1. Affordability. Rising incomes mean that people are able to afford to spend more on housing. During periods of economic growth, demand for houses tends to rise. Also demand for housing tends to be a luxury good. So a rise in income causes a bigger % rise in demand.

House prices

This graph shows that house prices (and therefore demand for housing can rise much faster than earnings, suggesting there are many other factors influencing demand – at least in the short run.

2. Confidence.

Demand for houses depends on consumer confidence. In particular it depends on people’s confidence about the future of the economy and housing market. If people expect prices to rise, demand will rise so people can gain from rising wealth. In a boom, demand for houses rises faster than incomes as seen in graph above.

3. Interest Rates.

Interest rates play a big factor in determining the cost of mortgage interest repayments.

UK Base Rates

When interest rates reached 15% in 1992, demand for housing collapsed, causing a large fall in demand for housing. The relatively low interest rates of the 90s and 2000s, encouraged more to buy a house.

However, in 2008-09, interest rates were cut to 0.5%. Even though interest rates were very low, demand also remained low. This was because, other factors were reducing demand for housing – like the recession and prospect of rising unemployment.

Population.

A very important factor. It is not just the number of people but demographic changes. e.g. growing number of single people living alone has led to increasing demand for houses.

Effective Demand.

Another factor that determines the effective demand for houses is the willingness of banks to lend mortgages. If banks give mortgages with bigger income multiples, then the effective demand for houses is greater.

Factors Affecting Supply

• Number of new houses being built.
• Planning restrictions on the use of land.
• Profitability of building new houses. This is dependent on demand for houses and prices. In  a boom, builders are usually keener to build more. Falling house prices can lead to a restriction in supply.

Related

• Factors affecting house prices

House Price to Earnings Ratio

The interesting thing is to see how much the house price to earnings ratio for first time buyers fell at the end of the 1990-93 crash. The ratio of house prices to earnings fell close to 2.0.

At the height of the 2007 boom, house price to earnings ratios peaked at over 5.0 and in London at over 7.0. This reflected

• low interest rates
• High mortgage multiples
• Use of parents to get deposits

Although house price to earnings ratios have fallen, they still remain high by historical standards.

UK House Prices since 1985

• House prices peaked in Q3 1989 at £62,782
• They fell until Q4 1992 when they were £50,128
• The next peak was in Q3 2007 at £184,131

House Prices since 2000

Long Term House Prices UK

Graph showing nominal house price growth. Notice two big house price crashes of 1991 and 2008.

Also these figures are not adjusted for inflation. The real house price growth is less. But, house prices have still outstripped the rate of inflation.

In 1952, the average house price was £1,891.

They peaked in Q3 2007 at £184,131

House Price Affordability

This graph shows the fluctuations in house price affordability in the UK. At the height of the 1980s boom, mortgage payments as a % of take home pay were a record 140%. The cost of mortgage payments was heightened by the period of high interest rates.

The following house price crash and decline in interest rates led to a sharp drop in relative cost of mortgage payments. By 1995, mortgage payments were only 45% of take home pay. This helped fuel another boom in house prices. Although interest rates remained relatively low, banks lent mortgages which were a bigger % of people’s income meaning the cost of mortgages soared relative to income.

Annual Change in UK House Prices

This graph shows the annual % change in UK house prices during the past 10 years.

The early 2000s involved a rapid house price boom with the annual rate of house price inflation exceeding 25%.

The boom was caused by:

• low interest rates,
• positive economic growth
• Generous mortgage lending
• high confidence
• relative shortage of supply

The housing crash began in early 2008. The market turned at the end of 2007, at the onset of the credit crunch. Bank lending froze making mortgages difficult to get. This also caused a drop in confidence. At its worst house prices were falling at an annual rate of 15%.

Annual % Change since 1992

Despite the scale of the credit crisis and depth of the recession, the fall in house prices has been relative modest. By long term House price to earning trends, UK houses are far from being cheap. Therefore, any house price recovery will be limited by lack of affordability and continued reluctance from the banks to lend.

There is a strong momentum for falling house prices and this is likely to continue into 2009. There are some bright spots on the horizon such as prospect of lower interest rates and a freeze on stamp duty. But, in the short term it is hard to see when the house price drop will end, as many wait on the sidelines for house price falls to bottom out.

House price forecast 2009

It is estimated that the average house price  worth £187,500, will drop by  12.8 per cent, this year. However, the % fall is likely to be bigger for houses worth more than £200,000.

Falling House prices are a reaction to:

• Shortage of mortgage funds
• Falling demand due to economic slowdown and rising living costs
• Overvalued house in the 2000 boom
• Lack of confidence in the housing market
• Expectations of house price drops encouraging people to save and rent in short term.

The future of house prices depends on many factors such as:

• Supply. If there is a chronic shortage of housing then house price to incomes ratios can rise. For example, the UK has very low levels of new housing being built. Therefore, they are less vulnerable to a long term collapse in house prices. There is still a fundamental disequilibrium between rising demand and restricted supply. However, in countries like Spain and US, there is a much greater excess of supply. For example, in 2006, Spain saw the supply of houses built reach over 800,000. The US, also has many homes unsold. Therefore, it will take a lot longer for house prices to recover in these countries.
• Long Term Interest rates. The global boom in house prices has come during a period of low interest rates making mortgages relatively cheaper. If long term interest rates remain low, it again will make a mortgage an attractive option. Long term interest rates depend to a large extent on inflation rates. There is a danger that rising oil prices could trigger inflation in many countries, requiring relatively higher interest rates.
• Economic Growth. A fall in growth and rise in unemployment would cause lower demand for housing
• Credit crisis. A prolonged shortage of credit would make borrowing more difficult and contribute to falling prices