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What affects house prices?

Posted By Robert On Friday, August 22nd, 2014 With 0 Comments

Property prices has become a national obsession within the UK, for good reason too! For most people that buy a house it is their biggest asset. But what exactly affects house prices?

The answer is to do with the forces of supply and demand. There has been an increase in demand for homes.

 

There has been a population growth since the 1950s due to increase in longevity and the impact of net immigration into the UK which has more than offset a falling birth rate.

More importantly, the average size of households has been shrinking – so for any given population size, more homes are needed. For example, in 1971 the average household size in Great Britain was 2.91. By 2003, that had fallen to 2.32 people per household.

This is a consequence of changes in the nature of the family such as more people staying single for longer and an increase in the number of divorces.

A mixture of growing affluence, rising house prices and the comparatively weak performance of other long-term investments like stocks and shares since the mid 1990s also generated additional demand for property from existing home-owners, such as the purchase of holiday homes, houses bought-to-let and homes bought for investment purposes.

Another boost to demand has been the low level of interest rates since the early 1990s. Lower interest rates make mortgages cheaper and therefore more affordable.

Throughout this period, employment levels have remained high and with real incomes rising there was capacity for people to afford larger mortgages.

As people had access to larger mortgages, so competition between buyers forces up the price of property.

There have also been issues of limited supply. In many areas of the UK, construction of new property has not kept pace with demand. For example, the Barker review of housing supply noted that 39,000 more homes than are being built are required in England simply to keep up with population growth and changes in household formation.

One of the main constraints identified by Barker was a reluctance to invest and innovate on the part of the housebuilding industry. In fact she noted that in order to maximise profits the industry accumulated landbanks but ‘trickled out’ just 100-200 houses per year.

Property for Sale

When it all goes wrong!

The credit crisis of 2008 is the most potent property crash of the current generation. With rising house prices came over-confidence and as any investor worth his salt will know, over-confidence is a recipe for disaster.

Speculation is a huge driver of house prices, people become more willing to pay higher prices in an environment of rising house price.

A falling house price market usually leads to a reduction in the supply of houses for sale. If people think they will receive less for their house they will be reluctant to put it for sale.

Given that a home is likely to be a household’s biggest asset, then a decline in the value of this asset will have both a psychological and practical impact on household spending.

From a psychological perspective, if households feel less wealthy they will be less likely to make large financial purchases – not just in housing-related industries but others as well.

This then affects other sectors of the economy that rely on household spending and subsequently, will affect people working in those industries, with the risk of unemployment.

From a more practical perspective, if the value of homes is falling banks will be less likely to allow remortgaging which often creates borrowings which were used for general consumption. Any fall in market activity and bank profitability is also likely to lead to unemployment in the financial services sector.

In fact, economists describe the housing market as a leading indicator, which means what happens in the housing market is an indicator of what is likely to happen in the rest of the economy.

Property Crash

House Prices and the Economy

House prices are a key factor to the economy, house prices and consumer spending have moved in tangent throughout history, when house prices have fallen – consumer spending has receded.
There are two explanations for this:
The Wealth Effect – Psychologists and economists claim that rising house prices make us feel richer, it makes us more optimistic about the future and therefore more likely to spend money. When house prices fall, it makes us more concerned about the future and more likely to concentrate on saving.
If house prices seem to rise year on year then it may make people more relaxed when saving for retirement. After all, property is a store of wealth.

There is a commonly utilised notion known as ‘Equity Withdrawal’. This is drawing money on your existing mortgage, this type of “loan” is lower risk to the bank lending you the money because there is an asset (the house) that can be put up as collateral.

If an individual was unable to make payments then the bank could force a sale of the house to settle the remaining balance. A secured loan such as this could be offered under more favourable terms as it is perceived as lower risk by the lender(s).  When house prices rise there is more opportunity to borrow against equity that has built up in the asset.

Tumbling House Prices

A Final Note on House Prices and Savings

Another type of data to look at, apart from that of savings, is data about saving. This is usually done by examining what is called the household saving ratio. This is the percentage of annual household disposable income that is saved rather than spent.

In the past, when the economy has been growing quickly and so personal incomes have been rising, the household saving ratio has been lower. This can be explained by the fact that when things are going well, confidence is high and people tend to spend more.

When the economy has experienced very low growth or even recession – where incomes were not rising as fast or even falling, the household saving ratio was higher. This is when people are more concerned about their future, they tend to cut back on spending and save more.

Other factors also help to explain changes in the UK household saving ratio. When inflation was high, for example, in the mid and late 1970s, households needed to save more to stop the real value of their savings falling – consequently the household saving ratio increased.

There appears to be an inverse relationship between house prices and the household saving ratio. That is, when house price increases were higher (e.g late 1980s and most of the 2000s), the household saving ratio was lower. When house prices were lower the household saving ratio was higher.

This may be because people often feel that they do not have to save as much when their wealth is increasing due to the increased value of their house. Conversely, in 2009 there was an increase in saving as house prices fell and households repaid some of their borrowings.

‘Safe as Houses’ is an excellent book on house prices – it explores price movements throughout history in numerous countries allowing the reader to learn a wide range of factors that affect house prices

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