Zorin Finance

Why it is better to err on the side of caution

I like to regard myself as a reasonable chap. Educated to a good standard, I seek the testimony of experts and weigh up the evidence on both sides in order to reach an unbiased conclusion.

I stand very much in contrast to my friend Justin. Justin is, for want of a better word, a conspiracy theorist. An expert in flat earth-ology and a self-certified authority on alternative Rothschild family history. The problem is that over several of the key events of the last decade, Justin’s erratic ramblings have proved correct far more often than my own considered viewpoints.

In 2011, Justin told me to buy bitcoin, saying it would be worth tens of thousands before the end of the decade. Justin now has a yacht from which he mocks my lack of faith in him. In 2015, Justin also proclaimed that Donald Trump would win the US presidency. Brexit? Indeed, Justin was sure we’d leave, and when we did, there’d be no recession, rather, the stock market would soar and unemployment fall.

The problem I have now is that Justin is telling me to sell my home, because a housing market crash is imminent. The experts tell me that we have a shortage of housing and a resilient economy. Now I’m not saying that Justin is correct, after all a stopped clock is right twice a day (or three times a decade in Justin’s case). However, as professionals in the real estate sector, it is worth pondering what would bring the next crash on.

The usual recipe for a house market crash has been homes purchased with cheap debt, gleefully acquired in the expectation that its value will increase precisely because people are acquiring homes with cheap debt because the value will go up because other people are getting cheap debt to… Well, you get the self-fulfilling logic. And this cycle does sustain itself as long as everyone is dancing to the same music. The music is augmented by bullish lyrics on market fundamentals, such as an insatiable demand for housing borne by population growth and historically compounded lack of supply.

Then something happens to skip the needle. Affordability reaches a limit and people stop believing that they can sell their home on to someone else for more.

In the past, it has been falling wages, rising rates and spikes in unemployment that has reduced affordability. Between 1989 and 1993, house prices dropped 20%, largely due to ice being poured on an over-heated market through interest rates reaching almost 15% in 1989 and a sharp rise in unemployment. About 250,000 homes were repossessed between 1989 and 1993, wrecking countless lives. The pounds extrication from the European Exchange Rate Mechanism and a lowering of rates to 6% helped to re-establish affordability and a recovery in the housing market.

The crash in 2008 was much less severe due to the BoE’s rapid decision to lower rates to 0.5% in 2009. Affordability increased again and cheaper-than-ever debt allowed the bullish beat to carry on once more. However, the affordability limit is again being stretched as low rates have led to asset price inflation. The average home is eight times median annual earnings, very near the 2007 peak. With rates already at historic lows, affordability can only be increased by surging growth in wages or a fall in house prices, which would lead to panic selling and further falls. On balance, ask yourself which seems more likely?

One aspect of the housing market which curbs mass sell-offs of this manner is that people need somewhere to live and so are inclined to hold on to their homes even if they are in negative equity. It has been this which has protected the market from larger crashes in the past, especially in the South East, where the strong jobs market attracted demand for housing and helped people meet mortgage repayments.

However, as Mark Twain once said: “History doesn’t repeat itself, but it does rhyme." So, we should be mindful of the past, yet not adhere to it so much that it blinds us as to what is different now.

And what is different now? Well for starters, the buy-to-let market. Buy-to-let mortgage lending increased by 40% between 2008 and 2015, compared with an increase of 2% in owner-occupier mortgages. Due to the BoE tightening lending criteria for buy-to-let, and government reform to stamp-duty surcharges and tax deductions, being a professional landlord is far less lucrative now than before the last crash. Unlike residential homeowners, as soon as the numbers don’t stack up, landlords will have little hesitation in off-loading housing stock.

Second, the era of low rates is coming to a close. With higher rates comes higher mortgage bills and also higher investment yields elsewhere. Hitherto, buying a two-bed flat for £600,000 made sense as long as you could get a 3% rental yield and decent capital growth. This makes less sense if capital growth is stagnant, rent is taxed more heavily and you can get 3% from a savings account.

Of course, these are just the known unknowns, which could bring about the next crash. Who knows what other black swans are stirring the waters of the market. Justin thinks an upcoming burst of solar flares will be the catalyst, and I don’t have the heart to disagree with him.

The Oxford historian RG Collingwood once said that because historians have read a lot about the past, they see “tigers in the grass” that the unwary traveller may not see. Though a significant crash may not materialise for some time, as professionals in the real estate sector, it is better to err on the side of caution and see the tiger that isn’t there, than miss the one that is.


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