Supply and demand

 

In the discussion of house prices, most commentators and analysts tend to focus on the relationship between prices and individual or household incomes. These measures of affordability, some very crude and simplistic, others more sophisticated, tend in many instances to lead to the view that prices were bound to correct as the house price/income relationship was no longer sustainable and that a house price correction was therefore ‘inevitable’. Aside from the flawed assumption that the house price/income relationship is something that is a constant through time (i.e. that people will always commit the same portion of their income to housing through time), the big unanswered question is why house prices have (until the recent period) been rising so fast in the first place?

 

Large parts of the media would seem to be firmly of the view that much of the price rises up until 2007 were largely the result of irrational exuberance and speculation that drove prices to unreasonable levels. It would not be going too far to say that price rises were somehow seen as a  part of national housing hysteria. Whilst in any rapidly rising market there is an element of speculation, the biggest reason why prices rose and will rise again in the future, is the most basic and fundamental:- SUPPLY

 

 

The impact of falling prices on housing development

 

It is an often stated fact that we are not building enough housing to cater for demand. This statement held true even in the peak of the market when 177,000 dwellings were commenced in England in 2006/7. The situation is now significantly worse, with housing starts in Q1 2009 in England at just 37% of the market peak

 

 

Whilst the fall-off in housing starts is clearly a reaction to falling property prices, it would be wrong to assume that building levels will simply pick up again once property prices stabilise and/or start to rise. New developments operate in a long cycle of land purchase, planning and development that can typically be  3 - 5 years. In addition, many of the land banks currently held by developers were purchased at the peak of the market, making development often marginal until prices pick back up again to circa 2007 values. The most optimistic scenarios I have seen (assuming no widespread government intervention) do not have house building levels coming back to the 2006/7 levels until 2016/17.  In short we are looking at a 10 year period where house building remains constrained.

 

 

 

The levels of house building are of course irrelevant without looking at the demand side. Two crucial factors at inter-play here; Rising population levels and decreasing household size. The UK is in a relatively unusual position in Europe in that the population is continuing to rise (unlike for example Southern Europe and Germany).

 

 

At the same time, as people live longer and more often in single person households, the average household size continues to diminish

 

 

 

 

The net result is a government estimate that from now until 2031, an average of 250,000 new households will form every year in England. If you juxtapose this against the anticipated level of house building, the net result is a massive under-supply of new homes.  In the graph below, the shortfall year on year is demonstrated by taking government estimates on household formation and comparing this with assumed dwelling formation (I have assumed housing starts recover to their peak by 2017 and then continue at this level.

-  refer to part two for rest of Blog