Summary: House Prices in Trouble
- A new European Central Bank (ECB) working paper estimates the impact of rising real rates on euro area house prices.
- It finds that an increase of the real interest rate from very low levels reduces real house prices by three to eight times more than pre-2016.
- We apply this result to the UK residential housing market, showing how nominal house prices could fall back to pre-GFC levels, wiping as much as 40% off property values by 2024.
Mortgages are the largest form of household debt. And, until recently, the cost of taking one out had never been lower (Chart 1). In September 2021, the average two-year fixed rate mortgage in the UK reached an historic low of 1.2%.
This changed in 2022, as central banks began to raise interest rates to tackle inflation. In the UK, the Bank of England’s policy rate is now at 4.25%, returning to levels last seen in the early 2000s (Chart 2).
How will this rise in the cost of borrowing affect house prices? A new ECB working paper looks at previous changes in house prices around interest rate rises in Europe. Typically, a 1pp rise in the real interest rate leads to roughly a 3% decline in real house prices. However, the authors believe this could be three- to eight-times larger this time around.
The aim is to uncover the relationship between real interest rates and real house prices. Much of the literature assumes this to be linear, but the authors test whether a non-linear relationship (i.e., larger house price changes at higher or lower interest rates), is better suited. And it is.
A non-linear model can explain movements between the two variables 1.2-3.5pp better than a linear one. Moreover, the non-linear relationship gains even more explanatory power over a linear one towards the end of the sample, when the cost of borrowing was particularly low.
In numbers, the authors find that a 0.1pp increase in real mortgage rates leads to an average euro area real house price decline of 2.41%. That is huge. It is three- to eight-times higher than existing literature suggests. It is also twice as large as the predicted decline pre-2013, when the real cost of mortgages was closer to 1.5% (Chart 3).
The Implications for the UK: House Prices Falling Fast
Nationwide Building Society, the timeliest source of actual house prices in the UK, today recorded an -0.8% fall on the month. This was a larger-than-forecasted monthly decline, and annually, house prices are now 3.1% lower than the same time last year.
This should be no surprise given the results from the ECB paper. But just how low might these prices go?
Firstly, we need to distinguish between real and nominal house prices. Nationwide publishes nominal house prices, while the paper discusses changes in real terms. So, we need to convert the Nationwide’s data into real prices, which is done by deflating the series by the CPI index.
Moreover, the authors also discuss the real cost of borrowing, not the Bank of England’s nominal interest rate. While the cost of borrowing is intricately linked to the interest rate, a mortgage rate (say, a two-year fixed rate) would be more applicable if we are looking at how expensive it is for individuals when buying a home.
To calculate the ‘real’ cost of borrowing, the authors use long-run inflation expectations, rather than the actual inflation rate. This is because interest rates, and therefore people’s willingness to borrow, are typically linked to the outlook of inflation, rather than the current level of inflation.
Below, we have real UK house prices (Chart 4) and the real cost of borrowing (Chart 5) from 2006. House prices in nominal terms reached record highs last year (£270,000), but in real terms they had only just returned to pre-GFC levels. Meanwhile, the real cost of borrowing reached its lowest point on record by the start of 2022.
Now we are well positioned to see how far house prices may fall in the coming years. According to the paper, for every 1pp rise in the real cost of borrowing from its lowest level, house prices could fall between 9% and 24%. In the UK, the real rate has increased 3.1pp from trough to peak (Chart 5).
Using the middle estimate from the paper, this would imply a real house price decline of around 57% from the turning point. As we can see in Chart 4, real house prices have already started to fall. In fact, by the end of 2022, they had already fallen 7%, leaving a further 50% decline in real house prices.
In nominal terms, this will not be as large. If inflation rises by, on average, 5% per year for the next two years, we could then expect a 40% decline in nominal house prices from December 2022 (by comparison, the OBR estimates a 10% decline).
This would be a fall from £265,200 to £160,000 by the end of 2024 (Chart 6). However, using the paper’s lowest estimate, we would only see a modest decline to £228,000. So far, house prices have fallen to £257,000 this year.
This drop in nominal house prices would be larger than during the recent Financial Crisis of 2008 (-19%) and only in the best-case scenario would it be as bad as the housing market collapse in the early 1990s (-25%). Crucially, this is because of how low the cost of borrowing has been in recent years.
The Remortgage Revolution
This certainly has the potential to be the mother of all house price crashes. However, households are financially much better placed than during the GFC. In the early 2000s, individuals were estimated to be saving roughly 6% of their after-tax incomes. This has doubled since 2020, so it is unlikely homeowner will need to sell their homes.
On top of this, back in 2007, around three times as many mortgages were on 90% LTV ratios compared to today. This should mean that households have larger buffers, just in case house prices do decline.
The latest Financial Conduct Authority (FCA) data confirms this. It shows far fewer mortgagors are in arrears on their loans and that possessions are significantly below 2008/9 levels (Charts 7 and 8).
While the residential housing market may not be flooded by a large supply of existing homes, there are plenty of new homes being built. In 2022, construction on 178,000 new homes began, the most since 2007. If the economy struggles, interest rates stay high, and the cost-of-living continues to bite, there will be plenty of new homes on the market.
Moreover, demand is particularly low. Buy-to-Let mortgages are down at their lowest level in 10 years and almost half of new loan commitments in Q4 2022 were for remortgages, not mortgages on newly purchased homes. This remortgage ratio is at its highest since Q1 2009 (except 2020) – the last time the housing market started to dry up.
In this inflationary world, real prices matter. This paper shows that the potentially large hiking cycles currently underway in advanced economies could have dramatic implications.
In the UK, house prices could decline by their largest amount on record, wiping almost 15 years of capital appreciation from the records. That being said, Covid-induced savings and more responsible loan-to-value lending ratios mean households are unlikely to need to sell their homes any time soon. Hopefully, then, house prices will not decline as sharply as the ECB paper predicts!
Sam van de Schootbrugge is a Researcher at Macro Hive, currently completing his PhD in Economics. He has a master’s degree in economic research from the University of Cambridge and has worked in research roles for over 3 years in both the public and private sector, most notably at the IFS.
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