Why house prices have further to fall

There is one simple reason why house prices need to drop: for decades, they have risen many times faster than wages.

According to the Land Registry (which records all residential-housing transactions in England and Wales), the price of the average house dropped by 2% in February. Over the past twelve months, the Land Registry's house-price index has fallen by almost a sixth (16.5%).

The Land Registry calculates that the average property in England and Wales is now worth £153,862. This equates to a drop of £30,361 in one year, or over £2,500 a month. After eighteen months of falls, property prices have been rolled back to a level last seen in September 2004.

Of course, after a twelve-year housing boom lasting from 1995 to 2007, it was inevitable that prices would have to fall back. In the words of Herbert Stein, an economic adviser to Ronald Reagan, "If something cannot go on forever, it will stop." Then again, I can suggest several structural and cyclical reasons why the UK enjoyed rising in house prices from the Eighties onwards. These three immediately spring to mind:

Three reasons why house prices rose

1.    The owner-occupancy boom

Although property ownership as an aspiration is firmly embedded in the modern mindset, it wasn't always this way. Indeed, in 1918, less than a quarter of the population (23%) were owner-occupiers, so renting was very much the norm. By 1961, owner-occupancy had climbed to three in seven households (43%), rising to four in seven (57%) by 1981. In 1997, this ratio reached roughly seven in ten households (69%), where it has hovered pretty much ever since.

In the Eighties, the steady trend towards homeownership was boosted massively by Mrs Thatcher's 'Right to Buy' initiative, which encouraged tenants to buy their council homes. Of course, this scheme created millions of new homeowners -- a one-off surge which is unlikely ever to be repeated.

2.    The boom in mortgage lending

As the base rate declined from the early Nineties, mortgage lenders saw increasing demand for more -- and larger -- home loans. This caused our total mortgage debt almost to quadruple between 1992 and 2008, as follows:

UK mortgage debt, 1992 to 2007

Source: Bank of England

As you can see, the yearly increase in mortgage debt was below £26 billion until 1998. It then took off, hitting £55 billion in 2001 and peaking at an incredible £112 billion in 2006. However, when the credit crunch took hold, mortgage lending collapsed, with a net increase of just £38 billion in 2008 -- the lowest rise since 1999.

One reason for this boom in cheap home loans was the rise in 'residential mortgage-backed securities' (RMBS). These were bonds made up of parcels of mortgages which were sold to major investors, such as pension funds and insurance companies. Alas, as the US and UK housing markets started to slump, the value of these mortgage bonds dived and the market froze. The effective collapse of the RMBS market means that this one-off credit event may not return for years, if not decades.

3.    The collapse in the base rate

When I bought my first home in late 1992, in the depths of the last property crash, the Bank of England base rate was nearly 8% a year and my mortgage interest rate was broadly similar. However, over the next few years, the base rate declined fairly steadily, falling to a low of 3.50% in mid-2003. During this time, mortgage rates also fell, making monthly repayments much more affordable and thus encouraging homebuyers to take on ever-larger debts.

Over the next four years, the base rate climbed, peaking at 5.75% in late 2007, although mortgage rates remained competitive. However, the weakening economy forced the Bank of England to take a knife to the base rate, sending it plunging from 5% in October 2008 to a record low of 0.5% today.

Given that the base rate is now at its lowest level in the Bank's 315-year history, there's only one way it can go: up. This means that the huge boost to house prices provided by ultra-low rates is over, at least for the near future, as I warned in A big danger for homeowners.

One reason why house prices should keep falling

However, one grim fact remains, which should cause eager homebuyers to pause for thought. Despite eighteen months of falls, the increase in house prices has hugely outstripped wage rises, as the table below shows:

25 years of house prices and wages

Sources: Halifax House Price Index; Office for National Statistics (mean average for full-time male gross earnings)

As you can see, over the past 25 years, house prices have risen more than fivefold (up 419%). Meanwhile, wages have risen almost quadrupled (up 285%). Taken to the extreme, if the growth in house prices continued to outstrip rising wages, then mortgage costs would eventually consume all of our take-home pay. Of course, this wouldn't happen, which is why there is a limit as to how long house-price inflation can exceed wage rises.

As house prices outperform earnings, the house-price-to-earnings ratio (HPER) climbs. This measures how many years of gross (pre-tax) earnings it takes to buy a typical home. The above HPER measure peaked at 6.20 in 2007, before falling to 4.98 in 2008. However, this is still ahead of the 25-year average of 4.37, which indicates that houses remain expensive in historical terms, despite recent falls.

Indeed, were the HPER to fall back to match its low of 3.12 in 1995 (at the end of the last housing crash), then house prices would have to fall by nearly three-eighths (37%) from here, assuming no change in earnings. So, either wages have to soar (which is most unlikely, given weak economic demand and low inflation), or house prices still have further to fall. Given the weak outlook for employment and earnings, I'm betting that it will be the latter.

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