Winner of the New Statesman SPERI Prize in Political Economy 2016

Monday, 19 February 2018

House prices and rents in the UK

I am not a housing expert, but it seems to me that the public debate is completely confused because it fails to make the distinction between house prices and rents. If we are talking about the supply and demand for housing, the price that equates those two things is rent, not house prices.

I discussed why here, but let me summarise the argument. Rent reflects the cost of being housed, of having a roof over your head. If there are less houses to go around, rents will be higher: higher enough to make some people share flats, live with parents or whatever. Because houses to buy can quickly change into houses to rent, there are not really separate markets for buying and renting, but just one big housing market.

The price of a house is the price of an asset. The asset in this case provides a roof over your head for as long as you own it. This means that house prices depend on current and future rents. Crucially, however, like any asset, the price is the discounted sum of future rents, where the discount rate is the real rate of interest. If real interest rates fall but future real rents stay unchanged, housing becomes a more attractive asset, and so wealthy people will buy more houses, pushing the price up.

Below is a chart of the ratio of house prices to rents in the UK and France, from OECD data.

There are large swings, but no major trend before around 2000. (That may surprise people, but it reflects what has happened to rents which we will come to.) In the early years of this millenium the house price to rent ratio increased substantially in both countries, and has stayed higher. I have included France with the UK to suggest that there may be some common factor influencing their similar behaviour. [1]

That common factor is real interest rates. You can define real interest rates many different ways: here I’m just going to be very lazy and pull data from the World Bank.

Again ignore the details (I have no idea about 1995) and focus on the trend. Around 2000, real interest rates started falling, and falling substantially. As real interest rates fall, house prices rise.

This will only be true if the housing market is liberalised so that this kind of arbitrage works, and that there are no taxes that stop the arbitrage happening. That was not the case in the UK before the 1980s (mortgages were rationed when I bought my first house), which is just one reason why you would not expect this relationship to hold over that period. But in the last two decades, lower returns on other assets has seen the rise of the middle class landlord as a way of saving for retirement.

This substantial fall in real interest rates is a worldwide phenomenon, and it goes by the name of secular stagnation. Why it has happened and to what extent it is permanent is still the subject of lively debate, which is beyond the scope of this post. The key test will be when nominal interest rates begin to rise over the next few years: to what extent do real interest rates rise with them. All I can say for sure is do not rely on those who say house prices always rise over time.

Thus the rise in house prices in the UK and France since 2000 has got little to do with a lack of house building, a point that Ian Mulheirn has stressed. But what about rents, which is where we should look for any imbalances in supply and demand. Here is some IFS data from a recent paper by Robert Joyce, Matthew Mitchell and Agnes Norris Keiller.

Outside London, there has not been a rise in the proportion of income spent on rent. Essentially, and I suspect this applies before the mid-90s, housing costs (rents) have risen with earnings rather than prices, and at constant real interest rates that would mean house prices rising with earnings. This represents a very reasonable return on any asset, and is why we think buying a house is a good investment. Now you could argue that we should build enough houses so that this proportion of income spent on housing falls, as it has for food for example. What you cannot argue is that building too few houses has anything to do with why houses have suddenly become unaffordable to young people.

The situation for rents has clearly been different in London in recent years, and London house prices have also risen much faster than elsewhere. David Miles and colleagues have written an interesting paper on how house prices in cities can rise as more people work in them but transport costs do not fall. In recent years UK governments have been trying to reduce the subsidy for train travel, and higher rents are a natural consequence. One way to reverse this is to invest in new and improved transport links into cities. However I think the main reason that house prices have recently risen in major cities in many countries is the decline in real interest rates noted above. (Here is the same debate in Vancouver.)

Does secular stagnation (low real interest rates) mean that a whole generation has to rent rather than buy? The main problem is the deposit that first time buyers have to find. Low real interest rates mean a mortgage is easier to service once you have one, although low rates of nominal earnings growth mean that it doesn't get so much easier over time as it used to. But rising prices means rising deposits, which if parents cannot help means saving for a long time. Banks do not want to take the risk of lower deposits, particularly if there is a real chance that house prices could fall. Help to Buy is about the state taking over the risk that Banks will not take, but is that something we collectively want to do? That is the debate we should be having in an age of secular stagnation. Building more houses may or may not be fine, but if real interest rates stay low it is not going to make houses affordable again for the generation that can no longer buy a home.

[1] It is fascinating to look at the countries that are similar to the UK and France, and those that are not (like the US and the Netherlands, but especially Germany). If anyone can tell me why these countries have not seen a permanent upward shift in house prices I would love to hear it.


  1. In Germany and the Netherlands (and perhaps Scandinavia) house prices are controlled for the same reasons that they were in pre-Thatcher Britain (rent controls and restrictions on mortgage lending).

    The United States is more complicated. In the desirable coastal areas (essentially the states that voted for Hillary Clinton in 2016) there has been a permanent upshift in house prices.
    In some areas neighbouring these (especially the Southwest) prices bubbled sharply up and then down a la Ireland, while in the Midwest and South (excluding Florida) they didn't rise appreciably at all.

    The reason why Southern and Midwestern house prices didn't rise appreciably is because of the extremely low urban density (typically no more than 1000 people per square kilometre) typical of these regions, which means that even at typical suburban build densities there is still a large fraction of unbuilt land within the urban area.

    In the Midwest this low population density is the result of population losses following deindustrialization, while in the South it is because the fierce summer humidity delayed the development of cities until after air conditioning became affordable for the masses (which was also when car ownership became the norm), meaning there was no reason to build dense walkable neighbourhoods.

  2. How much of the demand is speculative, rather than driven by lower interest rates?

    I'm in Australia these days, and the rental yield on a property in the Eastern Suburbs of Sydney is around 2%, versus borrowing costs of 4% or more. (It was often cheaper to rent in the UK before the financial crisis.)

    It only makes for investors to invest if they believe that capital gains will cover the losses, and allow them to show a profit. However, there's a common belief that property prices double every seven to ten years, so a lot of people are willing to take a punt.

    There's also evidence that price rises are correlated to the number of investors in the market. So when the financial regulator (the APRA) made life harder for them, price rises stopped, and have started to go into reverse.

    The idea that speculative demand is driving up prices would seem to be supported by the article on Vancouver you posted. (There's been a significant amount of building in Sydney.) It might also suggest that things will unwind rapidly when investors realise they're losing money...

    1. Yes, when Wren-Lewis says "house prices depend on current and future rents" he is ignoring finance.

      Mortgage-backed securities bundle up mortgages and tranche them and sell the high-rated tranches for more than the summed value of the underlying mortgages, because the high tranches can be used as collateral for bank borrowing. The MBS asset becomes bid up by market mechanisms to many more times the price value of the underlying mortgages. It is good for the bank, who may even self-deal in MBS to bid up the booked asset value.

      Housing prices can be seen to inflate as buyers get more and more created money from the world finance sector, as their investments appreciate thanks to financial instruments that are multiplying any real underlying assets such as mortgages or student loans, or whatever.

      The size of the financial market outweighs the size of world GDP by a factor of ten. Yet Wren-Lewis blithely ignores the potential influence of finance, by talking only of pedestrian rents. I think he assumes the same rules that apply to rentals apply in the world financial sector, but I hold that finance has figured out how to relax constraints on budgets (by expanding their balance sheets) and how to create money from promises that won't be decided until later but circulate as money today. And those promises can be paid by insurance if they default, and the insurance itself is paying based on still future promises that are circulating as money today ...

  3. "If anyone can tell me why these countries have not seen a permanent upward shift in house prices I would love to hear it."

    My suspicion is that this might have a lot to do with the specific regulations placed on the sector in those countries. Becoming a landlord is only an attractive investment for the typical person if there aren't restrictions placed on letting property which either make it less profitable or make it obviously risky or time-consuming. I think you're right that a lot of house price rise is essentially caused by people who want to buy to live in a property being outbid by wealthy retirees who want to rent it out.

    Also in Germany and the Netherlands I believe new housing is generally built on land purchased at agricultural use value, not developed use value - as Labour recently proposed for the UK. I'm not sure what the impact of that is, but it does take the highly profitable business of land speculation out, which cannot be a bad thing for house buyers.

    1. Good point about how landowners in Germany and the Netherlands are not allowed to capture the planning gain – this was the case in the UK in the immediate postwar era (and was exploited to create the New Towns) but it ended with the Land Compensation Act 1961.

  4. Re footnote 1, German municipalities have their budgets set per capita so are incentivised to grow their populations, whereas UK councils have fixed budgets and are incentivised to resist population additions. Hence German planning gets less resistance than British planning and supply suppresses prices.

    Eastern Germany has had demographic outflows so regional house prices in some areas have fallen A LOT. National averages don't capture this.

  5. "If anyone can tell me why these countries have not seen a permanent upward shift in house prices I would love to hear it."

    One possibility is population projections. The European Commission projected population growth from 2013 to 2050/60 to be +25% for the UK, + 15% for France, but -10% for Germany and +1.8% for Netherlands.

    The same report project + 36.5% for Sweden, +37.5% for Belgium, -21.9% for Portugal and -1% for Spain. So a reasonable spread in data for correlations.

    1. Really interesting

    2. "One possibility is population projections. The European Commission projected population growth from 2013 to 2050/60 to be +25% for the UK, + 15% for France, but -10% for Germany and +1.8% for Netherlands."

      And these projections (which are to a certain extend nonsense) affect the situation in 2017?


    3. I don't know which report those figures came from, but the figure for the Netherlands seems absurd, given historical data.

      Based on the current Eurostat report (2016-2080, see link below), the data looks to be: UK +21%, France +18%, Germany -5%, Netherlands +16%, Sweden +44%, Belgium +26%, Portugal -27%, and Spain +10%.,_1_January_2016-1_January_2080_(thousands)_PITEU17.png

  6. I agree with almost everything here, Simon, as you'd expect from what I've written. But lest anyone be tempted to jump to conclusions on London based on the IFS chart, I think we should be careful about measuring rent as a proportion of renters' incomes to draw any conclusions about the supply situation there.

    The composition of the London PRS has changed radically over recent years, so we can't be sure we're comparing like with like over time. Secondly, and more importantly, we know that groups that tend to rent (e.g. the young) have been hit hardest by weak wage growth and cuts. All of that means rent is likely rising as a proportion of the average renter's income, but not necessarily as a proportion of average incomes for all London households. If that's the story, then the reason why the London line in the chart is rising is distributional: it's not that London housing costs/rent have got more expensive but that the incomes of the people renting have deteriorated.

    To isolate these effects, we can compare changes in the ONS's rent inflation index and gross household disposable income per head for London. Those series suggest that rents as a proportion of average incomes have not grown since 2005 in London and have fallen elsewhere. That suggests that even in London housing costs/rents have been benign, and the problems (and hence solutions) are distributional.

    1. What about the market failures that bedevil the land and housing markets?

      With respect to the distributional problems/solutions, not clear what you are proposing.

      Does it involve increasing the supply of accommodation provided at an affordable cost to potential households located commanding disposable incomes below an affordability threshold?

  7. I get that interest rates are a big driver of house prices, but I'm slightly confused by the middle paragraph. You say that you could argue that we should build enough houses to reduce rents, and that house prices are related to rents, but affordability is not related to building rates. That seems contradictory.

    Where I live a large number (relative to old stock for sale) of new houses have been built. The result - predictably, I would have thought - is a fall in sales of old stock, and a reduction in house prices.

  8. The price of labour was very high for a slave. Was the answer to this either to

    a) pay wages (abolishing slavery)
    b) increase the supply of slaves, bring down their selling price?

    Housing issues are land issues.

    Like the non-payment of wages, if those excluded from valuable locations aren't compensated for their opportunity loss, we get a net transfer of incomes and baked in inequalities.

    So for some groups in society things, like housing, becomes very expensive because their discretionary incomes are unfairly low.

    The price of land, like the price of a slave, is the capitalised value of that transferred income. ie the measurable price of economic injustice.

  9. Surely the following facts have something to do with house prices:
    residential space per capita in UK is 33 sq. m.and in Germany, 55 sq.m.! In other words too little housing has been built in the UK for decades, now about 170,000 completions vs. 250,000 in Germany with a larger but declining population apart from the refugee influx in 2016.
    33 m

  10. Ian Mulheirn says: "To isolate these effects, we can compare changes in the ONS's rent inflation index and gross household disposable income per head for London. Those series suggest that rents as a proportion of average incomes have not grown since 2005 in London and have fallen elsewhere. That suggests that even in London housing costs/rents have been benign, and the problems (and hence solutions) are distributional."

    There's a complicating factor even there: I'm not sure that the rent index fully takes into account what the renter gets for their money. If we assume that a large number of people are already spending all they can on rent, then if rents *per unit* increase, they'll simply have to get somewhere smaller - and landlords will, to an extent adapt to that. I'm not sure the rent index would reflect that.

  11. In general, renting regulations in Germany are more focused on protecting the renter and not the landlord. Long-term renting is attractive and feasible (i.e. all contracts are rolling contracts by default, fixed-term contracts are rare). You are permitted (after a certain amount of years even obliged) to decorate/renovate the flat/house you are renting. Thus long-term renting is attractive whilst you are waiting to buy the property you will move in *for live*.

    So typically, you will not buy a property to go on the property ladder and buy a bigger one after a few years, when you had kids, but you will wait until it's clear how many kids you will have or until you had them before settling down. There is much less buying and reselling amongst people living in a house that they bought. If there is no such big change as moving away for a different job or so, you would never sell your house by happily stay >20 years in it. And you would never buy a house, if you knew, you would move in the next couple if years. Only with rising house prices the later approach has become a tiny bit more widespread but by no means as abundant as in the UK.

  12. The property owning democracy has predictably crashed.

    High prices are kept high through artificial rationing, deliberately created by so called developers in order maximise their profits.

    Rents are high because private landlords who borrow to invest want the highest returns, council housing is virtually finished.

    The housing madness dressed up as economic rents, were predicted to mean that housing costs would rise, but people generally ignored this in the early years because wages were rising and house prices climbed in tandem.

    With falling incomes and insecure work, it is obvious that long term housing costs will weigh heavy on their ability to pay.

    As an example of the difference in attitudes between Germany and Britain, I lived in Germany in 1968-1969 and it was a very good year, my rent for a room was £7 per month, when I arrived home my rent was £7 per week. This of course is not a scientific sample, but does indicate how Germans could sustain economic growth by the level of disposable income of its workers.

    The greatest inhibitor to our economy is the cost of housing, I suspect now though things might be a little different in Germany today, Neo-Liberal politicians are reversing the gains achieved in the golden years leading to the 1970s.

  13. I'm not sure I fully understand.

    are you saying house prices = present value of present and future rents/real interest rates

    and that rent has stayed pretty much stable relative to income so the rise in house prices is a result of a fall in real interest rates, not a rise in the demand for housing relative to supply, as this would lead to a rise in rental rates.

  14. There are lots of questionable assumptions here. These are not universal principles - it all depends on which country you're talking about.

    "If we are talking about the supply and demand for housing, the price that equates those two things is rent, not house prices."
    In 1947, 27% of housing in England and Wales was owner occupied and 58% was private rented. By 1961, the position had reversed - the figures were 42% and 28%. Owner-occupation was more than half the total stock by 1971. The price of housing throughout this period (and arguably before) was primarily determined by owner-occupation.

    "Rent reflects the cost of being housed". It doesn't. For much of the period from 1945 to 2007, most rents were far below rates of return available through other investments, and that was why the sector was in decline. However, some part of the market was sustained by the prospect of cpatial accumulation. With the collapse of the demand for higher-end renting in the 20s and 30s, the rate of return for landlords came to depend on growth in the capital values. When rents were decontrolled in 1957, landlords left the market - selling up - in droves - quite the opposite from the standard assumption in economics textbooks.

    "There are not really separate markets for buying and renting, but just one big housing market." Regardless of tenure, there isn't a single national market; housing markets are highly localised (and it's important to recognise that the "market" is typically represented by a small proportion of properties that change hands.) In the period I've been writing about, the private rented market survived best in large cities with student populations, such as London and Brighton.

    "House prices depend on current and future rents." This is not true, given the dominance of finance for owner-occupation, but not even rented housing can be looked at in this way. Landlords calculate not by rent alone, but by the rate of return, and that reflects the balance between rent and capital accumulation. That calculation also depends on the ability to convert between tenures.

    In the UK, for most of the period since the 1920s, the market has been dominated by house purchase rather than renting. In the 1920s and 30s, the combination of growing owner-occupation (largely due to new financial arrangements) and the creation of council housing took about 4 million households out of the traditional housing market. Those were mainly people in relatively stable circumstances, greatly reducing the demand for rented housing. By the time we got to the 1940s, the private rented stock was ageing (nearly all of it built before the first world war) and rates of return had fallen; private renting took the brunt of clearance policies directed at the oldest housing.

    From the 1960s through the 90s, owner-occupation was heavily subsidised and at its high point two thirds of property was owned, with only 10% of stock being rented. Private renting has recovered partly because of an indirect subsidy (the sale of council housing) but mainly because low interest rates make the rate of return more attractive and the prospect of sale easier. Expect the calculation to change when interest rates eventually rise again.

  15. The big uptick in house prices and decline in affordability is primarily a London/SE issue. Why those areas?

    London has:
    A Green Belt
    Protected Views
    Conservation areas

    These three factors jointly act to reduce the supply of land for high density planning and increase the costs.

    On top of this, councils with the most greenfield land tend to be Shire Tory, and implacably opposed to any kind of new development. Their willingness is not aided by councils collecting a tiny proportion of the uplift in land value from granting planning permission. Contrast with e.g. Switzerland, where local income taxation means LAs compete for tax paying citizens...


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