According to the IMF, house prices are most overvalued in Ireland (30%), Netherlands and Britain (29%) America by contrast have house prices overvalued by only 10%. Therefore, there is a real possibility of housing slumps in other countries; if these housing slumps occur it could trigger slowdown in global growth, especially in Europe and OECD economies.
Graph of House Price Overvaluation
Why House Prices are Overvalued.
Era of Cheap Borrowing. In the past 10 years, lenders have been keen to extend mortgages to consumers who were previously thought to be high risk. Examples, include subprime mortgages and lending upto 5 times incomes. The competitive mortgage industry made mortgages cheaper than usual and encouraged more groups of households to take out mortgages. However, the subprime crisis has dramatically altered the mortgage industry. The number of mortgage products has substantially fallen, making it much more difficult to get a mortgage unless you have a large deposit. (see: credit crisis 2008)
Supply Constraints in Many Countries. The supply of housing is notoriously inelastic in many western economies. There is a shortage of land and a difficulty of gaining planning permits; this means housing supply struggles to meet with growing demand. However, the supply constraints do not explain all the house price increases.
Speculation. The era of rising house prices encouraged people to 'buy to let'. Landlords bought houses to gain income from both rent and capital gains. For example, in the UK, the proportion of mortgages held by landlords has risen from 1% to 10%. It may be that as the market turns this new group of homeowners will be much keener to sell.
Ratio of Earnings to House prices. The ratio of House prices to earnings shows that house prices have increased above long term trends and makes house prices susceptible to a substantial fall to correct the lack of affordability. This is particularly notable amongst first time buyers who are struggling to get on the property ladder.
Graph of House Price to Earning
Is the End Nigh? - Why the Housing Crash may be less Severe Than FearedDespite the grim prognosis of many analysts, the UK and other European economies may still be able to avoid a slump in housing prices similar to the US. These are some factors which may prevent a housing slump as bad as the US.
- Ratio of Mortgage payments to Earnings is below historical highs. Long term Interest rates are lower than in the early 1990s and this has made the cost of paying for a mortgage relatively cheaper.
- Prospect of Lower Interest rates. If house prices do fall and western economies slow down this will lead to lower inflation and therefore, there can be cuts in interest rates. This will make buying a house seem more attractive. It is also worth noting UK interest rates are much lower than the last time we had a housing slump. However, there are 2 complications
- Credit crisis is causing bank interest rates to be more expensive. Therefore, base rate cuts may not lead to cheaper mortgages
- Cost push inflation due to rising oil and food prices makes interest rates cuts more difficult.
- Negative Equity will be concentrated on a small % of the housing market. Because UK house prices have risen by 217%, even a 15% fall in house prices would leave most people with positive equity. Experian, a credit-scoring firm, reckons that if house prices fell by 20%, only 78,000 households would have mortgages worth more than their homes [ source]
- Supply constraints are more serious in Europe, UK than in America
- The American housing bust was related to a large oversupply in houses. The housing boom caused a big rise in the supply of housing and this was a key factor in pushing US house prices down. In the UK, housing shortages are still a problem
- America had the highest % of risky, unaffordable mortgages. The American mortgage industry was the least regulated, offering subprime mortgages to people who had a high chance of defaulting on their mortgage. Generally, european mortgage industries were better regulated. At the moment, defaults in the UK are not at a critical level and are unlikely to get worse.
- Move to Longer Term mortgages and borrowing from parents. As people move to longer term mortgages and borrow from parents for a deposit, it facilitates a rise in house price to earnings ratio in the long term. This does not necessarily mean it justifies the rise from 2.5% to 5% we have seen. But, there is no law the long term house price to earnings ratio has to remain the same.
The unprecedented rise in house prices do have some fundamental economic reasons behind them. Nevertheless there is also clear evidence that, at least part of the rise, is due to speculative buying, and this creates the potential for significant house price falls as the market turns. The extent of the house price slump may not be as severe as the worst predictions. (I don't think the European markets are precarious as the US, but, there were many who said US house prices would never fall. Also if conditions in the credit markets continue to worsen it will further worsen the prospects for house prices.