Changes in the UK Housing Market since 1983 - Essay Example

Changes in the UK housing market since 1983 (UK Average House Price Data 1983 - 2002: Office of the Deputy Prime Minister) The diagram below shows what happened to average house prices in the UK in the period 1983 - 2002. Initially prices went up rapidly until 1989. House prices recorded a growth of 7 percent in the year 1983 alone. House price inflation reached a peak of 34 percent in October 1988, when average house prices rose by 23.3% in one year alone. House prices doubled in just four and a half years. In their rush to buy a house before prices were raised any further, many people in this period borrowed as much as they were able. Building societies and banks at that time had plenty of money to lend and were only too willing to do so. Many people took out very large mortgages. In 1983, the average new mortgage was approximately 2.1 times annual average earnings. By 1989 this had risen to 3.4 times annual average earnings. House prices were rising uncontrollably and bringing considerable inflationary pressures to bear within the economy. As a result, the government increased rates and reduced government assistance to home ownership. The impact of these measures plus a worsening economic environment drove house prices down and the housing market into a state of recession (Williams and Holmans, 1996). In mid 1989 house prices started a downward trend for the next six years, falling by 12 per cent, before reaching a trough in July 1995.In the years 1990 - 1995 house prices fell by around 12.2%. Many people found themselves in a position of having negative equity on their property because the value of the mortgage now exceeded the property value. This meant many people were unable to move house without taking a loss. Then, in 1996, house prices began to rise again. The UK housing market started to recover with a 7 per cent increase in prices. The low interest rates enjoyed by UK homeowners have reduced mortgage payments as a proportion of gross earnings for the average purchaser from 22 per cent to just 15 per cent. Consequently, mortgage payments account for a smaller share of income than at almost anytime since 1983 and are well below the 36 per cent peak in 1990. Since May 1997, house prices have been on a steady rise. Many factors have contributed to this increase including growing population, rising employment, increasing number of households, limited supply of new housing properties and the emergence of alternatives like buy-to-let. Another important reason is the increase in popularity of real estate as an investment avenue. Fall in the level of confidence in traditional investments and increase in speculative avenues has contributed immensely to this. The fall in long-term real interest rates - the gap between inflation and interest rates on government bonds - has helped support property investments. The most complimenting factor, however, has been the short-term interest rate set by the Bank. The sharp fall in prices at the end of 1980s and early 1990s pushed the interest rates to very low levels in relation to rents and other assets and incomes. This, combined with the realization that lower interest rates were meant to stay, created a strong and steady rise. By 2001, though house prices were still below their long-term trend, the boom had begun to fade. Further to this, there followed a series of global events that ruptured the boom even further. In response to the bursting of the dotcom bubble, September 11 and the start of the Iraq war, the Bank cut rates, taking them all the way down to 3.5% during 2003. Then, however, the Bank switched into tightening mode, raising Bank rate five times between November 2003 and August 2004. The results of this on the housing market were significant, producing the famous 2004-5 pause in prices. Determination of equilibrium price and quantity The determination of price depends on the type of market organization the product belongs to. In a competitive market, the point of intersection of market demand and supply curves determines the price that will prevail in the market. As in other competitive markets, the forces of demand and supply determine house prices. In the diagram, P* is the point of intersection of the demand and supply curves and is called the equilibrium price. "The word 'equilibrium' denotes a state of rest from which there is no tendency to change" (Maddala and Miller, 2004). Price equilibrium occurs where the price that the buyers wish to buy matches the price that the sellers wish to sell at. The point C in the diagram describes a position of equilibrium in the market. When prices are above or below P*, i.e., P1 or P2, the market is said to be in disequilibrium. As can be seen from the diagram, supporting the price above P* creates an excess supply, whereas, fixing the price below that causes excess demand. When the demand for house properties is high and there is shortage of supply of the same, then the balance of power shifts towards the seller. This is because of the excess demand in the market for good properties. Conversely when demand both for new and older housing is weak and when there is excess supply of properties available on the market, then the power switches to potential buyers. This is because there is a wide choice of housing available and the buyers can afford to negotiate prices with the sellers. If demand rises due to changing factors that shift the demand curve to the right, then the equilibrium price in the housing market will increase. Similarly if the supply of houses were to fall suddenly then the equilibrium price would rise as the supply curve shifted to the left. When the demand for houses in a particular area increases, either due a flood of population into the area or a rise in incomes following a fall in unemployment, there is upward pressure on market prices. The supply of properties available in the market often remains inelastic. This is due to time lags in between shift in price and increase in supply of new available properties or owners putting their properties up for sale in the market. Thus when demand shifts outwards and supply remains inelastic the result is a large rise in market price and a relatively small expansion of the quantity of houses traded. As supply becomes more elastic over time, assuming the conditions of demand remain unchanged, there will be downward pressure on prices and a further increase in the equilibrium quantity of houses bought and sold. As average living standards rise, the market demand for housing expands. Determinants of demand (a) Incomes (both actual and anticipated) As average living standards rise, the total demand for housing expands, as does the demand for more expensive properties. The second half of the 1980's was a period of rapid growth in personal disposable incomes. The economy was experiencing an economic boom and many people wanted to spend this extra income on housing. Just as importantly people also thought that their incomes would keep on growing in the future at the same rate. Consumers stretched themselves financially because they were confident that their mortgage payments would become more affordable as wages continued to rise at a faster rate than mortgages. During the early 1990's however the economy went into recession and unemployment began to increase. Confidence fell and this affected the housing market. (b) The desire for home ownership The prime minister of the time, Margaret Thatcher, pursued policies that encouraged people to own their homes rather than renting. This had an impact on demand for housing and therefore on the equilibrium price. (c) Consumer confidence When the economy is enjoying sustained growth and rising prosperity, improved confidence raises the number of home buyers and shifts the balance of power in the market towards the seller if properties are in short supply. (d) The cost of mortgages During the second half of the 1980's mortgage interest rates were generally falling. This meant that people could afford larger mortgages and more expensive houses. After 1989 interest rates started to rise and people began to feel the pinch. (e) The availability of mortgages By the late 1980's credit liberalisation meant that it was relatively easy to obtain mortgages. Banks and building societies were happy to accept smaller deposits on houses and were prepared to loan up to 3.5 times a person's income against the value of the house, where previously this had only been 2.5. The recession of the early 1990's made banks more cautious as unemployment rose and mortgage defaults increased. (f) Expectations of future price movements In the 1980s the housing sector boomed because of a strong speculative demand for properties. Speculation of increase in demand sets in a positive attitude towards property prices. People buy today expecting the prices to increase in the future. This has the effect of encouraging people to buy as soon as possible and to go for the biggest mortgage they could afford. This speculation also had an effect on the supply side of the housing market as many sellers, who also believed that house prices would continue to rise, delayed their decisions to put their homes on the market. The result of this speculation was to bring about the very effect that people were actually predicting (i.e. that house prices would rise). This trend was reversed in the wake of the recession of the 1990's as people tried to sell quickly before house prices fell any more and buyers held back in the hope that prices would fall further. Future trend in housing In 1996 house prices started to increase again after the stagnation of the previous 5 years. This time however interest rates were also rising and people were more cautious after their earlier experiences in the housing market. Prices increased slowly at first but began to increase more rapidly after 1999. In present times, house prices are around six times higher in relation to earnings. This figure beats the peak touched in 1989. Moreover the burden of interest and repayments is about 10% of aggregate disposable household income, compared to about 15% around 1990. A rise in debt service costs could trigger a substantial downturn. Buy-to-let have effectively displaced a substantial proportion of first-time buyers as they contribute a fifth of new mortgages today. The risks may have been aggravated by borrowers exaggerating their incomes so as to obtain mortgages. The situation was, however, different from 1989-91 in some respects. Interest rates are low and inflation is low. The future course for house prices is one of the likely key drivers of the growth rate of the local and national economy. The behavior of buy-to-let investors may be crucial to future trends (Tyne & Wear Research And Information, 2004). In 2002 house price inflation reached an annual rate of 18.8%, the highest rate since 1989. Market analysts predicted that house prices were likely to continue growing though the prospect of higher interest rates and the uncertain economic outlook may mean a slow down in the rate at which they increase. The statistics prevailing in the UK housing market are thus: there are 22.5 million households in the UK, population is 60 million and total value of the housing stock is 4.3 trillion. This partly explains why there is currently very little panic in the UK housing market. Surveys suggest that even if housing prices dropped, the UK consumers spending patterns should not change significantly. House prices have doubled in the last five years. But equity has increased so much that most home owners would still have positive equity if price dropped by 25%. The increase in prices over the last 15 years has created a cushion to price drops of 10% in the future. Therefore, current trends all point to safe and steady house hold prices in the near future. Another contributing factor was the poor performance of the stock market. Many people decided to put their money into property as the only area showing strong growth. The supply still remains inelastic as opposed to demand. While the population grows 300,000 and more every year, the growth of homes is a meager 200,000 and households are progressively getting smaller. Thus prices are supported by a lack of supply and firm demand. Government intervention in housing In general terms, central government formulates housing policies and sets the overall social and economic context in which those policies will operate. The central government in the UK, however, does not involve directly in building or managing housing properties. This is done through agencies, non-departmental public bodies, under the strong influence of the central government. The most obvious government interventions are through these organizations. The government has been involved, and continues to be so in a limited sense, in land pricing, purchase and distribution through, for example, the Community Land Act 1975, in the building materials and production processes, in provision of loan finance, its own Option Mortgage Scheme, local authority mortgages and the regulation and control of mortgage finance in general and building societies in particular. Until the 1980s, the government was able to influence the housing market via the building societies and the building societies' cartel arrangements. Interest rates influenced the supply of funds to building societies and this in turn influenced the amount of mortgage credit available. In the 1980s this cartel broke down under competitive and government pressures. The housing finance market was liberalized and became highly competitive. The consequence of this was that supply of housing finance was able to match demand (Williams and Holmans, 1996). Government sometimes gives housing benefits for low-income households. This is essentially a government subsidy for the rented housing sector. The benefit is means-tested and covers all or part of the rent that low-income households have to pay. The government does not discriminate between private and social rented housing. It is up to the recipient of the benefit to choose the type of accommodation. Monetary Policy clearly affects the housing market. But control of interest rates vests in the hands of the Bank of England. Their job is to set interest rates at a level that will keep control of inflation. The Bank of England sets base interest rates and the main mortgage lenders set their own mortgage rates in a competitive market. Government intervention can sometimes set disequilibrium in the market. Sometimes the government, in an attempt to ensure farmers a higher and more stable income, may set prices higher than the regular equilibrium price. To achieve this, it sets a price floor or a minimum selling price that is above the equilibrium price. Another system followed by the government is price ceiling. On account of rising prices in some cities, the government, in an attempt to control the same, sets a ceiling on the price increase or a maximum selling price. In this case, however, it sets the price below the equilibrium price (McEachern, 2006). Stamp duty is a government tax levied on certain legal transactions including the purchase of property. In other words, if you buy a home for more than 60,000, stamp duty is payable. In 2000, government raised stamp duty on the most expensive properties (over 250,000) in a bid to cool the demand for properties in the London housing market. When government embarks on a social house building program, this will essentially lead to an increase in the supply of housing properties. This in turn will lead to a stabilization of prices as potential buyers get more control. The society benefits as the low income groups will be able to afford homes as well. There will be healthier competition in the market between the private and government builders. Direct subsidy to builders improves potential for new house properties, in turn increasing supply of good quality housing. Bibliography Tyne & Wear Research And Information, 'House Prices & Earnings in Tyne & Wear', June 2004. PropertyInvesting.net Team, Why a crash is unlikely in the UK, (URL: http://www.propertyinvesting.net/content/trends.htm) October 11, 2007 [Accessed: 23 November, 2007] Williams, Peter and Holmans, A. E. 1996. Directions in Housing Policy: Towards sustainable housing policies for the UK, Duncan Maclennan McEachern, William. A. 2006, Macroeconomics: A Contemporary Introduction, Thomson South Western. Maddala, G. S and Miller, Ellen. 2004, Microeconomics: Theory and Applications, Tata McGraw Hill Companies, New York. Smith, David. Times Online, End of house price boom is in sight, (URL: http://business.timesonline.co.uk/tol/business/columnists/article1844550.ece), 27 May, 2007 [Accessed: 23 November, 2007] Read More