U.K. Housing: Simmer or Boil?

Moody's

  • The risk of a nationwide U.K. property bubble appears contained but has risen since last autumn.
  • The return of high loan-to-value mortgages is a credit risk, but stricter underwriting standards may bring a soft landing.
  • House prices are forecast to rise strongly in London and the South East, and more modestly elsewhere.
  • Aggressive selling practices, cooling rents, and a surge in construction put London most at risk of a bubble.

In its latest global economic outlook, the OECD warned this week that U.K. policymakers need to do more to cool the housing market. U.K. house prices rose 4.7% y/y in 2013, after falling 0.7% in 2012, according to the Halifax house price index, but were up 8.1% y/y in the first quarter as pent-up demand was released after several years of stagnation.

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Just how large is the risk of a new U.K. residential property bubble? And what can policymakers do to contain it? For the national property as a whole, an examination of the factors involved suggests that the risk of a property bubble remains relatively contained but has increased since autumn.

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The key change over the past six months has been a loosening of loan standards. This is largely the result of the government’s help to buy house purchase scheme, which enables buyers to put down as little as 5% on properties selling for up to £600,000. The number of mortgages with high loan-to-value ratios has doubled in the past six months. Such loans nearly disappeared following the 2008 recession.

Meanwhile, with the government guaranteeing loans through the scheme, the number of mortgages approved has increased sharply and borrowing costs have fallen to record lows or near them. The risk is that whenever the Bank of England begins to raise interest rates, previously affordable mortgages will become burdensome. The ballooning of mortgage debt service burdens, which are thus far relatively contained, is another possible sign of a bubble.

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Historical data suggest that a 25-basis point increase in the BoE policy rate raises the cost of a 75% LTV mortgage by 22 basis points, and increases the cost of a 95% LTV loan by 32 percentage points. BoE interest rates are forecast to begin rising in 2015 and to increase by 350 basis points within three years of that. Thus the repayment rate on a 95% LTV mortgage could jump from 5% currently to above 9%.

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Borrowers with the weakest finances—given that they have been able to save for only a small deposit—will likely be hit hardest. This prompts worries of a future credit crunch as U.K. household indebtedness increases. Mortgage lending accounts for around two-thirds of private sector lending in the economy, and the U.K. already has one of the highest levels of household indebtedness in Europe, with total debt equal to around 130% of income.

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Moreover, accelerating economic growth could prompt the BoE to hike rates sooner than expected; the OECD forecasts U.K. GDP to expand 3.2% this year, while the European Commission expects U.K. growth of 2.7%. The euro zone is forecast to grow 1.2%, with Germany expanding 1.8%. Thus, U.K. mortgage rates could also increase sooner.

Other symptoms of a property bubble, which were evident during the pre-2008 boom, have yet to become widely established across the country. Although national house price rises are outpacing household income growth, several regions are just starting to see increases, and property prices remain far below pre-2008 levels in some areas.

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Outside London and the South East, prices are forecast to rise only modestly over the next couple of years, and the outlook for labour markets and wage growth is generally weaker. Therefore, demand for housing will remain weaker, and the risk of a new bubble is diminished. By contrast, London, and increasingly the commuter counties of the South East, are most at risk of a housing bubble.

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London house prices have reported double-digit rises since the summer. Prices in the South East have also accelerated and are forecast to continue growing strongly as undersupply combines with strong domestic and foreign demand. Even the stamp duty of 5% on properties worth more than £1 million, and 7% on properties worth more than £2 million, has done little to restrain demand. The number of properties worth £1 million to £2 million sold in London in January was up 74% y/y.

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Reduced affordability in London is pushing up prices in commuter counties as well. The average asking price of a property in London was above £570,000 in April, up 15.9% y/y, and asking prices have risen as much as 40% in some London boroughs. Average asking prices in the South East are up 5% y/y.

Record low mortgage rates and the government’s help to buy scheme have helped drive up demand. Although 92% of loans made through the scheme have been outside London, expectations of easier access to credit has boosted demand in the capital.

Selling turns more aggressive

Other symptoms of a developing housing bubble evident in the London market, and increasingly in the commuter counties of the South East, are aggressive selling practices, including open days and sealed bids. The average number of days a property stays on the market in London has fallen to less than 50 from more than 90 in late 2013, according to Rightmove.

Gazumping by sellers—raising a property's price or accepting a better offer after verbally agreeing to a sale—is also a returning feature of the London property market, as are speculative investor purchases. There are also signs of a building boom, with employment in construction in London hitting a new high early in 2014 and reports of labour shortages in the industry.

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A weakening rental market can also signal a housing bubble, suggesting more households are choosing homeownership over renting. Private rents in London rose 1.4% y/y in March, compared with 2.3% a year earlier.

Reducing to a simmer

Twelve months before a general election, and with around two-thirds of voters owning their homes, the government will be reluctant to dampen the relatively recent housing recovery. Instead, the government recently announced plans to extend help to buy for newly built residences to 2020, hoping to bolster the recovery in construction. New private house building rose 7.5% y/y in 2013, after falling 2.2% in 2012 and is up a robust 23% y/y so far this year. Yet extending the scheme risks increasing household indebtedness further.

The onus therefore lies with the Bank of England to cool the market. While worries about overheating could prompt monetary tightening sooner than expected, the BoE is likely to focus first on restricting secured lending.

Acting directly to control asset prices is outside the remit of ordinary monetary policy. However, the BoE's Financial Policy Committee, which is tasked with “taking action to remove or reduce systemic risks,” can use macroprudential tools to try to contain asset price rises.

Tighter lending rules

Late last year, the FPC recommended that central bankers end the Funding for Lending scheme, a factor behind the fall in mortgage repayment rates to record lows. Last month, mortgage underwriting rules were tightened to ensure that banks assess borrowers’ ability to repay loans after interest rates start to rise.

More FPC recommendations could come as soon as next month. Possible steps include advising the government to restrict the help to buy scheme, suggesting that banks hold more capital against residential mortgages; and more rigorous stress testing. The Prudential Regulation Authority’s latest stress test for U.K. banks assesses their ability to withstand a 30% fall in house prices combined with a sharp rise in interest rates.

Aiming at London

The FPC could also recommend a reduction in the supply of certain mortgage products. New Zealand recently introduced limits on the proportion of new lending above 80% LTV to try and cool the housing market there. However, the OECD has warned of a risk that such relatively untested policies might be ineffective.

Specifically targeting the London market is likely to prove trickier. Affordability constraints and tighter mortgage underwriting standards could lead to a soft landing for the market, but strong demand remains a fundamental driver. Any restrictions on purchases by foreigners would be controversial; moreover, similar restrictions in Switzerland have not noticeably restrained property prices there. Reducing the £600,000 limit of the help to buy scheme, or limiting the scheme to regions outside London and the South East, could help cool exuberance.


Melanie Bowler is an Economist at Moody's Analytics.


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