The real estate industry had been undergoing a phase of declining housing prices globally (BBC 2 June 2009). The reason behind the slump in house prices is being cited as the financial crisis that the world economy is currently undergoing. In some countries like Latvia, property prices fell by 20 percent in 2008. On comparing, the global property prices in table 1 we see that the prices change annually has been a great fall from the previous year. Countries like the UK and the US have been hit badly by a falling housing price. Therefore, the table clearly shows the grim picture that the global property market has been facing since 2007.
Table 1: HOUSE PRICE CHANGE (INFLATION-ADJUSTED) Country, Source: (BBC, 2009)
House prices in the UK have been falling UK since 2008 (Thelwell 30 April 2008; BBC 30 April 2008). The first fall started in 2007 December after which there was a continuous fall in prices. The maximum fall in prices was experienced in August 2008 through July 2009 (Halifax 2009). Experts believe that the fall in the prices may be attributable to the weakening of the market conditions. The fall in the prices may have a serious impact on the GDP growth of the economy. Housing investment in the UK has been around 4.5 percent since 1970 (Corder & Roberts 2008). However, housing prices have shown a very volatile trend in the UK and have a considerable impact on the economic cycles of the country.
This paper will discuss the housing property market in the UK since 2007. The paper will examine the reasons for the slump in the market and the effects it has had on the UK economy. The paper will draw intuitive reasoning from economic theory to justify its analysis.
The housing prices in the UK have been experiencing a downward trend in their price as the prices in the UK houses spiraled down.
When comparing the fall in the prices of real estate in the UK with the Real GDP growth it is observed that falling house prices also induced a declining trend in the real GDP growth. In 2009, the real GDP growth of the UK was -4.1 (IMF 2009). As the growth rate of house prices started falling, it led to an induced reduction in the growth rate of GDP growth. Inflation too rose to 3.6 percent in 2008, which resulted from a “marked decline in dwellings investment” (Corder & Roberts 2008). The reasons, which may be cited for such a decline in house prices, are deterioration of macroeconomic outlook, which led to a sharp decline in house prices, builder’s profit, and market activity (Corder & Roberts 2008).
Housing prices slump in the UK has resulted in the decline of housing investment by private and individual investors. This has led to a sufficient slump in the housing market. The main concern of this concern is to understand the economic explanation of investment. Here it must be noted that public sector investment in real estate is not considered in this paper, as it is a function of public policy and hence out of the scope of the paper. Therefore, the paper concentrates mainly on private household investments.
The housing market sells durable goods. Houses are bought and are consumed for many years. Therefore, a decision to invest in housing is similar to investment in capital or machinery by companies.
Theoretically, a company must continue investing in new capital until the marginal benefit i.e. the benefit of acquiring an extra unit equals marginal cost. The benefit is derived from the return on an extra unit of sale. Cost is the price of the investment good, depreciation, taxes, and rate of interest on the loan to finance the investment. In this case, if the expected return increases and the cost declines, the investment must be continued until marginal returns again equate to marginal cost. In this, the companies change their desired stocks, wherein a small alteration in the desired stock can lead to a large change in the flow of investment.
Some costs need to be adjusted with changes in the stock of capital. For example, if there are large investments involved in the capital it may drive up labor costs if capacity constraints are binding. Further, investment projects may take a long period to complete which is another factor on which investment decision is dependent. These create a risk environment, as most of these investments cannot be reversed. If one can wait for more information, then the risk factor can be dissipated. Therefore, usually, there is a delay in decision-making about capital investments, which is mainly to reduce cost.
Adjustment cost of capital prevents investment to go up quickly to an equilibrium position. Therefore, in the short run, the supply-side response is less than what it is in the long run.
Figure 2 shows the short-run and the long-run investment scenario. Here it is clear that the short-run investment supply curve is steeper than the long-run curve. In the absence of adjustment cost, the short and long-run curves would have been equal and would give higher returns to investment (due to an outward shift in the demand curve D1 to D2). This would immediately lead to an increase in capital stock from a to c. However, due to the presence of adjustment cost, the process of adjustment is far slower from a to b and then to c.
During this investment, phase the marginal return to the housing investment (shown through point b on the demand curve) is higher than the marginal cost/ thus the disequilibrium created in investment is called Tobin Q (Tobin 1969). Q here means “market value of capital relative to its replacement cost, so it measures the profitability of investing. In the long run, when demand is equal to supply, Q should equal one: the return from an additional unit of capital equals the cost…Investment should therefore just be sufficient to offset the depreciation of the capital stock.” (Corder & Roberts 2008, p. 394)
Housing investments are subject to adjustment costs (Topel & Rosen 1988). Previous research has shown that the UK demand for housing changes is lower in the short run than in long run (Barker 2003). This rate is lower than that in other developed economies around the world.
This indicates that the companies produce and use the goods themselves (in the case of capital goods) while others produce them for other companies to use. Housing is very similar to this. Some people make their own houses while others make them be sold. Thus using the same model of capital investment with adjustment the nature of the housing demand and market can be analyzed.
Applying the Tobin Q model in the housing market, we get Q to be the expected price of houses divided by the cost of producing them. Here Tobin Q measures an individual’s incentive to invest in housing after comparing the market prices of the houses to the cost of replacement. Thus in the case of the housing market, the relevant comparison that needs to be considered is the market price of a new house vis-a-vis the cost of making it. As there exists a lag in the decision to start construction and the sale of the completed house, housebuilders conjecture the expected price of the house once construction work is completed. The house prices that are used in this paper are the prices provided by Halifax housing data and they show the monthly housing prices.
Various researchers have applied Tobin Q to the UK housing market. Like Barot and Yang (2002), who have used a ratio of housing prices to construction cost, and Tsoukis and Westaway (1994) implicitly estimated the value of Q by building a model in which the house prices were a function of the price of houses, land prices in residential areas, construction cost, cost of capital, and availability of credit.
This paper assumes that the planning cost is constant in real terms. Given this assumption, the house building Q indicator is the initial sign of investment. The price of houses depends on the discounted cost of the future services available in the housing. Here the discounted amount is the rent that the house fetches. This will depend on the balance of demand and supply. In the housing market, the stock of goods i.e. in the case of all other capital markets is expected to be fixed in the short run and so the charges on demand are expected to increase the house prices initially (Barker 2003).
The demand and supply for houses depend on various factors. The factors that determine the demand for the house are the price of the main product, price of other products, income, population, preferences, and future price expectations. The factors that determine the supply of houses are the price of the main product, the price of substitutes & complements in production, price of a factor of production, technology, number of suppliers, and future price expectation.
Demand for houses depends on income or rather disposable income of consumers. When the household income is high, apparently the demand for houses increases, and vice versa. Research has shown that when there is a 1 percent increase in real disposable income, it increases housing demand by 1 percent. In the UK household income explains the decline in household prices in the country. Argument Thus, paradoxically the housing demand declined even though the population increased in the UK. Higher average household size led to reducing household demand, which drowns down prices. As figure 3 shows, as there is a decline in income, the demand for houses falls, supply and prices remaining the same. The quantity demanded houses falls from Q1 to Q.
Demand for Houses
Thus as the average household income fell, there was less disposable income for households to invest in housing. Therefore, there was a reduced demand for houses. This led to reduced prices. As prices fell this led to a reduction in demand, which led to a slump in the housing market. This is seen in the following figure (Figure 4). As the prices of the houses in the UK fell, there was volatility observed in the yearly change in the demand of the good. This was due to the price adjustment of the houses.
The prices of other products, which are complementary, also affect demand. In the case of housing, the complementary products are mortgage rates or interest rates. The rise in the mortgage rates, and the rates which are risk-free which was an outcome of the weakening financial market conditions, led to a lowering of demand for houses.
The central government went on to increase interest rates to restrict the financial market to reduce the flow of liquidity in the market. This increase of the interest rates in the market also made houses dearer, reducing their demand considerably. Further construction of houses in the market would have increased supply in a market where demand was already falling due to weak economic conditions. This would have continued to reduce the prices of houses further. These factors are responsible for the large slumps in house prices in the last two years. As figure 5 shows, as there is an increase in the bank rates, mortgages become dearer, making the demand for houses go down from D’D’ to DD, consequently reducing the demand for the houses from Q1 to Q.
The reason for the increase in the earlier housing market was due to lower mortgage costs, which instantly started increasing, as the economy was moving towards a downturn. This reason has been reported by Halifax chief economist: “Housing market conditions remain challenging in the face of the significant pressures on householders’ incomes and the reduction in the availability of mortgage finance since last summer.” (Burridge 6 November 2008).
Further, there has been a downfall in the mortgage payment since 2007:
“For existing borrowers on variable rates with a typical loan size, the reduction in interest rates since 2007 has led to a significant reduction in mortgage payments. About one-third of the overall stock of mortgages is on a base-rate tracker mortgage2. For these borrowers, the 4.5 percentage point fall in rates seen since the end of 2007 means that their monthly mortgage payments have fallen by around £240 per month. Those on standard variable rates have seen a fall of a similar amount. Unsurprisingly, those borrowers in the highest-priced areas have seen the biggest change to their housing costs, with Londoners seeing monthly savings of more than £350 and those in the Northern region seeing nominal falls of just less than half this amount.” (Nationwide 26 February 2009)
Since 2007, the mortgage lending spread has increased considerably, and household prices expectations have drastically fallen due to bearish market conditions. In the third quarter of 2008, new house prices were 8 percent less than the previous year, and there was a negative expectation of prices among the builders. However, the prices of houses remained higher than what they were a decade ago. Nevertheless, the cost of construction and land prices, which are two important components of Q’s denominator, remained high, thus reducing the incentive to build houses.
The price of cost of raw materials increased, increasing the cost of construction, thus driving up the cost of production of houses, thus increasing the price. This in turn reduces the demand for houses. Construction costs rose considerably due to rising raw material costs, and labor charges. All these costs increased very sharply due to the inflation in the country which reached 3.6 percent in 2008 highest after 1992 (IMF 2009). One explanation for this may be the changes in building regulation may have increased compliance costs.
Another problem was the reduction of labor after the 1990s recession created an indefinite shortage of labor in the market, which drove up labor costs. Further rising wage costs also increased competition in the labor market increasing the shortage of labor. It has been noted in the UK construction industry that the labor who left the industry after massive layoffs in the 1990s did not return to join the industry once the market recovered. This consequently raised wages sharply. In 2004, this constraint was eased due to the influx of migrant workers.
The reduction in construction may also be attributable to the lowering of incentive to invest in the housing sector, which may have occurred due to increasing construction costs. Another important reason for this lowering of prices is island prices.
House prices increased until the end of 2007. House constructors to reap maximum profit out of the booming real estate market bided up the price of residential land, which was already limited. As land is fixed capital, its density cannot be increased in the same manner as increasing the density of housing buildings. Thus, the availability of residential land became a key constraint for the barriers to the construction of new houses. Thus, it must be noted, “The availability of land is likely to be the key constraint on house building and so must be captured in any measure of Q. The amount of new land released will depend on the price of residential land relative to the returns from alternative land uses.” (Corder & Roberts 2008, p. 397)
As the residential land, prices in the UK peaked in 2007-08 and then started declining, as the demand for non-residential land increased, as they were considerably cheaper to have.
Thus, the prices of houses in the UK fell due to various reasons as captured in the above discussion. In addition, the movement of the household prices follows the same rule as that followed by investments in capital. Therefore, house prices may fall due to adverse expectations in prices in the future, which may arise due to various reasons, as in the case of the UK it is mostly recession.
References
- Barker, K 2003, ‘Barker review of housing supply: ‘, Interim report, HM Treasury.
- Barot, B & Yang, Z 2002, ‘House prices and housing investment in Sweden and the United Kingdom: econometric analysis for the period 1970-98’, Review of Urban and Regional Development Studies, vol 14, no. 2, pp. 189-216.
- BBC 2009, Global house prices drop further.
- BBC 2008, UK house prices in 1% annual fall.
- Burridge, N 2008, House price falls hit record levels.
- Corder, M & Roberts, N 2008, ‘Understanding dwellings investment’, Research and analysis Quarterly Bulletin, pp. 393-403.
- Halifax 2009.
- IMF 2009, IMF Data Mapper.
- Nationwide 2009, Improving affordability helps new and existing buyers.
- Thelwell, E 2008, UK house prices drop year-on-year for first time since 1996.
- Tobin, J 1969, ‘A general equilibrium approach to monetary theory’, Journal of Money, Credit and Banking , vol 1, no. 1, pp. 15-29.
- Topel, R & Rosen, S 1988, ‘Housing investment in the United States ‘, Journal of Political Economy, vol 96, no. 4, pp. 718-40.
- Tsoukis, C & Westaway, P 1994, ‘A forward looking model of housing construction in the UK ‘, Economic Modelling, vol 11, no. 2, pp. 266-79.