This post analyses the affordability as measured by Halifax and Nationwide. A recent article in the Guardian discusses the issue of house price to earnings ratio. The author surmises that house prices would have to fall by 25% to reach average price-earnings ratio of 4.04 (currently 5.4, according to Nationwide). The author purports the price correction will occur gradually as opposed to overnight.
This post will also review previous cycles to see how affordability in house prices in the 1990’s cycle corrected.
Chart 1 highlights the two approaches of measuring house price affordability. The Halifax price to earnings ratio (HPE), which is measured as follows “Ratio of the Halifax standardised average price to national average earnings for full-time male employees. Price Earnings ratios revised to reflect new data in the Annual Survey of Hours and Earnings (ASHE).”Please see http://tinyurl.com/ce5f8b. Interestingly, it only includes the earnings for men not the combined earnings of the household. However, an increasing number of households have dual incomes, which is likely to have meant a rise the proportion of household income that can be allocated to meet housing costs. The other affordability measure assesses mortgage repayment to income (MRI) and evaluates the ability of borrowers to service the mortgage.
Chart.1 Measuring Affordability
Chart.1 highlights that the current house price to earnings ratio is above average. In fact, current HPE levels are close to a + 1 standard deviation level. In early 1990’s cycle, the HPE peaked at 4.98 while in the latest cycle, HPE peaked at 5.86. Conversely, mortgage reached high levels of 65% of income. In the current cycle, which peaked in Aug 2007, MRI was at 47% far above the average of 37%. Thus, by HPE measure of affordability, houses were less affordable by the Aug 2007 peak relative to the May-1989 peak. Chart.1 shows that the Halifax mortgage affordability tends to peak and bottom ahead of the HPE ratio. This is mainly because interest rates lead house prices, while earnings lag house prices.
Chart 2 shows the Halifax House price earnings ratio and the annual growth rates of the components of the ratio. The annual change in the Halifax house price index and the annual growth rate in earnings are graphed on the same scale. This has the effect of assessing earnings growth relative to house price inflation. It is evident from Chart. 1 that late 1980 and early 1990’s where characterised by strong earnings growth.
Chart.2 Breaking-Down House Affordability
During the downturn in early 1990’s earnings continued to show decent earning growth, while house price growth rapidly declined. Actually, HPI annual inflation did not turn positive until early 1996. Following the decline in house price HPE was relatively stable from late 1992 to early 2001. During this period, HPE ratio ranged between 3.09 and 3.37. However, since late 2000 earnings growth has been modest. Thus, the rise in HPE can be attributed to an increase in house price, fuelled by other drivers other than earnings.
Chart.3 below reports the speed of adjustment of the house price-to-earnings ratio during the last two periods of house price growth. Earnings, House Price and HPE re-based to May 1989 and Aug 2007, the dates for the house price peak of the last two cycles. The solid lines represent Aug 2007 peak, while the dotted lines represent the May 1989.
Chart.3 Comparing Cycles
It is apparent that earnings growth was more robust in the May 1989 downturn than in the Aug 2007 cycle. Price decline in the current cycle tracked a v-shaped, but tentative recovery. HPE ratio in the 1990’s was flat for an extended period.
HPE ratio is cycle and follows the path of house prices. Secular decline in interest as resulted in below average mortgage repayments to earnings ratio (see http://tinyurl.com/35no59k on interest rates and house prices). In the 1990’s, interest rates were elevated due UK government attempt to defend the pound. Earnings growth has moderated along other economic variables (GDP, inflation, interest rate), the so-called Great Moderation. However, house price growth and volatility did not moderate to the same extent. Is it possible that we are going to experience a period of above average HPE and below average mortgage payments to income ratio? The low mortgage rates under-pin house price or else provide resistance to the downward momentum in house prices.
At this point in the cycle access to mortgage financing is scarce, as the cycle loan-to-values ratios fall. Low LTV creates a wealth barrier for first time buyers, who are most likely at lower quartile of the earnings band. The next post will look examine affordability for first time buyers and spatial affordability