House price to income ratios and why we haven’t seen a reversion to trend
So the IMF has joined The Economist, Capital Economics and others in stating that UK house prices are overvalued on the basis of house price to income ratios.
Despite a fall in house prices at the onset of the crisis and a broadly flat market over the last two years, the house price-to-income ratio remains roughly 30 percent above its historical average (Figure 10). Although the above-average ratio can be partially explained by the trend decline in real interest rates over the past two decades and by supply constraints due to tight planning restrictions, historical experience suggests that such elevated ratios do not persist. As such, staff projects house prices to decline relative to income by roughly 10-15 percent over the medium term
IMF Article IV Report United Kingdom (pdf, page 22) July 2012
There is no doubt that prices are well above their trend based on these measures but then why, despite the longest economic downturn in memory, have house prices remained at such a high level relative to incomes?
During the 1980’s and up to 1998, the Council of Mortgage Lenders recorded new mortgage advances at 2.11 x income and, including deposits, this meant the average purchased house price was 2.49 x income which is, unsurprisingly, the long term trend referred to by many commentators.
But, as discussed in a previous post, house price rises during the last decade were driven by a loosening in mortgage lending criteria (with limited evidence of supply constraints driving national price growth). As lower mortgage rates and increased competition drove lenders to increase the amount they were willing to lend (up to 3.16 x income in 2007) combined with an increase in deposits, the house price to income ratio of new mortgage lending rose to 3.93 x income and hence drove up the market prices as seen in the chart below.
Following the credit crunch, market transactions collapsed but, aided by this lower turnover, mortgage lenders have been able to continue lending at high loan-to-income ratios (3.09 at Q1 2012) by catering to only those borrowers that have sufficient deposits to bridge the loan-to-value constraints in the market.
This means that house prices have remained well above the levels suggested by historic house price to income ratios and particularly in those markets with sufficient equity for the large deposits required at these levels (see my previous chart for the relationship between equity and the house price recovery).
Therefore; as long as market turnover remains depressed, there’s sufficient cash/equity for the high deposit requirements and mortgage lenders continue to lend at current loan-to-income levels then house prices will probably remain well above historic trends.