A decade-long party for homeowners is drawing to a close. The cost of servicing mortgages in the UK, Europe and the US has skyrocketed at the same time disposable income has shrunk, and predictions of a recession or even falling house prices are now common .
Last week, Knight Frank forecast that London house prices would fall 10 per cent over the next two years, a highly unusual move for an estate agency, coming on top of independent analysis and bank predictions of declines in at least the whole UK.
How could housing markets, which have felt nothing but rising prices for a decade, slip into crisis territory?
The 2008 financial crisis offered a punishing lesson in the dangers of excessively borrowing against housing.
Back then, about one in seven mortgages was highly leveraged with a loan-to-value ratio equal to or greater than 90 percent. In the years since, banks have tightened their lending criteria and only 4 percent have the same lending levels.
Today’s borrowers must take out relatively large deposits and show that they can withstand interest rate hikes. Reckless lending has been largely kept in check, reducing the danger of homeowners slipping into negative net worth.
The other key feature of the last decade has been rock-bottom interest rates, allowing buyers to obtain large mortgages at low monthly costs.
In turn, anyone able to put up a deposit could afford a more expensive property, gambling to pay for it as long as rates stayed low and the mortgage term was long enough. In effect, low rates have made larger homes affordable, driving up home prices in return and crowding out those who can’t raise cash for a deposit or use “mom and pop’s bank.”
But rates have soared higher this year, with the Federal Reserve raising the base rate from 0.25 percent to 3.25 percent and the Bank of England and ECB doing the same, and markets expect them to continue to rise sharply. next year as central banks try to contain runaway inflation.
Suddenly, that image of affordability has changed dramatically.
“Only 2 or 3 months ago we said that interest rates [in the UK] up to 3 percent would be a challenge, given the affordability. Markets are now expecting mortgage rates to go up about 6 percent,” said Noble Francis, director of economics for the Building Products Association.
The rise in interest rates has had an immediate impact. Mortgage lenders in the UK were quick to withdraw products after Chancellor Kwasi Kwarteng’s “mini” tax cut budget last month raised expectations of a rate hike.
As a result, anyone buying a home in the UK today will face much higher home loan costs. Mortgage payments, as a proportion of first-time buyers’ income, are about 17 percent on average, according to data from consulting firm BuiltPlace.
However, it’s not just those at the beginning of the property. There is also an effect that will be felt more gradually. Every month, tens or hundreds of thousands of UK homeowners enter into fixed-term agreements and have to re-mortgage. When they do, they will face costs that are much higher than what they currently pay, and some may be forced to sell.
“In a time period when most people are likely to see declines in real wages, it’s a perfect storm for homeowners who have bought in the last 10 years and aren’t used to high mortgage rates.” Francis said.
There are signs that higher borrowing costs are already weighing on demand for new homes, with real-estate portal Rightmove reporting that prospective buyer activity declined last week compared to recent averages, albeit modestly.
The decline in demand will reduce UK transactions from an already low base by historical standards. Lower demand typically limits house price growth and the scarcity of transactions means data can be skewed by a limited number of transactions.
“Clearly what you will see is a much lower transaction property market dominated by the needy move-ins and the cash rich,” said Lucian Cook, head of UK residential research at estate agency Savills.
In the US, there is already evidence that the sales market is coming to light, with transaction volumes falling in several large cities.
FT analysis of data provided by real estate company Zillow through the end of July 2022 shows that monthly growth in US home sales has fallen from 4.4% at the height of the post-pandemic rebound in mid from 2021, to a low of -2.2 percent on a rolling 12-month basis.
Outside of necessity (death, debt, and divorce are frequently cited as the top three drivers of sales by real estate agents), there is little incentive to sell in a down market. But higher costs to remortgage could pressure some homeowners to negotiate at a discount, dragging down the average prices set by recorded transactions.
Declining sales numbers, stretched affordability and pressure on homeowners to remortgage could precipitate painful price corrections in the UK, US and elsewhere.
In the wake of Kwarteng’s budget, multiple forecasts now show average UK house prices falling by more than 10 per cent in nominal terms over the next two years. Thanks to rising prices during the pandemic, even such a steep drop would only send prices back to levels seen in May 2021.
However, the consequences could be dire, especially for recent buyers. Because inflation is at such high levels in the US and Europe, a drop of 10 in nominal prices would represent a drop in real terms of close to 25 percent, a drop larger than the painful correction that followed The financial crisis.
Data Visualization by Steven Bernard and Patrick Mathurin