Bitesize: The divergence of house prices and rents in Prime London

Philippe Bracke and Alice Pugh.

Economic theory suggests that property prices and rents should move together: rents represent the flow of housing services gained from living in a property, and prices are determined by the discounted value of all future rents.

But data collected by LonRes show this has not been the case for Prime London. Whilst prices of rental properties have risen by 180% since 2005, rents charged have risen less than 40% (Chart 1). As a consequence, rental yields have fallen to between 3% and 4% (Chart 2).

Chart 1: Divergence between house prices and rents in Prime London

pugh_chart-1

Chart 2: Rental yields in Prime London

pugh_chart-2

What has driven this divergence? The most likely explanation seems to be an increase in competition between investors in the rental market.  Whilst the number of buy-to-let transactions fell sharply during the crisis, it has since rebounded to around its pre-crisis levels. A higher number of properties available to let has meant that landlords have been unable to raise rents – whilst the prices paid to purchase these properties have risen sharply. Consistent with this theory, the LonRes data show that the median number of days it takes to rent a property has increased since the crisis, to over 50 days.

Philippe Bracke and Alice Pugh work in the Bank’s Structural Economic Analysis Division) 

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14 thoughts on “Bitesize: The divergence of house prices and rents in Prime London

  1. It is not true that “[e]conomic theory suggests that property prices and rents should move together” when supply is artificially constrained and yields on other assets are compressing.

    There is extensive econometric literature on the highly constraining impact of British land use regulation on housing supply: see for example the work of Paul Cheshire and Christian Hiller at the LSE. There is also evidence that such regulation has constrained GDP by on the order of 30 percent per year. (For an econometric analysis of the US, see the paper by Enrico Moretti and Hsieh showing an impairment of 9.5-14%; the distortion in the U.K. is much greater, as explained in Robin Harding’s article in the Financial Times in 2014, ‘Target the planning laws…’

    In such circumstances, economic theory predicts that yields on such assets will compress through prices rising when yields on similar assets also compress, as they have done so globally since 2005.

    If you would like more information, please contact the @LondonYIMBY twitter account.

  2. interesting. So if landlords are finding it difficult to raise rents, what happens if interest rates rise and the 3% to 4% yield is no longer sufficient to cover their buy to let mortgages?

  3. Could another explanation for these diverging trends be that the properties sold and those rented in prime areas may be vastly different, making this an apples and oranges comparison?
    For example, large Georgian properties sold may be split into apartments and rented as multiple smaller units; former social housing, student accommodation and low quality (or deteriorating) stock may more frequently appear in the data for rent, and less often on the market for sale, etc. Or is the LonRes data quality-adjusted to help better compare like-with-like?

  4. This is all grand as far as it goes. But as interest rates have fallen wouldn’t we expect to see asset prices increase and yields fall across the board? Wouldn’t it be more surprising to find a property market where yields are constant?

  5. This divergence is not uncommon at all and is repeated in many cities in the world including Vancouver, Aukland and Sydney to name a few, and it relates for the most part how asset prices have responded to, and are correlated with the availability of cheap credit (or debt). That is to say rental yields are not the principal driver of property asset price, rather credit availability and speculation are the main drivers.

    I would consider it more actuate to say that economic theory (and historical evidence) dictates that asset prices are influenced more by speculation rather than fundamental valuation. This is the more likely reason that house prices are not connected to rental yield because the price of the asset is not correlated with the yield, instead asset prices are more correlated with the expectation of returns i.e. from capital gains. The total return on an investment in property is rental yield plus capital gains, so it follows that given that the return from capital gains has been significantly higher than that from rental yield then investors rational will make an investment decision based on expectations from capital gains not rental yield. One only has to look at the return from capital gains on a house in london over the last 2 years vs rental yields, 90% of the gain is from capital not yield. This theory explains why prices rose then fell sharply before and after the GFC as asset prices were reflecting investors expectations of capital gain, when over this period rental prices were similar. Investors sold when prices fell, they bought when prices rose, rental yield had little to do with the decision. This also explains why housing “booms” occur as investors respond to price action, if an asset increases in price then this makes it more appealing to invest if significant future capital gains are expected, so more investment drives demand which drives price up and so on until the asset becomes so overvalued that price then corrects. This is typical behavior of any asset “bubble” where price is dictated by speculation and not fundamental value (thus housing meets the technical definition of an asset bubble in this regard).

    Looking at what determines the maximum limit for asset price and rent is instructive, the price an investor is able to bid for an asset is based on the availability of credit (debt), given credit is dictated by interest rate burden and these are at historical lows then it is not surprising to see high prices currently as an investor can take on more credit (debt) as the cost to service this debt is currently very low. Compare this situation with the ability to pay rent which is dictated by income, as incomes have barely risen over 10 years then rents are capped by affordability.

    Put simply the price paid as rent is limited by income, the price paid to purchase is limited by the cost of debt and expectations of the future valuation of the asset. Income has been stagnant but debt has got cheaper hence rental prices rise more slowly than asset price.

    One must also look at who is buying, this is generally cash rich overseas investors and older (baby boomer) UK residents. They either can purchase an asset outright (and so have no debt to service), or if they do have debt have access to the lowest rates as the banks deem the credit risk low due to large deposit payments. So if you have an influx of cash rich investors looking for capital gains at a time of low interest rates and when asset prices are rising such that capital gains outstrip gains from rental yield, is it surprising that prices have dislocated from rental yields? I would say not.

    So is economic theory is not wrong? No its just the wrong bit of economic theory that is being taken as the base case to explain movements in asset (house) prices.

    As an aside it is interesting to note the other reason that credit is abundant is that the banks are knowingly taking large financial exposure to the risks of this asset price bubble (as a result of low interest rates). They are lending large sums of money for very low rates of return, at a time of high asset pries and for term periods of decades. Risk is simply not being adequately priced into this scenario (mortgage rates of 2% or less infer almost 0 probability of default). When interest rates rise, or a recession occurs (which is almost certain over the term of a mortgage which are decades) defaults will rise at a time that asset prices will fall (exactly what happened in the GFC). Either the banks are not pricing this risk in, or more likely, they are assuming that the risk will be once again be passed on to the government.

  6. Could it also be that rental yields have fallen in line with all other yields? Generic yield expectations lowered?. Also equivalent rental property acquired at all different times and at all different prices and landlords simply have not kept their rents up-to-date.

  7. It is not correct to say landlords have been unable to raise rents. According to your data rental costs have risen broadly in line with/ slightly above inflation over the period. Whereas the steep rise in Prime London prices is presumably a reflection of the fact that since 2008 these are a safe haven asset class for investors generally – regardless of whether those properties are then rented.

  8. The falling base rate means discounting future rents changes. So house prices have risen because mortgages are cheaper. You should be comparing mortgage costs with rent.

  9. I suggest a simpler explanation for the divergence between rents and house prices. The capitalised return from owning a house is the present value of the expected rents plus the present value of the capital appreciation. In equilibrium this must equal the market price of the house. Therefore a rise in expected capital appreciation will raise house prices with no change in rents.

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