UK House Prices: Learning the Correction Lesson

UK house prices -- like many other places -- are falling because that is what needed to happen; correction is definitely the right word to use.

I have been looking at Nationwide's historical house price indices and first time buyer affordability indices. They show an unmistakeable trend: whenever house prices see a period of rapid growth, that period is always followed by a severe correction.

Another trend is in how prices fall and how much they fall by in relation to the affordability index; the corrections have a noticeable pattern, which I think can be used to predict how much further prices will fall in this correction.

According to the Nationwide house price index, house prices rose consistently between 1952, but never by more than 10.1% per year until 1971. Before 1971 the annual rise remained at around 5% or less -- a steady incline if you will. The annual rate of growth hitting 10.7% in 1971 marked a turning point; this was when the cycle of rapid price growth acceleration followed by price growth slowing (the growth/correction cycle) began.

The corrections in the next decade were minor in comparison to the crash today, and the last crash in the early 90s. This is because homes were still affordable for first time buyers, with average mortgage repayments still below 70% of the average first time buyer's salary. This was changed by the period of growth acceleration that began between 1981 and 1983.

Growth accelerated from 1.3% per year in Q4 1981, to 11% by Q2 1983. It then hovered around the 10% per year mark; accelerating to 13% before dropping back to 7% until 1987, when the average price rise would have been round about the 13% mark. Meanwhile the affordability index shows that by the end of 1987, first time buyers were having to commit 95% of their monthly salaries on mortgage repayments in order to buy a house --meaning that first time buyers were beginning to be priced out of the market.

The camel's back was finally broken in 1988, when price growth accelerating from 10% in Q1 to 22.3% in Q3 saw (the affordability index) average mortgage repayments jump to 115% of the average salary for first time buyers. Thus -- on average -- first time buyers were completely priced out of the market. Still price growth accelerated to 29.1% in the last quarter of 1988, and 32% in Q1 1989. By then mortgage repayments were 147% of the average first time buyers salary

The slowdown increased in speed till it went 5.2% into negative territory in Q2 1990. The decline continued to accelerate, prices were falling by 10.7% per year by Q4, and the annual rate of decline never dropped below 4% until Q2 1993. The market then bobbled around on the bottom until 1996.

If we look at the affordability index it shows that the correction took average mortgage repayments down to just 55.9% of the average first time buyer's salary, when the continuous decline stopped at the end of 1993, and 46.2% of the average first time buyer's salary when the continued price increases began in Q2 1996.

The affordability index shows that the next time homes went out of reach for first time buyers, and the index crossed the 110% threshold was in the latter part of 2004. This was turned around slightly to below 100% when growth slowed, without going into negative territory. If growth had remained at that slow speed (around 2% on average), price falls would probably not have been necessary -- but for the toxic assets explosion of course. Even without toxic assets UK house prices would have fallen however, because price growth accelerated again at the end of 2005 and the trouble really started.

Growth went from 3.2% to 4.9% between Q4 2005 and Q1 2006, at which point affordability began to worsen again. As growth hit over 9% in Q4 2006 and stayed there into Q1 2007, the affordability index again crossed the 115% mark. In fact, by Q1 2007 mortgage repayments were 122% of the average first time buyer's salary; a severe correction, with severe price drops was once again inevitable.

The decline started with a 4% decline in Q2 2008, and accelerated rapidly. Prices were falling at 14.7% per year by the end of 2008.

The 1990 correction was the first severe correction in UK house prices since the Nationwide index began in 1952. Like I said before that the corrections were very minor, and price growth merely slowed to a nominal level. The 1990 correction was bad, and this one is worse, the next one may well be worse again. There is a clear lesson to be learnt from these corrections:

UK house prices often correct themselves with slowing growth, but if (the affordability index goes over 100%) first time buyers become priced out of the market, then a severe correction will not be far away. It is also fairly safe to say that the correction will cause prices to drop until houses are not only affordable to first time buyers, but comfortably so. Whereas before the affordability index crosses the 100% threshold, minor corrections need only take it back to 90%. So maybe we would be better controlling prices, before the affordability index crosses the 100% threshold.

Where are we currently in this correction process?

Growth slowing to 2.2% in Q1 2008 and then to -4% in Q2 2008, took 15% off the affordability index. So the 16% falls will be correcting the affordability problem all the quicker.

Affordability figures last month said that first time buyers would have to spend an average 96% of their monthly salary to make mortgage repayments. When the downturn started (Q4 2007) the figure was 136%. While this means that the average first time buyer is still priced out of the market, it also means that affordability has improved by 40% in just over 1 year.

Based on that we can say, that if the decline in house prices stays at around the same annual rate, and failing for a massive increase in interest rates, then price drops will persist until at least the first quarter of 2010. But it may well be some time before prices start growing again -- most likely when the wider economy is in much better shape.