Despite some impressive increases in UK house prices over the past year or so, yesterday's RICS survey highlighted the fragile nature of the recovery in the housing market. In particular, with new instructions still rising, the recent upward pressure on prices may be starting to wane as supply catches up with demand. But how should we gauge the outlook for prices over the longer term?

A key indicator that many economists use to determine whether house prices are at a “sustainable” level is the house price to earnings ratio, or HPE. This ratio makes a lot of intuitive sense: when house prices rise more swiftly than incomes, some households will find themselves priced out of the market. So, to bring demand and supply back into balance, prices will have to fall or at least stagnate as earnings catch up and the HPE reverts to its long-term average. Certainly, previous sharp rises in the HPE subsequently reversed (Chart 1). But not this time. Does this suggest that house prices still have a lot further to fall?

Chart 1: House price to earnings ratio

Source: Ecowin and Daiwa Capital Markets Europe Ltd.
(a) Quarterly Nationwide house price series divided by whole-economy average earnings index.

Well, it depends whether you should expect the HPE always to revert to its long-term average. We do not. Expecting that to happen assumes that households today are prepared only to spend the same share of income on housing as they did forty or fifty years ago. And, in fact, the share of spending on housing – measured as the value of services that housing provides – has risen slowly and steadily over the past 45 years (Chart 2).

Chart 2: Housing and non-housing consumption

Source: Ecowin and Daiwa Capital Markets Europe Ltd.

Why has the share of spending on housing risen? The move reflects two key factors. First, and most obviously, the relative price of housing – housing prices compared with the prices of DVDs, cars, haircuts and cabbages – has risen, probably reflecting supply constraints. The second factor, critically, is consumers’ preferences. If they put relatively little value on having somewhere nice to live, then, when housing prices rose, spending on housing would have fallen or been unchanged (as a share of total spending) as consumers moved somewhere smaller or less salubrious, and spent the money saved on something else instead. But if they were unwilling to downsize or move down-market, in return for more clothes, better food or a new car, then when the price of housing rose, their share of spending on housing would have too. And if households were willing to spend a greater share of their income on housing then – everything else being equal – house prices should have risen, relative to earnings. The data suggest that this is indeed what has happened in the UK over a long period of time.

This means that comparing housing to other prices in the economy – including wages – does not necessarily tell you the right thing. Instead, we should compare the price of owning a home to a much closer substitute, such as renting – and, on this basis, house prices do not appear to be significantly overvalued (Chart 3). That does not mean that we will not see falls in house prices in the short term, reflecting the cyclical volatility that is often evident. But, fundamentally, we should not assume that house prices need to fall a long way to return prices to a sustainable level.

Chart 3: House price ratios

Source: Ecowin and Daiwa Capital Markets Europe Ltd.
(a) Quarterly Nationwide house price series divided by whole-economy average earnings index.
(b) Quarterly Nationwide house price series divided by actual rentals deflator from the National Accounts.

Colin Ellis, European Economist

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