Tremors felt in the UK housing market

The first time I flew to San Francisco, I was disturbed to learn en-route that the city was overdue a massive earthquake.

San Francisco apparently sat on a continental fault line. This San Andreas fault hadn’t ruptured for 200 years. I wasn’t sure what ‘ruptured’ meant, exactly, but it didn’t sound promising.

I would be sleeping on top of a pressure cooker!

Of course, once we landed, I forgot about the imminent disaster and got on with enjoying the legendary city. As do millions who call it home.

Twenty years on, San Francisco is yet to be hit by The Big One. A lot of worry over nothing?

Not quite. The tectonic plate shifts that drive earthquakes are more like a game with an inevitable conclusion than a matter of chance. Think Jenga, not dice.

It’s when, not if, as the pressure builds. Eventually it will explode.

The London fault line

Which brings me, of course, to the UK property market – particularly London.

Because living in the capital has felt like dwelling in an earthquake zone for 20 years too.

Not literally. London’s homes are more likely to sink into the clay beneath them than be brought down by a seismic event.

I mean financially. On measures like the ratio of house prices to income, London has looked extended since at least the early 2000s.

Yet life went on, and prices kept climbing. Mini tremors from the sub-prime crisis and Brexit are mere wobbles on a relentlessly rising chart.

What’s more, as fortunes were made in the face of all fears, confidence that UK bricks and mortar was immune to a meaningful price correction spread across the country.

So nowadays, almost all UK residential property seems expensive.

I know this, yet I still own my own home. Like a San Francisco resident, as a UK homeowner you have to get on with your living life.

Yet, earthquakes do happen. And similarly, there have been house price crashes in the UK – as recently as the early 1990s.

Though you might be talking about the eruption of Mount Vesuvius for all anyone remembers.

She’s gonna blow

Arguably – and people have argued for years – low interest rates acted as a safety valve for UK property prices, releasing the pressure by lowering borrowing costs.

The average UK home now costs at least seven times average household earnings, says Nationwide. Perhaps as much as nine times, according to the Office for National Statistics.

The London the ratio is nearly 14 times!

The ONS says the UK ratio was below five times in 2002. Homes are thus priced nearly twice as highly as 20 years ago.

Notice this isn’t just a matter of inflation. Wages should rise with inflation, too. It’s more like a P/E multiple for a stock re-rating from 10 to 20.

Yet all things equal, with lower rates you can meet a bigger monthly mortgage payment from your household budget, and so afford a more expensive house.

And so, until recently – even with those rising prices – falling rates kept the proportion of people’s incomes spent on mortgage payments roughly in line with the long-term average.

However, rates have soared in the past year. First steadily, as the Bank of England gradually lifted rates to fight inflation. Then sharply, following the ill-fated Mini Budget.

At mortgage rates closer to 6% than 3%, typical borrowers will be spending close to half their household income on servicing their mortgages thanks to those lofty income multiples.

Previously that’s a level that’s triggered downturns.

The Office for Budget Responsibility (OBR) last month forecast UK house prices will fall 9% over the next couple of years as a consequence.

The cuts begin

True, we’ve been warned unsustainable UK house prices would have to fall before.

But with mortgage rates having more than doubled in a year, this time is surely different.

And with everyone from the OBR to the Bank of England to independent economists saying Britain is in recession, a 9% house price fall does not seem outlandish.

Already rumblings can be heard. Halifax says UK house prices fell for the last three months – down 2.3% since September. That’s the fastest rate of decline for 14 years.

As individual borrowers, we’ll have to do what we can to shore up our finances. Budget carefully, remortgage to better rates, and avoid other debt. Try to keep your job if you can.

You especially don’t want to become a forced seller of a property that’s worth less than you paid for it. If you can ride out any slump while meeting your monthly payments, then you should be okay.

But what should we think as investors?

The residential property market is at the heart of the UK economy. It’s hard to see how a fall in prices and a slowdown in activity wouldn’t have repercussions.

Firmer foundations

However, I believe there’s good news on this at least.

To return to the earthquake metaphor, the shockwaves from the global financial crisis in 2008 made both institutions and households more resilient, ahead of any Big One hitting the UK market.

House prices did suffer a mostly short sharp decline back then. But there were few repossessions. Nothing like the widespread defaults in the US, or in the UK in the early 1990s slump.

And after the crisis, new regulations made UK banks more careful about how much they lent via strict affordability tests. The banks now hold more capital themselves as a buffer, too.

A moderate fall in house prices is unlikely then to threaten the balance sheets of big High Street banks like Lloyds or Barclays. They could even see more benefit from a higher net interest margin from rising interest rates, boosting bank earnings across the board.

The listed house builders look much healthier than in 2008, too. Back then, many carried a huge amount of debt. Smaller builders went bust when sales dived and financing dried up, while the big volume builders had to refinance and issue equity to get through the slump.

Since then, though, most listed builders have been more focused on generating and returning cash to shareholders rather than gearing up to build as many houses as possible. Perhaps a reason why we still have a shortage of new homes in the UK? Maybe, but it also means the homebuilders’ finances look pretty strong, with net cash in many cases.

Builders will certainly be hit by a protracted slowdown. They’ve already suffered from inflated input costs, and selling homes for less will further squeeze margins. Declining sales will pressure the bottom line, while book values could be impaired as land banks are written down.

Yet house builders’ shares have already declined sharply in anticipation of all that. Remember the market always looks forward!

If you think the slowdown will be limited to a year or two, certain builders might even be a buy.

Hang tight

Assuming we see nothing worse than the 9% decline as predicted by the OBR, I suspect the worst affected companies will be retailers.

Higher mortgage costs are going to eat up take home pay. That means even less money to spend on other things. People feel less wealthy when house prices decline, too, further dampening their propensity to splash the cash. This wealth affect can be made tangible if it curbs lending against falling property prices, draining yet more money from the economy.

Closer to the property market, estate agents like Foxtons and Winkworth and suppliers to the trade like Howdens Joinery could also suffer – even if we avoid mortgage defaults. They’re geared more to transaction volumes than prices.

But again, the market has anticipated much of this. Just look at their price graphs. Howdens – a well-run company – is down nearly 40% since late 2021. The warning lights have flashed amber for UK property for years, and the stock market heard the emergency alarm months ago.

Perhaps I’m being as complacent as a San Franciscan skyscraper dweller, but I don’t think this is The Big One. We’ll be shaken by price falls, but the market won’t crumble.