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Rates of change

by: By James Newton
  • 17/11/2003
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The market has adapted to keep affordability levels at a more constant level, but the key to future sustainability will be what happens to interest rates

The Government recently announced plans to put aside a £5bn housing allocation to drive forward its commitment to affordable housing for key workers, such as teachers and nurses. While this may appear good news for a cross section of the working population, what assistance is there for everyone else who is struggling to get onto the property ladder or climb further up it? The answer lies within the mechanics of supply and demand.

On the supply side there are plans to increase the level of affordable housing, but this article focuses on the demand side, examining the market drivers that have meant that demand has more-or-less kept pace with escalating house prices.

Like water, the housing market will find its own natural level at some point. At present house prices continue to rise, while many lenders are experiencing record levels of lending. So the question is how long this can be sustained and at what point will affordability constraints put a brake on the market, and more importantly will the brake cause a sudden stop or a gradual slowdown?

Market indicators suggest that there will be a gradual slow down rather than the sudden fall experienced in the late 1980s and early 1990s. This is because the market conditions are very different today – there is much more consumer choice and product innovation, which has helped borrowers during the time when the affordability gap (the difference between what people can afford to pay and what they actually need to pay) appeared to be widening.

The gap looked to be widening because house prices have been growing at a much faster rate than earnings. This implies that borrowers need to stretch their income to afford the loan they require. But this has not necessarily been the case.

Take the example of someone with average earnings – currently about £25,000 – who is looking to buy a property valued at the current average of around £120,000. Assuming they have a 10% deposit they would need an income stretch of 4.32 times income. This compares with the equivalent transaction occurring in 1998 where an income stretch of just 2.59 would have been necessary.

This implies that property is much less affordable today than five years ago. But adding interest rates into the mix creates a different picture. Despite the recent rise, interest rates are still at their lowest point for 40 years, and while property prices may have doubled over the last five years, interest rates have virtually halved, keeping affordability levels constant. In 1998 average repayments (interest only) represented 16% of gross earnings compared with 15% today. So on this basis it could argued that property is more affordable today.

This calculation is based on gross earnings and based on averages. At an individual level things may be different, but it is clear that people are still buying and selling houses despite continued house price growth.

First-time difficulties

The plight of the first-time buyer (FTB) has been well documented – which is only fitting given the importance this sector plays in the market. In some respects, FTBs these days are competing on an uneven playing field because they are competing with the burgeoning number of landlords snapping up property through buy to let. Nonetheless, FTBs are still entering the market, albeit in smaller numbers, as the latest Council for Mortgage Lenders (CML) figures show, making up around 30% of all house purchase transactions, compared to an average of 40% in the past.

However, is it really just the cost of buying a property that is putting off all FTBs? There are other factors to consider such as the growing number of people attending university. 10 to 15 years ago, about 5% of school leavers went on to higher education. Today that figure is 50%. This means people have three years less time to save up for a deposit. And this problem is compounded by the fact that so many students are leaving university with huge debts which most wish to repay before they enter a new debt agreement such as a mortgage.

Attitudes to renting are also changing and this is why people are buying their first property later and later. Research shows that the proportion of FTBs under 25 has been falling, while there has been an increase in FTBs within the 35 to 45 age bracket.

We have also seen the average loan size for FTBs increase over the last five years. According to the CML, the average loan is currently £92,065 compared with £50,413 in 1998 – the equivalent of an 83% increase. Yet income multiples have not increased at the same rate, currently about 2.94 compared with 2.38 in 1998 – a 23% increase. This implies that the earnings of FTBs have risen at a faster rate than average earnings. So it can be argued that those who are able to get on the property ladder have higher earnings potential and are pricing out other FTBs.

This suggests that FTBs are creating their own solutions to the problem of a widening affordability gap – in many cases by paying a more sizable deposit. The proportion of first-time borrowers who have more than a 25% deposit has increased. And this has been during a time when house prices have grown, when you would probably expect the opposite to occur. This is because anecdotal data suggests that in addition to waiting longer, many FTBs are benefiting from parental assistance, often with their parents remortgaging and releasing equity from their own homes, in order to provide some or all of the deposit. And in some ways this is artificially pushing prices up further.

Lenders have been developing products, such as 100% mortgages, and guarantor schemes, to try and meet the needs of the first-time buyer, but it appears that many have devised their own strategies to counter any problems with affordability. But what about experienced buyers?

Some existing homeowners have also found it difficult to move up the ladder, which is one reason for the increase in remortgage activity occurring in the market. But despite this, people are still moving – often helped by the fact that lenders have redeveloped their products and lending criteria to adapt to changing demands. This is not to suggest that lenders have deviated from responsible lending, far from it. But there is a natural adaptation to market changes, such as income stretches. But perhaps one of the most pioneering products to counter issues of affordability has been self-certification.

There are different aspects to this. First: self-employed people normally have different levels of affordability than might be shown in their annual returns. Second: there have been changes in the employed sector that has meant that self-certification has become the right solution, particularly those with second jobs and/or income from many different sources. However, as the recent BBC Money Programme revealed it should not be a license for borrowers to lie about their income and no one wants to see borrowers over-stretch themselves and put their property at risk of possession. The role of the intermediary is key here, as they need to work with the client to ensure that the loan is not only affordable today but also in the future when the interest rate climate may be different.

Greater understanding

Technology has also played a big part in adjusting to the need to fill the affordability gap. Lenders have become far more adept at assessing and understanding the risks of self-cert lending, which is why more lenders have entered the market and driven down prices. The growing use and increasing sophistication of credit scoring systems has helped the market to evolve and will continue to do so. Technology now allows lenders to assess a borrower”s credit worthiness via other means, such as electronic scoring systems and CAIS data, which can calculate the applicant”s ability to maintain the mortgage repayments.

It is clear that the housing market has been given a huge boost from lower interest rates and higher earnings. There have been some concerns about the level of house purchase activity in the first half of 2003. This may prove to be a short-term blip as consumer confidence was hit by the Iraq conflict. Only time will tell, but the number of transactions has increased during the last quarter, albeit slightly lower than in the same period of the last two years. This suggests that the predicted gradual slow down has started, assisted by affordability constraints and the possibility that the market has begun the process of naturally correcting itself.

The key to the extent of a slowdown in the market rests on interest rates. If rates rise further as expected, and if they rise gradually, there should be a gradual slow down. But if they rise sharply, it may be a different story.

key points

House prices have risen faster than income, but interest rates are much lower than ten years ago and affordability has remained constant.

FTBs are getting older due to greater student debt and relaxed attitudes towards renting.

Self-cert has helped maintain affordability but the onus is on advisers to ensure clients are truthful.

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