Housing market commentary is full of received wisdom which is not all that wise.
There are issues that remain unconsidered, even taboo, perhaps because they threaten the widely accepted easy soundbites, memes and even outright myths that abound among residential property pundits.
I think we have an incomplete understanding of the way the housing market works, particularly with regard to human behaviour. Even when we think about elements of finance and economics, we ignore some behaviours that don’t fit the narrative. We can’t continue to complain about a continuing “housing market crisis’ and not be prepared to think harder about the complex systems and mechanisms that help to perpetuate it.
In the hope of shedding some light on these dark and unexplored corners of one of the 21st century’s wicked problems, I want to talk about an issue that has been bothering me for a few years now. That is: our understanding of the composite value of housing, of its opportunity costs, the role of equity and the great yield compression of the last three decades.
Artificial Intelligence provides the evidence that our conceptualisation of the mechanisms at work in the housing market are incomplete. When I asked Chat GPT to write this article for me, it gave me, as any large language model will, an answer based on all the (insert vast number here) billions of words that have already been written on this subject. If you want to know what humans think, what the commonly held view is, the collective wisdom on any topic – ask a robot.
ChatGPT, even with its new Reasoning function switched on, spoke almost exclusively about interest rates in the context of borrowing costs. In summary it said what almost any article always says:
“Summary
• Low Interest Rates: Lead to lower mortgage costs, increased affordability, and higher demand, often resulting in rising house prices.
• High Interest Rates: Make mortgages more expensive, reduce affordability, and typically decrease demand, which can slow the growth of house prices or even cause them to fall in some cases.”
Source: ChatGPT 10.2.25 when asked “what is the effect of interest rates on UK house prices”
To be fair, Chat GPT did also acknowledge there were other factors to consider namely supply constraints; economic conditions (wage growth, inflation and employment rates); and government policies. Sometimes, (I have asked it a few times now) the AI mentions market sentiment and investor behaviour but, even here, in relation to borrowing.
“Investor behaviour:
• When interest rates are low, property investment becomes more attractive not only for owner-occupiers but also for buy-to-let investors. Increased investment can further drive-up prices.
• Conversely, higher rates may deter investors who rely on borrowing, reducing the demand side of the market”.
Source: ChatGPT 10.2.25 when asked “what is the effect of interest rates on UK house prices”
Now, if we look at the constituents of the housing market itself rather than all stock – that is properties that are privately owned and freely tradable in the open market, we see that under half of existing owner-occupied properties are mortgaged. Of those that are mortgaged, borrowing accounts for less than half of the total value. The country has been paying off its debts as mortgages, and homeowners, have matured since the nation started borrowing in the 1960s,70s and 80s.
In the marketplace itself, as many as one-third of buyers, not just landlords, are buying with cash, with no borrowing. So, we need to consider the impact of interest rates on the psychology and behaviour of these buyers, not just mortgagees, is. Equity still has costs – but they are less likely to be affected by sudden changes in the Bank of England base rate.
The inadequacy of only considering the impact of interest rates on mortgages, rather than more broadly on how people make decisions about their deployment of equity, becomes apparent by looking at how we talk about the same issue in the context of commercial property.
When I asked Chat GPT about the impact of interest rates on commercial real estate, it not only included analysis of finance costs and leverage but also gave an answer which included comments on valuation and discount rates, cap rate compression and the search for yield alternatives.
“Discounting future income:
• Commercial property values are often estimated using models that discount expected future rental incomes. Lower interest rates reduce the discount rate applied to these future cash flows, resulting in higher present values (i.e., higher property prices).
• Conversely, higher rates increase the discount factor, which can reduce the present value of future earnings and, therefore, lower property valuations.
Cap rate compression:
• The capitalisation rate (cap rate) used in valuation models is influenced by prevailing interest rates. Lower interest rates typically lead to lower cap rates, which drive up property values. When rates increase, investors require higher yields (i.e., higher cap rates), which can depress prices.
Search for yield:
• In a low-interest environment, traditional fixed-income investments (like government bonds) offer lower returns. This often pushes investors to seek higher yields in assets such as commercial real estate, boosting demand and prices.
• When interest rates rise, alternative investments may become more attractive relative to commercial property, potentially reducing the flow of capital into the property market and exerting downward pressure on prices.
Source: ChatGPT 10.2.25 when asked “what is the effect of interest rates on UK Commercial property prices”
While well-established in commentary and analysis of commercial real estate, these concepts are woefully lacking in discussion about residential property markets. But they still apply, nonetheless. Homeowners may not know the name of the behaviour that they are exhibiting, or even be overtly cognisant of their decision-making processes, but ‘yield compression’ has been a major component of the UK and global housing market story over the past 30 years.
Homes have an imputed rental value – even if they are never let. Homeowners know what their house is worth to them, even if it is not articulated as the amount they would be prepared to spend each year to enjoy all the goods, services, amenities and other forms of value that a home provides. The rate that the average householder capitalises this value is unique to them but it is likely to vary over time – and might be expected to move at least somewhat in line with interest rates. The rate of return on capital available to the household at the time (and expected in future) is relevant here.
To put it as simply as possible, if the average householder is aware of the rate of return available on other investments like a bank or building society, without always being aware of the details. They will have some notion of the opportunity cost of their capital and are likely to have weighed up all the value (both financial and non-financial) that they will accrue now and in the future by buying a home. Without necessarily realising it or doing any maths, a household is capitalising (or allowing the market to capitalise for them) that imputed value in order determine what price to bid for a property.
If we consider that average savings rates available from banks or building societies fluctuate around the Bank of England base rate (averaging about +0.5% in the long term), we can look at how the opportunity cost of capital has changed for a typical homeowner.
If we use this as a proxy cap rate, the reduction interest rates between 1992 and today is sufficient, by itself, to account for a 300% rise in residential property prices irrespective of the use and availability of mortgage funding or any other factors.
There is much to be said about the net values that homeowners should be placing on housing values in the future (especially as the relative cost of maintenance, repair and upkeep accelerates). But the main point to take in here is that there is no more yield or cap rate compression to come. In the absence of yield shift (other than a few hundred bps up or down around 4%), there can be no automatic house price growth. All that house price inflation of the past three decades is over, interest rates are back to their 250 year pre-war average. There can be no capital value growth without actual or imputed rent growth or a growth in the real value that homeowners attach to a property. Home buyers are no longer stepping onto an ever-upward escalator of value when buying a house.
There are wide implications for the entire system of housing ownership and provision in this single fact. It will though also combine with social, economic, environmental and demographic issues in a way to change the way we think about housing and real estate more widely. The future ‘housing market crisis’ will not be the same one we think we’ve got now.
