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Why house prices could fall even further than feared

house prices
house prices

House prices are falling fast and there are widespread forecasts for a 2023 property downturn. But few analysts are expecting price falls to be as steep as they were during the financial crisis.

Andrew Wishart, of Capital Economics, said: “This year will be the most difficult year for the housing market since 2008.” But Capital Economics is forecasting a 12pc drop in prices this time around. Back then, values fell by nearly a fifth.

Analysts argue that stronger lending regulations following the credit crunch, the low supply of properties for sale and a strong employment market mean the property market is better protected now from such steep price falls than it was then. But these protections may be more shaky than they seem – meaning the downturn could be worse than forecast.

Homeowners now have far more debt

There is far less very risky lending now compared to 15 years ago, due to regulations introduced in the wake of the financial crisis. But Adam Slater, of Oxford Economics, an analyst, said evidence suggests the average homeowner now has much more debt in proportion to their earnings.

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Since 2007, the share of buyers taking out mortgages with a 10pc deposit or lower has dropped by two thirds – from 14.7pc to 5pc, according to Oxford Economics. In theory, this should mean that homeowners are more protected from house price falls.

At the same time, however, the share of joint-income mortgages (which account for 60pc of the total) in the UK with a debt-to-income ratio of at least 3.0 has doubled to 40pc. This is because house prices have climbed much faster than earnings over the same period.

The result is that although there are far fewer very risky loans – the type that was abundant before the financial crisis – now, the average homeowner is arguably more exposed to debt. “This means people are more vulnerable to an income shock. Maybe they have stretched themselves to the limit,” Mr Slater said.

If a couple has a mortgage that is relatively small in proportion to their combined income, and one of them loses their job, they have scope to make adjustments and continue making payments. If their mortgage is very large in relation to their income, that buffer zone may not exist at all.

The slow burn of interest rate rises

Mortgage rates have jumped from a low of 1.5pc at the end of 2021 to more than 5pc today, which has hammered buyer affordability. Monthly repayments are so high, especially on those with a high loan-to-value ratio, that house price falls are unavoidable, Mr Wishart said.

In every single region, the share of a median disposable income needed to cover mortgage payments on a typical home will jump above the long-run average. In London and the South East, this share will be even higher than during the worst of the financial crisis.

Even assuming average mortgage rates fall to 4.6pc this year, for a typical first-time buyer to keep their payments at a typical level of 25pc of their post-tax income, they would need to cut their homebuying budget from £263,000 at the end of 2021 to £220,000 by the end of 2023, Mr Wishart said. This is equal to a drop of £43,000, or a 16pc house price fall.

But this is only a threat on the demand side, which is cutting potential buyers’ budgets. The real question for the house price outlook is at what point sellers start having to accept lower offers.

This is where the higher debt burden is key – the more borrowing homeowners have taken on, the more magnified the blow of higher rates.

Prices in Britain are not falling as fast as in other countries such as Canada, New Zealand and Sweden, despite the fact that the UK has recorded some of the biggest jumps in rates. But this is likely because only a small share of mortgages here are on variable rates – just 16pc, compared to, for example, 60pc in Australia, according to Oxford Economics.

The impact of higher rates will be delayed in the UK, and will be felt increasingly as homeowners come to the end of their fixed-rate deals and have to remortgage at higher rates.

This adjustment will happen relatively quickly as although most deals are fixed rates, these periods are much shorter – typically two or five years – than in countries such as America, where 30-year fixes are standard. “The impact will come through in the next few months,” Mr Slater said.

As fixed-rate periods on loans come to an end, the household interest rate burden is on track to rise by an average of 2.2 percentage points in 2023, according to Capital Economics. On a £200,000 loan, that is equivalent to a £367 increase in monthly interest payments.

Why the employment market can’t save house prices

One of the other key arguments some analysts make against looming major house price falls is that unemployment is extremely low. Homeowners have been stress-tested against higher rates, so in theory they should be able to afford higher payments provided they don’t lose their jobs.

But higher mortgage rates are hitting homeowners just as they are grappling with a record jump in energy prices, the highest rate of inflation in 40 years, and the biggest drop in real earnings since records began. And unemployment is expected to rise.

Capital Economics expects a recession this year with a 2pc peak-to-trough contraction in GDP and a jump in unemployment from a low of 3.5pc to 5.5pc over the next 12 months.

Crucially, evidence suggests the relationship between mortgage arrears and unemployment is much more symbiotic. Although unemployment can lead to spikes in people not making their repayments, jumps in arrears may also depress the employment market.

During the financial crisis, mortgage arrears climbed for four consecutive quarters while unemployment was falling, before people started losing their jobs in Q2 2008, Oxford Economics data shows.

Mortgage arrears can worsen the economic outlook in two ways. Homeowners will have less money to spend, but also, if banks are losing money on loans, they tighten their credit conditions for all lending, Mr Slater said.

“That flows everywhere, to industrial borrowers and credit card borrowers. There is a genuine risk of a feedback loop,” he added.

This means that instead of protecting the housing market, low unemployment could be eroded by it.

The long-term economic outlook is bleak

On average in the UK, the mortgage debt-to-income ratio is 99pc. This is much higher than in America, where the ratio is 64pc, but lower than the Netherlands, where the ratio is 174pc. The UK sits in the middle of the 18 major economies ranked by Oxford Economics.

Paul Cheshire, emeritus professor at the London School of Economics and a former government adviser, said: “The situation is better than during the financial crisis and it is certainly better than 1990, but it is getting worse. People take out big mortgages because they expect their incomes to rise, and incomes haven’t risen.”

High inflation means real wages are falling and the Office for Budget Responsibility, the fiscal watchdog, has forecast a 7.1pc drop in real household disposable incomes over two years – the largest fall in 60 years.

“The economic outlook looks more gloomy than I can remember. It looks like we will have a downturn followed by no recovery. And that won’t improve the outlook for housing affordability because incomes won’t rise,” Mr Cheshire said.