Are house prices more expensive today, or have they always been expensive?
There are a number of ways of measuring the cost of houses. The most obvious measure is the actual sticker price, or nominal price, but for a comparison with previous years it is important to correct for inflation, creating the “real” price measure. Finally, it can be instructive to compare house prices to earnings or rents, highlighting changes through time.
The Nationwide House Price Survey is the longest running survey of house prices in the UK. Since 1952 this survey has recorded the price of the average home bought with a mortgage financed by the Nationwide building society. As you can see, the price of a house today is much more than 57 years ago.
However, the graph above only captures part of the story. It illustrates the nominal price. The nominal price is the actual price paid, but it does not account for inflation. In general terms inflation is the gradual decrease in the spending power of the money in your pocket over time. We all know that a pound or dollar today buys a lot less bread, milk, and goods than it did in 1974. This is because we earn a lot more than we did then, and all that extra money is chasing a similar amount of available goods. As a result everything has gone up in price. Because of this effect a graph of nominal house prices only tells a small part of the story. To fully compare how it feels to buy something at different times it is important to adjust for inflation. Inflation adjusted prices are called real prices. In real terms a #100 purchase in 1974 would have felt approximately equivalent to a #665 purchase in 2009. It was 6x better to be a millionaire in the 1970s than it is to be a millionaire in 2009.
The second graph illustrates that even in real, inflation adjusted terms UK house prices are still much more expensive than ever before (with the exception of the very peak of the “boom” in 2007). The “mountain” at the right hand side of the graph, from about 2001, shows that house prices increased much faster than inflation during this period. This means that even if you had a lot of savings and bought a house for cash today it would still feel a lot more expensive than buying a similar house during the early 21st Century or at any time in the 20th Century, including the very top of the 1989/1990 “boom”. You’d simply need more money, even adjusting for inflation, than you would have needed in the past.
It is also worth observing that the real price graph above also shows that the increase in real prices over time is not a given. It can work the other way too. If you go back approximately 15 years to the mid 1990s the real price graph shows that buying a house then would have felt a lot cheaper than buying in 1989, even though in nominal (actual) terms the house would have cost almost the same. This is because a period of high inflation during the early 1990s ensured that wage packets grew quite rapidly each year. By 1995 this meant that a house priced at the same nominal amount as the 1989 peak felt a lot cheaper, and as a result people were able to pay approximately the same amount for a home as at the peak of the bubble without experiencing anywhere near as much financial stress. In essence, wage inflation had made the houses seem cheaper without drops in actual prices being necessary. This meant that negative equity was less of an issue than it might have been in a low inflation environment like today.
Unfortunately how inflation impacts how it feels to buy a house or, more crucially, pay a mortgage, is commonly misunderstood and ignored. But it is very important – it affects everything from how it feels to pay off a long term loan, the impact of high debt loads, the return on investments, and the level of employment and corporate profitability.
Price vs. Earnings
How it feels to buy a house is further illustrated by the price vs. earnings ratio. This time the graph corrects not just for general inflation in the economy, but for earnings growth. Over the long term our pay-packets have tended to grow faster than inflation (generally at ~ 2% above). This is generally considered the result of greater efficiency in the workplace, for instance, the impact of computers and the IT revolution during the 1980s and 1990s.
Correcting for increased earnings over time rather than using inflation as a proxy creates the Price vs. Earnings graph. This graph represents one of the key housing measures. As you can see, it is similar to the real house price graph in that there is a lot more variation than seen on the nominal price graph. House prices have risen and fallen vs. earnings quite regularly. Historically, house prices in the UK have consistently been within the 3-4x earnings range, with notable spikes associated with housing boom-busts of the 1970s and late 1980s. At its peak, in 2007, the house price-earnings graph, at 7x earnings, was some 20% above the previous peak rates. Even today, after a significant fall in house prices, buying a house is more expensive than any previous peak.
Crucially, it is the relationship between house prices and earnings that has the biggest psychological effect. As house prices become more expensive relative to wages the housing market begins to feel like a free money making machine. Existing owners feel ever wealthier with little or no extra effort, and in some cases the annual increase in the market price of their home may even outstrip their annual wage. Whilst this wealth is, to an extent, illusory and can only truly be accessed by selling the property and trading down to a smaller home, many owners are able to convert some of their paper wealth to real money through Mortgage Equity Withdrawal, effectively taking out another mortgage on the property. This money can then be either used for consumption or investment. Multiple property owners benefit more directly as they are able to sell their asset and realise their cash without having to find somewhere smaller to live. Finally, even owners who do not directly access their paper wealth are able to feel a lot richer and more secure. In aggregate, existing owners feel empowered to spend more, with a decreased appetite for saving for a rainy day or committing earnings to a pension plan. For existing owners this seems like boom time.
Of course, whilst many existing owners feel that they have earned their wealth, the winners in this sort of market are defined almost exclusively by timing. Those who due to their date of birth were able to buy before the boom benefit the most. Others able to buy in the early part of the “boom” are also able to benefit, albeit to a lesser degree. It is important to note that these winners feel rich not just because house prices have a large price tag, but that they are expensive relative to earnings. It is by this crucial measure that owners judge their wealth.
The apparent ease by which wealth is generated through housing rather than through working ensures that the houseing market becomes ever more attractive to new entrants. However, the very thing that makes existing owners feel rich and attracts new entrants to the market – the high price compared to earnings – is the very thing that makes it difficult to enter the market, and even more difficult to profit from it. House prices cannot forever rise faster than earnings without significant social and economic implications.
For those purchasing new homes, on which existing owners fundamentally depend to support or increase their paper wealth, the disconnect between house prices and earnings represents a considerable challenge. As the importance of what you earn is diminished the importance of credit or access to a large deposit increases. Of course, earnings still matter, but on a relative scale they are dwarfed in this sort of market by the requirement of access to a large well of “cheap” credit, on ever better or ever longer terms, or increasingly large deposits. Most people take out ever larger debts…
In this manner, high house prices relative to earnings increases the importance of inheritance. The crucial point is that in most cases the wealth of the inherited estate is based primarily upon the price of the family home that was bought before prices escaped earnings. Because of this crucial housing link it doesn’t matter too much to the family if house prices continue to rise way beyond earnings. The larger the price rise, the larger the inheritance. The lucky timing of the early, older buyers can be passed on, in part, to younger buyers, and in this way many families remain relatively relaxed about price rises, considering themselves insulated from the vagaries of the market.
This may seem a relatively subtle point but it has important social implications. Families that are property rich today realise that in a world in which house prices are not connected to earnings it is important to pass on as much of their accumulated wealth as possible. They realise that replicating their success is harder, if not impossible (even if they don’t realize how much of that “success” was down to timing) and they rationally want to help their family as much as they can. The continued focus on inheritance tax, including the Daily Mail’s “ban the tax” campaign in the UK illustrates this awareness, and it is likely to become an important political issue with time.
But this is unfortunately not the whole story. The issue doesn’t simply stop with wealth planning and tax issues. Families in this position are also aware, at some level, that this sort of housing economy would also represent serious social change. This is most clearly illustrated by the contemporary fear of “missing the boat” and the common baby-boomer response of helping their offspring through deposit assistance and handouts. Both are recognition that in an economy of ever higher prices relative to earnings it will become harder, and eventually impossible, to buy a home based on salary alone. If prices are severed from earnings then it does not matter what you do, but simply who you are related to (or what credit you can access).
Whilst seemingly melodramatic this is a genuine and very important volte face from the assumption of an expanding middle class and meritocratic opportunity that formed the bedrock of the post WWII, baby-boomer social contract. It is in fact a large step towards a return to a more 19th century, Victorian, social class system and economy. In this society what you earn becomes irrelevant and housing wealth must be passed on through the family rather than bought via salary. The worries affecting the modern zeitgeist are reflections of this recognition. People worry about passing on (or receiving) their inheritance and of missing the boat because they realise that it is simply not possible to have house prices increasingly disconnected from earnings without consequences. We have to choose. Credit may seem like the answer, but it has its own problems, as outlined in the next section…
Price vs. Rent ratio
A final way to measure the relative cost of houses is to look at the price vs. rents ratio. This represents how much harder (or easier) it is to buy a house rather than renting it, regardless of how high inflation is or how much the average pay-packet has risen (it’s also broadly comparable to the price/earnings ratio commonly used to measure the value of stocks).
The price vs. rent ratio is a particularly interesting measure of relative housing cost because of the rent part of the ratio. The cost of renting a house or flat is a fairly good measure of broad housing demand in an economy. If there is a high demand for shelter rents will be high, as people will compete with other potential tenants and everybody will be prepared to pay more to get a roof over their heads. We all require shelter – it’s a fundamental need. Crucially, renting removes the complications associated with borrowing money. No bank will lend money to cover rent, so payments have to be made directly out of wages. This strips out the affect of credit costs, interest rates, and different banking systems. As societal demand for shelter increases renters will gradually pay more and more of their income in rent until finally they simply cannot pay any more and the poorer earners are forced to become homeless. With rents it is essentially simple – in a high demand society rents will be high and in a low demand society rents will be cheaper.
Thus a graph of house prices vs. rents adjusts, at least partly, for general housing demand. If overall demand was high the prices of both home purchases and rents would also be high, and thus the ratio of the two measures would not alter significantly. But the pattern illustrated in the graph above shows something very different. It can be seen that even by this measure the cost of buying a home in the UK is expensive relative to rents. This means that house purchase prices have recently increased more than rental prices, indicating that there has actually been a greater demand for buying a house than there has been for living in one. It therefore cannot be a simple matter of high demand (remember, demand is wanting, it’s both desire and the capacity to buy). Tenants aren’t prepared (or aren’t required) to pay increased rents. In fact rents in the UK have been static or even falling since the turn of the 21st Century, especially in real terms. Yet house prices have risen beyond previous extremes. The price vs. rent graph thus suggests that recent house price rises are not a result of broad societal demand for shelter, but something unique to the purchase of a house. The obvious difference in the late 1990s and early 200s is the availability and cost of credit and the psychology of the boom.
In short, you can argue some things about the current housing market but it is simply not true to say that house prices are no more expensive than they have been in the past. They are certainly not a “bargain” subsequent to the recent drops, as suggested by many commentators. Someone buying a house in the UK today will pay more for their shelter than anyone in the 20th century, by any measure you care to use.
Of course, very few people buy a house in cash. Most people take out a mortgage to do so. The comparisons illustrated above show that buying a house for cash today feels much more expensive than during previous periods. But they do not fully illustrate what it feels like to buy a house with a mortgage. Many people argue that, as interest rates are lower today than in previous years house prices can be more expensive and still be good value… They say that buying with a mortgage feels no more expensive than in previous years. Is this true? Is cheap credit the answer?