Saturday 24 October 2015

The man from Deutsche Bank gets it wrong, and right.

In an Australian publication, Sahil Mahtani of the Deutsche Bank sounds a warning note about London's property market.

Every £1 invested in London property in 1990 is now worth £5, double the performance of the FTSE 100.

Conservative estimates put average London house prices at 13 times average gross incomes.

London residential mortgage debt amounts to a quarter of the country’s total.

London’s housing market is huge, expensive, and hot. It’s not hard to find stories of property insanity in the capital and popular opinion holds that its a flood of foreign investors buying up homes and leaving them empty to accumulate value that has sparked the boom.

Mahtani says it’s simple supply and demand — the supply of homes has failed to keep pace with demand from buyers, be they foreign or otherwise.

But crucially Mahtani sees a second, overlooked factor for spiraling prices — buyers believe house prices will keep going up. People are willing to pay silly prices on the expectation prices will keep rising and they can cash in themselves later. That in turn bids up prices.


On the first point, he almost immediately contradicts himself:

He points to the Hong Kong property crash of 1997, when prices dropped 40% in just over a year, as evidence for what happens when the wind changes direction on public opinion.

Here’s Mahtani:

A shift in expectations about future supply was much more instrumental in bringing about the downturn. The post-handover government had made it known that it would welcome a decline in property prices and would increase supply by 85,000 units a year. In retrospect, at no point during the next five years did housing completions reach 35,000 annually. Yet because the decision had credibility, it changed expectations and the 85,000 figure is still cited today as a reason for the market decline. The government announcement precipitated a change in psychology that diminished the speculative increment in the market.

It didn’t matter that supply increased nowhere near as much as promised — the “psychology” had changed and that was enough to send buyers running.


In other words, the supply of housing did not change, but public perceptions did, which tends to suggest that the fall was all to do with psychology and nothing to do with supply and demand. Ricardo, in his Law of Rent, recognised that land prices are driven by public sentiment and there is ample historical evidence that this is so.

Whilst there is also evidence that supply and demand affect land prices locally, within London the "bubble" effect is so strong and demand is so ramped up by it, that there is simply not the physical space to increase supply enough to have any effect on price.

Those with large landholdings around the capital, hungry for for the windfall gains that change of use permission would bring, would like us to believe that the only way of controlling the price of land is to by controlling the supply. As Mr Mahtani points out, it is much more effective to control the demand.

16 comments:

Mark Wadsworth said...

Yes, good point about affecting demand/sentiment vis a vis selling prices.

But there is no speculative element to rents. Nobody rents a place in the hope that rents will go up etc. Yes, places come into fashion and go out of fashion, but that is not speculation.

Rents are a fairly fixed point. Divide them by the prevailing interest rate and that's your selling price. On that basis, UK house prices are not wildly wrong.

Bayard said...

Yes, infelicitous choice of word there. What I meant was that Ricardo noticed that what people are prepared to pay for rent seemed nearly always to be the maximum they could afford, rather than choosing to pay less on rent and more on something else, i.e. more subjective and less objective. It's the lack of objectivity that renting shares with buying, not the swaying by popular feeling of the time.

Mark Wadsworth said...

B, I'm not sure that he did notice that.

The only reason that people pay £x in rent is because there is at least one other person who is prepared to pay £x - £1 for those premises. It is a constant auction.

And seeing as rents are set by average wages for the area, people on below average wages are actually paying more than they can afford and people on above average wages still have a bit of free cash.

To the extent that this is not evened out by low earners living in small places and higher earners in bigger places, of course.

So we end up where most people are paying the most they can afford, but this is effect and not cause.

Bayard said...

Agreed, but I think "paying more than they can afford" should be "paying more than they'd like to pay". If they were paying more than they could afford, they'd go bankrupt.

"The only reason that people pay £x in rent is because there is at least one other person who is prepared to pay £x - £1 for those premises"

I'm not sure about this, otherwise, whenever supply exceeded demand, land rents would always collapse to zero. In an auction, if you have a lot which no-one wants then the auctioneer will reduce the starting bid from what he thinks is the "going rate" for that lot down to the minimum bid before giving up and putting it as a "not sold". When renting, or buying a house people tend to think "My budget is £x, what's the best I can do for that", more than "I want this type of home, what is the cheapest I can get it for?", although I'd guess you'd tend more towards the latter, the more specialised your wants (e.g. "I want a house with its own golf course within commuting distance of London.")

Mark Wadsworth said...

B, how can supply exceed demand?

With milk, the farmers get more and more efficient, produce more and more but demand is the same, milk is a commodity so price goes down, and keeps dropping until enough farmers have gone out of business and supply stabilises at a profitable level.

With housing, each home is unique, or only has a small number of competitors. If the supply of housing increases in Newcastle in a nicer part of Newcastle, that has no impact on house prices in Birmingham or Bristol.

Secondly, assuming population of Newcastle and demand for housing in Newcastle stay the same, then the rental value of the homes which are currently the least desirable will fall to £nil and people will move to the new homes in the nicer part instead. But prices in all the other parts of Newcastle will be entirely unchanged.

Bayard said...

"B, how can supply exceed demand?"

By there being more homes to rent than people who want to rent them. That's not an unlikely situation outside London and the Home Counties.

"If the supply of housing increases in Newcastle in a nicer part of Newcastle, that has no impact on house prices in Birmingham or Bristol."

Never said it did. However, Newcastle is a major city, so its "housing market" is going to be fragmented. When you get down to smaller market towns or rural areas, then each area would be its own market. Which is why, as we have discussed before, developers of large estates don't try and sell all the houses at once. The number of people who want a new three-bed detached in Carmarthen is limited, and you don't want to exceed that limit id you are selling.

Your auction simile doesn't really fit the reality in another way, unless you are thinking of a Dutch auction. Outside extreme cases like London, the landlord doesn't have tenants bidding each other up. It's much more likely that the property will either be let quickly or remain unlet for a while, after which he might consider reducing the rent until a tenant can be found. As I said before, tenants have a budget and they are looking for something in that budget first. That's why the first thing the agent tells you about somewhere to rent is the rent, then what it is like. It's no coincidence that the order of questions in Primelocation or Rightmove goes what area, then what price, then what type (no of bedrooms etc.). The "psychology" bit is why we are prepared to offer a particular proportion of out income to pay for accommodation and not much less or much more.

Mark Wadsworth said...

B: "Which is why, as we have discussed before, developers of large estates don't try and sell all the houses at once."

Exactly. This is the auction process. If you have to sell 20 new homes, you will only be able to sell them for the price which the 20th bidder is prepared to pay. So you just sell 10 homes for the price which the 10th bidder is prepared to pay, let that bed in until a new equilibrium is reached and then release the next 10...

As to the 'psychology', does it matter exactly WHY a landlord can get the money he gets or WHY a landowner can sell land for what he can? The fact is they can, and that is all down to their quasi-monopoly power, profits which cannot be competed away except by other landlords or other landowners.

Bayard said...

"As to the 'psychology', does it matter exactly WHY a landlord can get the money he gets.."

Well, no it doesn't, but acknowledging the fact that more is at play here than simple rational thought is important. We are not rational beings and very often don't act rationally, which is why all those economic theories based on the "rational man" don't really fit the reality.

Mark Wadsworth said...

B, but what is "rational"?

Seeing as we are all going to die, what is the point of anything? Why play golf? Why collect stamps? You might as well describe all activity designed to serve anything more than subsistence level existence as "irrational". That does not justify rigging the system to suit one small group of individuals.

L fairfax said...

Controlling demand would be very easy, just write to people who have been living on 100% housing benefit and don't work telling them they have to move somewhere cheaper.
It is a fair and logical way to do it.
Why should a 17 year old single parent get housing that many people who work can't afford (true story).

Bayard said...

There isn't anywhere cheaper, because the positive feedback inherent in the nature of Housing Benefit; you have to remember that the beneficiaries of HB are not the poor unemployed, but the rich landlords. The working people can't afford to rent the home of the 17 year old single parent because the state gives the landlord too much money to house the 17yosp. The 17yosp doesn't get to see a red cent of it and couldn't care less if it was reduced to tuppence ha'penny a week. Nor would reducing HB make the slightest difference to the non HB market because, by and large, HB claimants "pay" more for worse accommodation, than non HB claimants. If your working man was paying what the 17yosp was "paying", they'd expect a place a damn sight better than the 17yosp was getting.

Bayard said...

"B, but what is "rational"?"

Don't ask me, I'm not an economist.

L fairfax said...

"Bayard said...

There isn't anywhere cheaper, because the positive feedback inherent in the nature of Housing Benefit"
I think there are cheaper places outside of London. London is not the UK.

Bayard said...

Quite possibly, but as I pointed out above, moving all HB claimants out of London isn't going to make an ounce of difference as they are separate markets. Even if all the HB-receiving landlords did their places up and rented them to non-HB tenants, they would still be asking the same as what non-HB tenants are paying at the moment, because that's the going rate.

L fairfax said...

"Quite possibly, but as I pointed out above, moving all HB claimants out of London isn't going to make an ounce of difference as they are separate markets. Even if all the HB-receiving landlords did their places up and rented them to non-HB tenants, they would still be asking the same as what non-HB tenants are paying at the moment, because that's the going rate."
Really? So less demand and constant supply wouldn't change the prices?

Bayard said...

"Really? So less demand and constant supply wouldn't change the prices?"

No, because the level of demand is so high that the small amount of reduction would make no difference. All that would change would be the level of excess of demand over supply, which would really only be of interest to statisticians.