Housing Market: Part 5

Is there still a housing bubble and what-on-earth is going on?

A Recap of Where We Have Been

In Part 1, we established that there is a housing bubble.
In Part 2, we estimated how large this bubble is.
In Part 3, we compared the modern housing market to a Ponzi scheme (!?).
In Part 4, we speculated on what the future of the bubble might look like.

Today, in Part 5, we will re-value the UK Housing Market, address some of the more common objections that have been raised, and recap our thesis for what has caused the bubble.

The Valuation Model Output Summary

Figure 1: Valuation Model Output Summary Sheet

Since valuing the market back in July, interest-rates have continued to fall, risk-premiums have come down and average household incomes have risen, driving the current intrinsic-value of the average house in the UK higher.

But, growth in the average price of housing accelerated faster, with the average house now costing over £254k despite being worth £99.5k. The housing market is now the most over-valued it has been since 2007 and the second-most ever. Total household debt is higher than it has ever been, household debt to GDP is the highest it has been since 2009 and the second-highest it has ever been.

Figure 2: UK House Prices, Intrinsic Values & Household Debt

A Recap of Our Thesis For What Has Caused The Bubble

We have postulated previously that there are three legs to the housing-bubble stool - take one leg away and the stool will fall over. These legs are 1) culture, 2) financing and 3) misestimation of risk. We have covered these previously, so the following is just a brief summary:

Historically, a house was seen as an affordable place to buy and live. But, as house prices rose we began to develop a cultural herd-narrative that your house was also an investment and the best way to generate long-term wealth. These are mutually exclusive truths and cannot hold simultaneously.

In order to perpetuate the ever-growing canyon between these notions, we developed an increasingly complex Swiss-Army Knife of financing options to bring new buyers into the market and allow them to borrow ever-larger amounts.

Banks benefited from these financing products, and the fractional-reserve banking system, goose-stepping along with regulators’ Goodhartian methodologies for estimating risk, created a self-reinforcing credit-cycle.

Further reading for the keen-beans:

• Debt, Credit & Monetary Policy: The Debt Burden & Credit Risk, Monetary & Fiscal Policy, Interest Rates & Growth

• Fractional-Reserve Banking: Parts 1, 2, 3, 4 & 5.

But, You Can’t Put a Price on Having a Roof Over Your Head… Gotcha!

Without a doubt, the most common objection we get on this thesis takes on some version of:

“People want to own and live in a house. You cannot value what having a roof over their head is worth to someone. Housing (more specifically land) has a limited supply. Therefore, people will always want it and the real price has always, and will always go up in the long-term”

But, hold your horses there…

Economically, the value of living in a house is the rent paid (or forgone). For economic equilibrium and the no-arbitrage condition to hold then the NPV of all cash-flows from owning and living in the house must equal NPV of all cash-flows from renting and living in that house. If I own and live in my house, I am effectively renting the house to myself.

Finally, with a long-term view, has the real price of housing actually always gone up? The Herengracht Index, which measures real house prices on the Herengracht Canal in Amsterdam, is the longest-running record of real house prices. It shows that real house prices, since 1640 anyway, have goose-stepped in tandem with the long-term debt cycle.

Figure 3: The Herengracht Index

Buying in the 1730s saw it take about 260 years for you to break-even in real terms.

Where Do We Go Now?

We think it is likely that as income support and mortgage holidays come to an end, average incomes will reduce and mortgage defaults will increase. This will, according to their own risk measurement measures, drive an increase in the risk-weighting of bank mortgage books and spigot the flow of credit.

This is then likely to create a deflationary self-reinforcing feedback loop that could, in turn, lead to a systemic deleveraging.

Any sustained downturn in prices could then, in effect, kick-off a banking liquidity crisis and a dramatic rewriting of the cultural herd-narrative.

But, who knows?

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Disclaimer: This newsletter does not constitute financial advice. It is independent research.

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