Crash or blip?

Implications: There is no doubt that housing market activity has declined sharply over the last few months, with listing volumes down by 30% from September 2006 to September 2007.  Unlike the USA, it is doubtful that this will lead to significant price falls, but the reduced volumes are likely to continue.  What are the implications for providers of homes and services in the sector? 

Analysis:

There is no doubt that housing market activity has declined sharply over the last few months, with estate agents (realtors) listing volumes down by 30% from September 2006 to September 2007. However, a proportion of that is the result of the “spike” of increased listings during July/August, prior to the introduction of Home Information Packs for three bedroom properties. Around 30% of the second hand market is speculative vendors, represented by people who put their homes on the market (usually in response to the house next door going for an unfeasibly large amount last month), but the vendors are only likely to proceed if they get a really good deal. The introduction of Home Information Packs, and thus the increased transaction cost for vendors, will undoubtedly flush out these speculative vendors. Therefore we can expect a general reduction in the number of properties being offered for sale as a result of the introduction of the Home Information Packs.

However, general market sentiment is one of unease. In early September, we had the political uncertainty of whether or not there would be a general election. There is a general economic unease as the consistently positive trends of the last few years cool down. We then have the shock to the system of the run on Northern Rock, one of the leading mortgage banks in the UK, and in the last few days, Paragon, a buy-to-let mortgage specialist. This sentiment is likely to get worse, due to re-possessions: many first time buyers relied on competitive fixed rate deals two or three years ago, and as these expire, their mortgage costs could well increase dramatically as a result of increased base rate and increased risk margins now being applied by mortgage lenders. Many of those purchasers, often with very little equity in their homes, could face difficulties which may well lead to repossession.

However, the market is very different in the UK from the US. The demand and supply position is very different. Household formation is running at around 225k new households per annum, but house building was only 170k last year, and is likely to be significantly lower this year. Therefore, demand from additional households exceeds very significantly production of additional homes to buy or rent.

There are three drivers to the market:

·Household formation

·Trade ups

·Buy to let

There are three components to household formation, although a consistent theme in all of them is “going solo”, with virtually all of the growth in household numbers being single person households:

·Newly forming households: in other words, first time buyers. These may be new migrants to the UK, or young people setting up home for the first time. Those people can choose to delay leaving home for a few months longer, can continue to share with other singles for longer, or can continue to rent for a bit longer. However, at some stage in the future, a significant proportion of them will choose to buy.

·Newly widowed: older people can choose to delay when they move, even though they accept the need to move sometime soon. Again, that delay is going to be for a relatively short period, and is probably a function of their ability to sell their existing home.

·Separated/divorced: at least one of the parties will probably rent for a few months or years, until the divorce/separation settlement is resolved.

Therefore, there is a significant elasticity in when many of those newly forming households actually choose to buy, but that elasticity is probably months rather than years.

The trade up market is very different. There is an increasing recognition that many existing owner occupiers are over-borrowed, and they recognize that the cost of moving is increasing, particularly with the introduction of Home Information Packs. In addition, they face the transaction costs, moving costs, new furnishings and carpets, etc. There is undoubtedly an increased feeling amongst existing owners that they will limit their exposure to increased costs, and if they do want to improve their housing conditions, then either they wait or improve their existing home.

Buy to let has been a boom market over the last few years, initially in response to poor yields in equities, but it has blossomed into a real cottage industry with a proliferation of small investors with one or two properties each. It is now a significant component of total demand. Their main driver has been capital growth, so a slow down in price rises will cool their enthusiasm. Where highly leveraged, investors will be very vulnerable to increased borrowing costs. One the other hand, decisions by first time buyers to delay their entry will increase demand for rented property.

All of this signals a short term drop in demand from newly forming households, and probably a longer term reduction in the number of people trading up. But the fact remains that the UK has a relatively robust economy, relatively low levels of unemployment, but an increasing shortfall between household formation and house building.

So, expect a short term blip but not a crash.

What are the implications of a short term blip? Estate agents (realtors) will undoubtedly be hit badly, as their income is on sales commissions. In particular, they could see significant reductions in volumes as a result of a decline in the trade up market. On the other hand, house builders in the UK are pretty adept at managing the risks associated with fluctuations in demand. Many land deals have overage clauses, where vendors share in increases in sales prices following development. The other side of that coin is that many house builders now pay a relatively small proportion of the land value at the outset, with the balance being a proportion of final sale prices. That means they have less cash tied up in the land if sales rates slow down, and it is the vendor rather than the house builder who takes the hit if prices reduce. In addition, most of the leading UK house builders now do very little building themselves: they sub-contract most of the work packages to others. Therefore, it will be their sub-contractors and building operatives who suffer, rather than the house building companies.

Most estate agents and house builders were reporting that the market virtually stopped in early September, when these problems all coincided. First time buyers are coming back slowly into the market, as are the equity rich. However, the middle, trade up market is still extremely slow.

So what can we expect? A pretty slow market for the next year or two, sluggish price increases (or small falls), but probably not a serious crash. Casualties are likely to be amongst estate agents (and those servicing them) and the sub-contractors who work for the main house builders.