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.

House prices, rents, and supply

In a previous post I argued that high house prices, in the UK and perhaps elsewhere, could simply reflect lower expected long term interest rates. This had some people puzzled, because it appeared to ignore supply and demand. Surely it is higher demand combined with inelastic supply (supply that is insensitive to changes in prices) which is to blame for high house prices? This short post clarifies how both views can be correct at the same time. I also raise a question about housing wealth and inequality at the end.

The easiest way to think about this, at least for me, is to imagine no one owned their own home. Everyone rents, and houses are owned by landlords. Rents represent the price of ‘housing services’, which is the flow of benefits we get by having a roof over our head. If we calculate these rents in real terms, we have the relative price of housing services compared to other goods. Real rents will reflect the supply and demand for these housing services. If we all suddenly decided we wanted to rent a house in the countryside as well as our house in the city (or vice versa), and if the supply of houses did not increase, rents would rise dramatically until enough of us thought that maybe this wasn’t such a good idea after all.

Suppose real interest rates fall, but the supply of housing is fixed. There is no particular reason why lower real interest rates should change the demand for housing services relative to other goods. Then with no change in demand or supply, rents do not change in real terms. But house prices will, because they are - to use a bit of jargon - the present discounted value of future rents, where the discount rate is the real interest rate. This is a shorthand way of saying that lower interest rates mean that investments in financial assets yield lower returns than the same amount invested in housing, so investors will want to own houses rather than financial assets. This pushes up house prices until the rate of return on both types of asset are equalised.

That assumes housing supply is inelastic, which is a reasonable assumption in the short term. However suppose by some means (economic or political) these higher house prices generated an increase in the supply of houses to rent. If the demand for housing services is unchanged, greater supply will begin to push down rents. Falling rents push down the yield from owning housing assets. As a result, housing becomes less attractive as an asset, and prices begin to fall.

So if housing supply was very elastic, permanently lower real interest rates need not lead to higher house prices in the long run. Instead, they could produce much lower rents, because a lot more houses get built. Such an outcome seems unlikely in a country like the UK, but it could happen in a country like the US where there is plenty of land available to build on. This is one possible reason for the different trends in house prices in different countries that I commented on in my previous post.

So my original post was certainly not suggesting that increasing housing supply would have no impact on prices. What it was suggesting was that in evaluating whether current prices represent a bubble, we need to allow for the possibility that high prices today reflect a view that real interest rates may stay low for some time.

If interest rates do stay low for some time, and this does keep house prices high, an interesting question is why this matters. Take the case where everyone rents. Rents are unchanged, so those renting are no worse off. Landlords appear richer, but their future income in real terms has not changed. If people own their own houses, their houses have not suddenly got bigger or better. This is related to, but is not quite the same as, a question recently raised by Chris Dillow. It is different because it potentially applies to anyone who owns assets that get more valuable simply because interest rates fall, and not because the future incomes they generate increase. It is the same issue that is raised when some complain that Quantitative Easing, by - say - raising share prices, is benefiting the rich. I think this change in wealth does matter, as this evidence suggests, and I hope to explore the reasons why in a future post.