still fall through. Land registry is most accurate as the only one to record actual complete sales but lags several months. None include auction sales, which are probably the true measure of the 'live' market (although auction properties have a discount for the risk too!).

Check out housepricecrash.co.uk for more information and some of these stats. It is stuffed full of nutters and ideologists, but also some people with knowledge even if they have odd opinions.

For the record I am a crasher. We are reverting to the mean of the trendline. It's probable that we will go below it, as overshoots are usual thanks to economic and psychological momentum, but not certain. I do not know what will happen to nominal house prices - if in a depression they will continue to fall much further, but if governments print too much money and start inflation up again they could even go up, although the real house prices will still be destroyed.

This has all been simplified for you - there are nuances and complications to all of these factors, but it should help you get off the ground. I think they should teach this stuff in school as many of the concepts are the basics of finance and entrepreneurism, but unfortunately they don't.

If all this goes over your head, you'd better do a bit more self-education before you start investing in property. There is no reason why you cannot do it with adequate numeracy, a dash of intelligence and a great lump of common sense, but you need to do it with your eyes open.

Manual_Reversion

I would just like to say, what a fantiastic post from princeofpounds. As he/she alludes, there is no straightforward answer to what, on the surface, is a straightforward question. Having said that, post #12 above is one of the best attempts at tackling the fundamentals that I have come across.

The point that he/she makes with regard to fincancial matters being taught at school resonates strongly with me. It's great learning differential calculus in maths class but what use is this if, on the back of such knowledge, we are empowered to gain employement that allows us to purchase a property which ultimately results in financial ruin (thinking of poor souls who have bought off-plan, exchanged contracts and can now no longer complete, being chased for the drop in value when these places are inevitably auctioned off).

Another bug-bear of mine is pensions. It seems the majority of people make no meaninglful attempt at retirement provision until it's too late. I don't understand why the basic principles of long-term investment aren't explained at school, before the more interesting calculus et al is tackled.

Apologies for the pension rant. I have no wish to hijack this thread on house prices.

Thank you princeofpounds for a great post!

princeofpounds

Hey thanks for the compliments... I'm a he by the way.

Though it seems to have killed the thread!

I think there's a couple of other points I need to get across...

One is the concept of income and capital gains. You need to understand both sources of returns (or losses). An example will probably help you understand the pitfalls. Often you will hear people say something like 'why have cash in the bank paying 1% when bricks and mortar can give you a yield of 5%?'. And if you only consider income, they are right.

However, if you consider capital gains, they can be very wrong. If I buy a 100k house and receive 5k income I am about 4k better off than I would have been. But this neglects that concept of opportunity cost and capital gains/losses - if house prices fall 15% (as they have done and may do again) then I have lost the opportunity to buy that same house for 85k a year later. I am effectively 11k worse off in reality than I should have been.

Of course this is not a *cash* capital loss until I sell the house, but it's a perfectly real opportunity cost.

I should also talk about that word yield... It is a simplistic way to approach those factors of cashflow and how much cashflow is worth (because it is nothing more than cashflow divided by the market price of that cashflow). It is simplistic because it is static - it has embedded assumptions about the growth of cashflow and the discount rate, and that these will never change.

The fact is that they can and do change. A yield of 5% can look great right now, but with 7% interest rates (a long term average) it looks awful and the price you paid would look silly!

Finally, and probably the most important thing to understand is gearing. Real Estate is one of the few assets that the man on the street can actually get gearing on, and that is why it is seen as a path to riches far more than any particular virtue of real estate investing itself. Almost all the people you hear about getting 'rich' with property use this method. In fact, combined with stealing, being a 'star' footballer/manager/singer and inventing things like google, it's really one of the only four ways that people do get rich!
Gearing is borrowing money to increase returns to yourself and the equity you have put into a property. Again, it's best explained through example. I buy a 100k house. I put in 10k myself and borrow 90k from the bank paying 5k annually for the privilege. The house goes up 10% in one year. I have made 10k profit on the house, I have a 5k cost from the bank loan for 5k net profit. Not loads huh? Well, I only put in 10k of my own money - I received a 50% return in one year! Imagine what I could do if I had 100k and bought ten houses with 10% deposits! Imagine what I could do if I continued this for 5-6 years! (Answer, be a millionaire and control around 10m of property).

What's the catch? Gearing is nothing more than an amplifying mechanism for returns, and you have to pay a cost for the privilege. So if things do not work out, and your returns are below the cost of the debt, you amplify your losses.

If prices had fallen 10%, I would have lost not 10%, but 100% of my investment. If I stayed 90% geared as a millionaire, I would still be living in a cardboard box after only one year of 10% falls! That is why a lot of buy-to-let investors you think are rich are actually in serious trouble.

Eek! And to think people do this all the time without understanding what they do It's no wonder we have ended up in a dangerous financial crisis that stems precisely from this exact speculative activity.

Richard_Webster

These % are based on a very very small number of house sales too.

And the averages will vary from area to area and property type to property type so making meaningful comparisons about prices a few months ago and now is almost impossible because there are so few sales.

biderex

Remember that because the press pick up on percentages it can make it sound more dramatic. If they fall by £10,000 a month year ago when the average price was £200,000, that's 5%. If a year later the average price is half that, £100,000 the press can report prices falling at 5%, but in cash terms, that means the price has gone down £5,000 - half of the actual decline in cash terms compared to a year ago. I'm not saying it makes it better or not, just beware of how you read the statistics!

ukcarper

penguine wrote: »

This is likely to prolong the fall in house prices, rather than stop it. Interest rates have fallen almost as far as they can (we're not going to get a negative base rate) and they're not going to stay this low forever. Once they go up again, a lot of homeowners will start feeling the pain.

Although interest rates are at an all time low most people’s mortgages haven’t fallen by the same amount and when they start to rise again they probably won’t rise in line with the bank rate. People will find in hard when they do rise but if they could afford them before the fall in interest rates they should still be able afford them until they rise above the old rate. Rapidly rising rates with out a drop first put people in trouble straight away.

Of course there are lots of other things effecting house prices not least people waiting for them to drop before buying. There are fewer houses on the market and a fewer people wanting or able to buy so knowing what’s going to happen is very difficult to tell.

My guess is they will continue to fall but by how much nobody knows.