UK housing market valuation and forecast – June 2015 (part 2)

In part one of this UK housing market valuation and forecast, I looked at the latest house price-to-earnings ratio in the context of historic norms (here’s a link to part one).

My conclusion was that the UK housing market appears to be at the “expensive” end of its valuation spectrum, with the house price to earnings ratio at 5.16, some 29% above its long-term average of 4 (where the average house price today is £196,067 and average earnings are £37,962).

At the end of the article, I mentioned that the house price-to-earnings ratio had been based on the earnings of the average home buyer rather than the average UK employee (including those who cannot afford to buy).

I wanted to re-do the housing market valuation and forecast using the broader UK average earnings figure as I thought it would produce a more accurate measure of how expensive the market really was.

However, now that I’ve looked at the data a second time, that doesn’t appear to be the case (largely because I misread some of the data the first time around).

Instead, whether house prices are compared to home buyer earnings or average UK earnings, both ratios seem to be saying the same thing, to almost exactly the same degree.

The UK housing market is expensive on a price-to-earnings basis.

Note: The UK average earnings data comes from the excellent and the house price and home buyer earnings data comes from several Halifax spreadsheets.

UK housing market valuation: Expensive relative to average UK earnings

The average house price today is £196,067 while average earnings for UK employees in 2015 are £25,537 (an estimate based on 2014 earnings of £25,029).

Given those figures, it’s easy to calculate the current UK house price to UK average earnings ratio as 7.68. In contrast, the long-term house price to average earnings ratio, from 1983 to 2015, is just over 6.

On that basis, the average house price today is currently 28% more expensive than its historic average, relative to earnings.

That is essentially the same as the 29% “overvaluation” conclusion I came to in the previous housing valuation article.

Another way of looking at this is to say that, with UK average earnings at £25,537, the average UK house would cost £153,222 if it were valued at the historically average multiple of 6-times earnings.

That means house prices today could be “overvalued” by as much as £42,845 on average.

The “fan chart” below is the same as the one in the previous article, but this time based on an average valuation of 6-times UK average earnings, rather than 4-times home buyer earnings.

UK House Price to Average Earnings Ratio - Probability Fan Chart - 2015 06

A quick explanation of the fan chart:

  • The black line – is the average UK house price from 1983 to today
  • The left axis – is logarithmic, which means each step up is double the previous step, which you can pretty much ignore if you want to
  • The green bands – represent various house price to earnings levels, from 4.5 up to 9 (the average, in the middle, is 6)
  • Darker greens – Represent house prices that are closer to the average PE ratio of 6.
  • Lighter greens – Represent house prices that are far above or below the average PE ratio of 6.

The valuation “bands” in the fan chart cover the same range as before, i.e. from 25% below to 50% above the historic average, which in this case means house price-to-earnings ratios from 4.5 to 9 (where the average value is 6).

As you would probably expect, with the market on a high price-to-earnings ratio, the current price is towards the top end of the historically normal range of values.

I usually give each of those valuation bands a descriptive name and currently the average UK house price (at £196k) falls into the “expensive” band, as you can see in the table below.

House price to average earnings ratio table - 2015 06

UK house price forecast – Prices could easily stagnate for another decade

If we assume that house prices will return to the historically average multiple of earnings at some point, we can then make some reasonable statements about future house prices.

If, for example, house prices returned to their historically average multiple of earnings tomorrow, we would see the average house price fall to £153,222 from its current £196,067.

Obviously, that’s unlikely to happen overnight. What is more likely is that the return to average multiples will take several years at least (and some kind of change in the economy as well, such as rising interest rates).

If valuations took 10 years to return to normal, and if average UK earnings grew at 3% a year, we would see:

  • Average UK earnings in 2025 of £34,320 and
  • Average UK house prices in 2025 of £205,918 (i.e. 6-times earnings)

So in my opinion it is entirely reasonable to say that there is a good chance we could see virtually no increase in the UK average house price in the next 10 years.

If you think that’s impossible then remember that, according to the Halifax House Price Index, we have already had no increases at the UK average level since 2007, some 8 years ago.

Contrary to popular opinion, house prices do not always go up and future returns are closely related to current valuations.

You only have to look at the difference in returns between 1995-2005 (168% gain, going from low to high valuations) and 2005-2015 (18% gain, staying at high valuations throughout) to see how important current valuations are to future returns.

I will leave you with my “heat map” which uses the same data as the fan chart, but which highlights how future returns are likely to be affected by high or low starting valuations:

UK House Price to Average Earnings Ratio - Heat Map - 2015 06

A few notes on the heat map:

  • The black line – is the average UK house price from 1983 to today
  • Red – Indicates high valuations, where low future returns are likely
  • Yellow – Indicates average valuations, where average future returns are likely
  • Green – indicates low valuations, where high future returns are likely

Of course, there is a lot of regional variation in all this, most obviously between the southeast and the rest of the country, although that is perhaps an analysis for another day.

Author: John Kingham

I cover both the theory and practice of investing in high-quality UK dividend stocks for long-term income and growth.

7 thoughts on “UK housing market valuation and forecast – June 2015 (part 2)”

  1. I believe there is a better corelation between interest rates and house prices than with earnings. My regressions shows a corelation on 0.91 with interest rates and only 0.62 with earnings.

    There are areas where prices have already gone a bit crazy and decoupled from earnings all together.

    It is worth understanding that when buyers buy paying with cash in one area, the sellers dislodged will buy in another area at prices that have nothing in common with their earnings, because they have already made a huge gain on the first sale.

    I suspect there is still mileage in the property market at this moment. There are bigger boubles in Hong Kong or Australia in the property market, those would be affected first.

    We also have a shortage of properties for sale and a shortage of builders. There are too many factors, so I am long on property.

    I am more interested in commercial property where you can get more for your buck at this moment. We bought together a few investors a prime location shop leased to Tesco’s for another 12 years at 6.44% rental yield, index-linked with inflation.

    1. Hi Eugen, yes interest rates are a key input. The data is available from Halifax on mortgage payments, earnings, house prices, and so I could do some research on “affordability”, which relates to interest rates of course. Perhaps next month.

      I also think commercial property is a better choice than residential at the moment, but I don’t do real estate investing, at least yet, so it’s outside my circle of competence.

  2. Excellent post, John.

    The figures you quote on relative returns between 1995 and 2005 and 2005 and 2015 are very interesting. The next decade will be even more interesting from that perspective.

    For now, I am happy having my limited property exposure in commercial property through REITs. I agree, though, there does not seem to be much scope for notable growth going forward at present. But the world is an unpredictable place!

    1. Commercial property is a very different beast, and one I’m not super-interested in researching as I don’t invest in it.

      Also there’s a big difference between poor returns from housing in terms of national averages and housing in terms of an investment, i.e. buy to let.

      The massive leverage in real world property investing means that as long as your property is cash positive, or at least not cash negative, and you have a multi-decade time horizon, and inflation remains the order of the day, and the government doesn’t change various tax and legislative factors that make buy to let attractive, then you’re likely to make a ton of money in the long-run, if you can be bothered with the operational details of running a property business.


    1. Hi Anastasiya, I think property crowdfunding will be really interesting. As far as I know it’s unleveraged, i.e. houses are bought without mortgages, so there returns will be massively lower than they are for leveraged property investors.

      I think it’s unlikely to match the stock market for performance, but could be much less volatile. It will be interesting to see if there’s a flood of money into property crowdfunding, and if so, if it has any impact on valuations.

      1. I still do not know who is going to buy your £50 investment back, when you need the funds back. I am not going to!

        Unless the discount is good enough, in what I have seen already, the discount would be as high as 70%.

        I have seen many people investing in stuff, where there is no way to get out. In the end they are happy to recover 10-15% of their investments.

        I am/was involved in funding for a few commercial properties, using LLP structures for tax efficiency, but we made it clear that when less than 25% of “shareholders” would like to cash in, the property would be valued based on an internal rate of return based on LIBOR and the rent in payment, after which a 15% discount apply but the remaining investors are bound to buy the share of the property on offer.

        Anything about 25% request to encashment will result in the property being put up for sale, unless the existing investors would make an offer based on a 10% discount.

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